Bitcoin, the world's largest digital currency by market capitalisation, has generated great returns for some investors. The cryptocurrency's sharp gains have produced tales of so-called "Bitcoin Millionaires," individuals who got rich by investing in the digital currency and holding it long enough to generate significant wealth.
However, many have emphasized bitcoin's highly volatile nature. The digital currency has experienced sharp price fluctuations, a situation that undermines its ability to function as a currency.
Market analysts have pointed to numerous factors to explain why bitcoin is so volatile, and this article will detail several of those variables.
Investors interested in bitcoin should keep in mind that its market, as well as that for all digital currencies, is relatively small when compared to markets for more traditional assets such as stocks, bonds and fiat currencies.
The total market capitalisation (market cap) of bitcoin surpassed US$300 billion in December 2017, and the market cap of all digital currencies exceeded US$800 billion in early 2018. While these figures represent sharp increases in the space of a few years, they pale in comparison to the scope of more traditional asset markets.
The global stock market, for example, reached a total value of US$76.3 trillion roughly halfway through 2017, according to data provided by Bloomberg's World Exchange Market Capitalisation index. The value of the global bond market, on the other hand, exceeded US$125 trillion in late 2016, according to Bank for International Settlements data.
As for why this matters, small markets are more vulnerable to manipulation than large markets. Bitcoin's US$300 billion market value is aggregated from several exchanges. In other words, the total figure represents several different markets.
Broken down one by one, these markets—and especially the smaller ones—are vulnerable to fluctuations in supply and demand. Kerim Derhalli, CEO and founder of Invstr Ltd., said that even small changes to these key variables can have a significant influence on Bitcoin prices.
While these changes in supply and demand could be the result of factors like shifting market sentiment or investors reacting to news, they could also be caused by efforts to manipulate the market. All it takes is one major investor—or alternatively, a group of smaller investors working together—to create a sharp gain or loss in the value of a specific digital currency.
Several cryptocurrency exchanges have suffered so-called "flash crashes," which take place when the value of a particular asset falls sharply in a short period of time. Coinbase, one of the largest and most well-known exchanges, experienced one of these sharp declines in June 2017. During this event, the price of ether, one of the largest digital currencies by market capitalisation, fell from US$320 to US$0.10.
Later that year, Bitfinex, another major exchange, encountered a similar situation where three different digital currencies saw their prices fall up to 90% in a matter of minutes. As the price of these digital assets plunged, the exchange automatically closed out many leveraged wagers placed by traders.
Numerous analysts have asserted that bitcoin suffers from liquidity problems, which could in turn be contributing to bitcoin's sharp volatility. Having less liquidity—instead of more—can potentially exacerbate price fluctuations, making it so that the digital currency's inevitable declines are more severe than they would be otherwise.
Cedric Jeanson, founder and CEO of BitSpread, commented on the situation by stating that bitcoin's "high volatility is due to the low liquidity we have on exchanges today." He stated that exchanges can potentially address this problem by having more market makers get involved.
Regulation is another area potentially contributing to bitcoin's intense volatility. The first bitcoins came in to existence in 2009. Since then, several governments have made efforts to regulate bitcoin, along with other digital currencies.
For example, the U.S. Commodity Futures Trading Commission (CFTC) announced in 2015 that bitcoin and other digital currencies were commodities, and therefore the government agency could regulate them. The organisation said in a statement that the "CFTC holds that bitcoin and other virtual currencies are a commodity covered by the commodity exchange act."
China's government has taken a far more aggressive approach, cracking down on domestic exchanges in September 2017 and forcing them to shut down. The nation's government also banned initial coin offerings (ICOs), which are offerings of digital tokens.
In January 2018, South Korean government officials also cracked down on digital currency trading, announcing that individuals would no longer be able to make such transactions anonymously. The nation's government announced that as of 30 January, individuals would not be able to make trades through South Korean exchanges unless the name they gave to their exchange was the same as the one on their bank account.
While many governments have made efforts to develop regulations for bitcoin and other digital currencies, lawmakers and regulators have not yet worked together to create regulation that spans many nations.
One major factor that can fuel volatility in bitcoin prices is news events. When news is positive, it can spur investor interest and cause market participants to buy bitcoin, pushing its price higher. A perfect example is when news broke that major exchange Coinbase added 100,000 users in a single day after exchange operator CME Group Inc. announced in November 2017 that it planned to add bitcoin futures that year.
Another great example came later that same month when it was revealed that, as of October 2017, the number of Coinbase users exceeded the number of active brokerage accounts at major financial services firm The Charles Schwab Corporation.
Media outlets have also published plenty of negative news surrounding bitcoin. In August 2016, nearly 120,000 units of bitcoin went missing from Bitfinex. At the time, this amount was valued at roughly US$72 million, making it the second-largest bitcoin theft after the Mt. Gox debacle. The same day this news was announced, bitcoin's price quickly dropped more than 20%.
Another major cause of bitcoin's volatility is shifting sentiment. Major news events, for example, can have a significant impact on the views of market participants, causing them to become more or less optimistic about bitcoin and its future prospects.
If the sentiment surrounding bitcoin becomes more positive, this can result in sharp increases in demand and notable upswings in price. Further, price gains and optimism can combine to form media hype cycles. Basically, these take place when climbing values provoke greater media coverage, which in turn spur additional purchases and price appreciation.
Changes in sentiment can have the exact opposite effect on price. If an asset bubble bursts, and investors start fleeing an asset like bitcoin, the plunging prices can prompt widespread media coverage, causing even more market participants to either sell the asset or simply avoid purchasing it.
Inequality of Wealth
Another factor that could potentially fuel bitcoin's price volatility is how unevenly it is distributed. In late 2017, Aaron Brown, who previously served as managing director and head of financial markets research for investment manager AQR Capital Management, estimated that 1,000 individuals owned approximately 40% of all bitcoin.
Other sources have provided different figures, with data from BitinfoCharts showing that in late 2017, the top 10 largest bitcoin wallets held roughly 10% of the currency. The same source showed the top 1,000 wallets holding roughly one-third of all bitcoin.
If a single individual amasses a sizable amount of bitcoin, he or she can trigger substantial price fluctuations by selling just a fraction of his or her bitcoin holdings. Also, these individuals could potentially coordinate and work together to cause sizable shifts in bitcoin prices.
Key Role of Speculation
Many market observers have emphasized the key role that speculation plays in bitcoin's price fluctuations.
Philip Lowe, governor of the Reserve Bank of Australia, offered his two cents on bitcoin, asserting that it is not a very efficient payment method while warning that the digital currency may be influenced a bit too much by hype.
"When thought of purely as a payment instrument, it seems more likely to be attractive to those who want to make transactions in the black or illegal economy, rather than everyday transactions," he stated in December 2017. "So the current fascination with these currencies feels more like a speculative mania than it has to do with their use as an efficient and convenient form of electronic payment."
Dave Chapman, managing director of Octagon Strategy, an over-the-counter trading desk, offered a similar assessment when explaining why bitcoin had risen more than 1,000% in 2017: "There is admittedly a lot of speculation in this market." Investors were driven by fear of missing out, also known as FOMO.
There are many different factors that help fuel volatility in bitcoin. Variables including the digital currency's small market size, low liquidity and immature regulatory environment can all help contribute to bitcoin's sharp price fluctuations.
As a result, investors who are interested in the digital currency may benefit significantly from conducting thorough due diligence before getting involved.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…