Everyone knows that if something is volatile it may be unstable or manic. Volatility is often synonymous with uncertainty, chaos, terror, and bloodshed! That last bit may have strayed into hyperbole, but the cryptocurrency market is notorious for inspiring headlines about its wild west mentality. Speculators hit it big overnight – and lose it all just as quickly.
With regard to investing in crypto, Coyle CEO Gary Klaben has written about this in the past, but know that there are some key components to the crypto market that separate it from the traditional equity market which cause those erratic peaks and valleys.
1) The Market Is Brand New
The New York Stock Exchange was founded in 1792. The very first marketplace to exchange cryptocurrency was founded in 2010. It was called Bitcoin Market because Bitcoin was the only cryptocurrency around. A buyer would simply send the seller cash via PayPal in exchange for coins. Bitcoin Market would hold the coins in escrow until the seller received the cash[1]. That’s it.
It wasn’t until a year later, 2011, that alternative coins were even introduced. The market as a whole is still discovering how to value itself, both as an asset and as something tradeable in a robust market.
A comparable could be Initial Public Offerings (IPOs). IPOs also do not have any trading history, deriving value based on other metrics: earnings, cash flow, tangible assets, etc. – things found on a balance sheet. There is even a phrase for the value assigned after future cash flows can be estimated: Terminal Value[2]. The value of cryptocurrencies as a whole is still unclear. There is no terminal value. Without anything for a basis, the cloudy future becomes an opaque unknown.
In fact, comparing the crypto market against the stock market might be foolish because…
2) Cryptos Aren’t Stocks or Currency – They’re Commodities
In a paper titled Long- and Short-Term Cryptocurrency Volatility Components: A GARCH-MIDAS Analysis[3], it was found that volatility, specifically for Bitcoin, the coin with the most data available, decreases during periods of higher or higher-than-expected volatility in the U.S. stock market.
News outlets will often lump the stock market and crypto market together. They shouldn’t. Virtual currencies have been classified as a commodity by the Commodity Futures Trading Commission[4] – which makes sense, really.
Both are affected by environmental concerns, albeit in different ways – there is a big concern about the environmental impact of mining some cryptocurrencies.
Both derive part of their value from supply and demand – some cryptocurrencies have a cap on how many coins can be mined, others are infinite. Scarcity creates value in the market and can also be a quick metric of how high a ceiling, growth wise, a coin has by calculating the market capitalization (number of coins outstanding, multiplied by current price) versus the number of coins that can be mined. Coins with unlimited mining potential have a lower ceiling.
Both have footings in decentralized and centralized markets – the entire point of cryptocurrency was…
3) A Designed Lack of Regulation/Centralization
The NASDAQ and NYSE are heavily regulated. Companies listed on those exchanges have to adhere to strict reporting requirements in order to be traded. As mentioned above, the entire design around cryptocurrencies is an open, decentralized alternative to the current financial system. Yes, some of the markets where cryptos are traded are regulated. Not so for the creation of coins. No central bank or authority can stop someone with the right technical knowhow from creating a cryptocurrency and then having it listed on an exchange.
In addition to that, cryptocurrency exchanges do not use the same 7%, 13%, 20% circuit breakers which halt trading when stocks are plummeting[5]. Coins that gain momentum have nothing stopping them from shooting in either direction. A lot of that can be caused because there is a…
4) Higher Reaction to Investor Emotion
With no balance sheets, no terminal value, and nothing physical to hold like a big beautiful brick of gold, the crypto market is heavily affected by how investors feel at any given time.
News can become a snowballing effect. Positive buzz can send a coin soaring, but negative stories create a crash. Even a sliver of bad news, legitimate or not, can be the match that lights the fuse of significant volatility with no way of stopping itself, until it has run its course.
Picture walking up to a door and smelling smoke. There’s no smoke billowing from under the door, and the doorknob isn’t hot. Maybe there’s a fire, maybe somebody left a batch of cookies in the oven too long, maybe it’s nothing at all.
Then a stranger bursts out of the door and sprints down the hall, out of sight.
Is there a fire? Not sure. Could be. But there are no flames. Is there a reason to panic? Maybe it was just those cookies. That person sure did leave in a hurry. There has to be a reason. Better get out of here, quick!
Why are so many investors in the crypto market so quick to cut and run even if they aren’t sure of what they’re seeing? Perhaps because…
5) Average Investors Are Younger and More Inexperienced
A study conducted by the University of Chicago found the average age of a crypto investor is 38 years old. Average stock investors are 47 years old.
Just like brokerage firms offering zero-dollar commission trades, the barrier to entry for the crypto market is low. That’s great for the individual investor who doesn’t have tons of capital. It also means the market as a whole is less experienced. In periods of extreme volatility, the more seasoned investor may keep a level head whereas others could quickly panic and sell.
Bonus) Alright. Alright! It’s Time to Talk About Elon Musk
It would be irresponsible not to mention the unparalleled effect that Tesla CEO Elon Musk has on the crypto market. Musk’s opinions on cryptocurrency have propelled coins to rise, propelled coins to crash, and propelled the Shiba Inu to become the new chic dog breed.
Bitcoin prices have moved as much as 15% after a Musk tweet. Dogecoin increased 30% in May after Musk tweeted about it. With Bitcoin being the predominant driver of the crypto market, as it goes so does most everything else[6]. This means that all these factors are meaningless if one person can tank an entire market with the push of a button.
That type of volatility is truly difficult to measure.
Joe
Joe has a degree in Finance from the University of Illinois at Chicago. Afterwards, he worked for Morgan Stanley and Bank of America/Merrill Lynch, obtaining both Series 7 and 66 licenses. At Merrill, he was on the self-directed side of the business, exposing himself to every aspect of the financial services industry.
[1] https://www.gemini.com/cryptopedia/crypto-exchanges-early-mt-gox-hack#section-more-bitcoin-exchanges-hit-the-scene
[2] https://www.investopedia.com/terms/t/terminalvalue.asp
[3] Conrad, C 2018 ‘Long- and Short-Term Cryptocurrency Volatility Components: A GARCH-MIDAS Analysis’ Journal of Risk and Financial Management. vol. 11, issue 2, 1-12
[4] https://www.cftc.gov/digitalassets/index.htm
[5] https://www.nyse.com/network/article/nyse-increases-resiliancy-during-extreme-volatility
[6] https://www.vox.com/recode/2021/5/18/22441831/elon-musk-bitcoin-dogecoin-crypto-prices-tesla
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