Why is the Cryptocurrency Market so Volatile and Irrational, and When Will it Improve?

One of the largest reasons that cryptocurrencies like Bitcoin cannot achieve their goal of being a true hedge against the dollar and achieve currency status is due to their volatility. Since their inception, the cryptocurrency market has been incredibly volatile and irrational, as proven by Dogecoin’s rise to the top 3 and Elon Musk’s tweets causing pumps and dumps. This irrationality is mainly due to the nascency of cryptocurrencies and will be solved as the market matures and becomes more regulated.

One of the most important characteristics of a currency is its stability. If everyone woke up one day with significantly more or less purchasing power than they had the day before, it would be nearly impossible to fairly transact with others. Even though this lowering of purchasing power does happen with government-backed currencies such as the U.S. dollar, the rate of inflation is fairly predictable and low, so that a millionaire may only wake up with a dollar or so less purchasing power than the day before.

Bitcoin, whose goal is to be the world’s reserve currency, experiences extreme price volatility. A move of 5–10% in a day, which would be unheard of in the S&P 500 or NASDAQ, is commonplace in crypto and leads to massive gains and losses happening seemingly overnight. As a result, having all of one’s wealth in cryptocurrency proves to be risky, as the chance of waking up 10% more poor is a real concern. If a shop accepted Bitcoin, they would have to change their prices multiple times a day to remain competitive and keep making a profit.

Alongside this large volatility comes the sheer irrationality of the market. Currently, Dogecoin, one of the most irrational and economically unsound cryptocurrencies on the market, has a valuation of over $50 billion. Similarly, a tweet from Elon Musk on May 12 stating that Tesla would not be moving their Bitcoin until it became more environmentally friendly led to over $200 billion of value leaving the cryptocurrency space. This is over 10 times the amount of Bitcoin that Tesla holds, and billions more than Musk’s total net worth. Why does a market, which is supposed to be economically efficient and rational, act in such irrational ways?

One of the most obvious reasons is the speculation and nascency of the cryptocurrency market. Bitcoin has only been around for about 12 years, and only viewed as a serious asset for less than half of that time, so it would make sense that the asset is still in its price discovery phase. Unlike stocks, which have been around for hundreds of years and have concrete value based on them giving the holder rights to the future profits of a company, there is no such measure in Bitcoin. It’s more similar to gold, which has been used as a medium of exchange for almost the entirety of human history and still experiences price volatility and speculation. As time goes on and the cryptocurrency market matures, the price will begin to become more stable and universally agreed upon. This maturation will come as more people begin to hold cryptocurrency, use it as a medium of exchange, and generally understand its value.

Another driving factor in reducing the volatility of the market will be regulation by world governments. In the traditional stock market, people who hold lots of stock are usually subject to regulation about when they can sell and the public reporting of these sales. However, in the cryptocurrency market, anyone can sell at any time without any sort of legal repercussions, meaning that the whale who holds 28% of the Dogecoin supply could sell everything they own and crash the price without any consequences. Similarly, large companies or influential individuals have no rules about what they can or cannot say or do related to cryptocurrencies. For example, J.P. Morgan could buy lots of Bitcoin, announce Bitcoin-positive news, then dump the Bitcoin on unsuspecting investors. Studies have shown that similar price manipulation is what brought Bitcoin to its high of $20,000 in late 2017.

This manipulation is also evident in the price action after tweets by Elon Musk. He is one of the main reasons that Dogecoin has reached such a monumental valuation, as he frequently Tweets about the coin to his millions of followers. Unsuspecting retail investors, assuming that Musk knows what he is talking about and truly believes that DOGE will dethrone Bitcoin, buy the coin, leading to a massive pump. It is more likely that he is simply being ironic or satirical, and his followers are not picking up on it. Musk has gotten in trouble with the Securities and Exchange Commission for tweeting about Tesla’s stock before, but in the cryptocurrency world, this type of manipulation is completely legal, and causes irrational increases and decreases across the market.

As cryptocurrencies become more prevalent in our society, governments will have no choice but to regulate them to protect investors. When this happens, lots of the scams and manipulation taking place behind the scenes will disappear, and massive pump and dump schemes will stop taking place. Furthermore, the volatility of cryptocurrencies will also decrease, as regulation will cause less speculation about government actions towards crypto, and it will achieve a similar status to gold.

Even though regulation seems like the natural enemy of the cryptocurrency market, it will ultimately cause less speculation and manipulation, but may cause crypto to stop making millionaire investors overnight. A difficult tradeoff, but a necessary one for cryptocurrencies to become a staple of our modern financial world.

By Lincoln Murr