Making Sense of Crypto Volatility

Masterworks
January 8, 2022

Cryptocurrency is one of the most buzzed-about alternative investments, a $2 trillion market drawing a lot of interest from investors and regulators alike.

There’s just one problem: out of all alternative investments, cryptocurrencies are notoriously volatile. And like other investments, that volatility doesn’t happen in a vacuum. It’s the product of several unique features of cryptocurrencies as an asset class and the market they occupy.

As an investor, an asset’s volatility plays straight into your potential payout. Here’s a look at why cryptocurrency is so volatile and whether it’s worth the investment risk.

What is Volatility?

In investing, volatility refers to the statistical measure of the dispersion of returns for a given asset or security. In more colloquial terms, it frequently refers to the amount of risk or uncertainty caused by fluctuations in the asset’s value.

Basically, the more volatile an asset, the less reliable your returns, and the riskier the investment.

This happens because higher asset volatility translates to a larger range of potential values that could be attached to the asset at any given time. Because the price can change dramatically, the value of the asset (and the returns you can gain from it) are highly uncertain. Conversely, a less volatile asset provides more steady value. This is measured in terms of variance and standard deviation from a mean price point.

Unfortunately, cryptocurrency is a notoriously volatile asset—in just one day, Bitcoin’s value plummeted 30%. For context, on Black Monday, the biggest one-day percentage drop in U.S. stock market history, saw a drop of 22% in a single day. In other words, it’s quite possible for cryptocurrency to experience catastrophic price drops—the asset class itself is more prone to them than many other assets.

Why is Cryptocurrency Volatile?

Cryptocurrency is volatile for several reasons, but the root of all of them is simple: uncertainty.

While proponents herald cryptocurrency as the future of money, the future of cryptocurrency itself is uncertain. Many investors don’t even understand how cryptocurrency has value, since most cryptocurrencies are not tied to any recognized national currency and no cryptocurrency is issued by any national bank. And while cryptocurrency holds potentially exciting prospects in a world where our lives remain highly digital due to COVID-19, it remains to be seen whether cryptocurrency can deliver on those promises.

We see this uncertainty because of several factors. Here’s a look at some of the big ones.

Emerging Markets

When you deal with fiat currency, you have established markets with decades of reputation and proven functionality. When you handle a U.S. dollar, for example, investors can easily establish what that currency is worth and the strength of the market.

As for cryptocurrency, that market is still taking shape.

After all, the total $2 trillion market value of cryptocurrencies is impressive until you remember that the U.S. stock market is worth an estimated $28 trillion. The total value of the cryptocurrency market is a mere drop in the bucket compared to the stock market—just the U.S. stock market, never mind the total value of other stock markets.

This is because unlike the larger stock market, cryptocurrency adoption is still in its infancy. And because the market is much smaller, smaller forces can have a much larger impact on the price.

Developing Technology

Granted, investor participation isn’t the only driver of cryptocurrency volatility. Another major driver is the fact that cryptocurrencies are a purely digital asset and the technology behind them is still in its infancy.

After all, it’s been a little over a decade since the idea of decentralized, digital-only currencies was first published in Bitcoin’s founding whitepaper, never mind the smaller number of years that have passed since cryptocurrency technology first became viable.

This also means that the technology required for cryptocurrency still faces major growing pains, like the blockchain scalability problem. And because the technology is so young, it’s hard to know where it will evolve in the coming decades—or if future technology will even continue to support cryptocurrency.

Speculation

This leads us headlong into speculation, one of the classic drivers of asset volatility.

Basically, cryptocurrency has value because investors agree that it should. And like other investments, this also means that how investors bet on the value of cryptocurrency changes the value of the asset itself. Their guesses directly play into the volatility of the whole cryptocurrency market.

In some cases, that volatility happens on purpose. The volatility of the market makes it attractive to speculative investors looking to capitalize on big market swings, which of course makes the market swings worse.

In short, we have a roller coaster ride of a market because investors are betting on that roller coaster ride hoping to make money on the highs.

Media

Of course, investors and professional traders have to get their information from somewhere. In many cases, the media is their go-to source. And because the cryptocurrency market is smaller than the stock market, the media’s influence is even more pronounced.

It works just like the regular stock market. As soon as market-moving news hits, investors race to buy or sell. But the market is smaller, and the impact is outsized—like that 30% drop in a single day of trading. Granted, cryptocurrency is now being tracked by more reliable news sources (especially compared to past reliance on social media) but the reality is that the market is still quite susceptible to uninformed media speculation.

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Masterworks
Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.