In 2021, the crypto market experienced a bull run as a result of increased crypto participation during and after the Covid-19 pandemic. But in 2022, the market lost over $2 trillion (with Bitcoin losing more than 60% of its value).
For years, crypto volatility has been a concern among investors. While you can 10× your investment in a short time, you also risk losing your account by a single market move.
What factors drive crypto volatility? And can we predict how the market will react to these factors?
- Demand and supply is a key factor in determining the price of cryptocurrencies
- Governments cannot control cryptocurrencies but they can influence citizens’ decisions about holding the asset.
- In the long run, crypto regulation will ensure transparency in the market; increasing crypto adoption and price.
- Increased institutional investments will provide a stabilizing force for cryptocurrencies but it is unlikely to permanently solve the volatility concerns.
You will find our beginner’s guide to cryptocurrency helpful if you are new to the crypto space.
1). Market Sentiment
Also called investors’ sentiment, market sentiment is the overall attitude of investors and traders towards an asset or the general market. This can be based on the crypto’s fundamentals (tokenomics, utility, project, vision, or background of the team). Other times, the market sentiment may be from economic reports, world events, or even social media hype.
Positive market sentiment is not always followed by a sustained bullish period. For instance, Dogecoin’s price was flat for seven years (December 2013-December 2020) but leaped in January 2021 following a series of tweets by Tesla CEO, Elon Musk. However, by May 2021, the coin was down 29.5%.
Another example is the Wakanda Inu token whose demand in 2021 rose among the African community because of its cultural appraisal.
How does market sentiment affect the crypto price?
When demand exceeds supply, prices tend to rise and fall when the supply exceeds demand. Positive sentiment towards a crypto project will increase the demand for the coin leading to rising in price. The reverse applies to negative sentiment.
2). Economic and Political Events and Policies
The price of cryptocurrency is impacted by the economy of nearly all countries of the world. Inflation, economic expansion, recession, and unemployment drive the volatility of crypto prices.
Inflation is a state where too much money is chasing a few goods. This leads to a continuous rise in the price of goods and services. Inflation decreases the purchasing power of the fiat currency, resulting in a weaker currency. For instance, if in the Year 2000, ten shirts cost 200 Naira and in 2022 the cost climbed to 500 Naira, with 1000 naira, you could have brought 50 shirts in the year 2000 as opposed to 20 shirts in the Year 2022. The value of the fiat currency (in this case ) has dropped.
During inflation, people seek a better store of value. This is where assets like crypto and gold come in. Cryptocurrencies have fixed supplies with specific schedules on release. Bitcoin for instance has a fixed supply of 21 million BTC and its mining reward is halved every 4 years. There is no chance of having excessive BTC in circulation (leading to a drop in price).
Cryptocurrencies are counter-inflationary assets, an increase in demand leads to an increase in value and price.
Economic expansion and recession
During periods of economic expansion, people are more willing to invest. This increases the demand for assets like crypto and hence its price.
On the contrary, in recessions where there is a decline in economic activity, people spend on essential commodities and ignore investing. This leads to a decrease in demand for crypto.
To scrub inflation, the Government increases interest rates making it expensive and difficult for people to borrow money. This reduces the amount of money in circulation. With high-interest rates, investors are less interested in investing in high-risk assets (like crypto) since they can earn a good wage by saving their money in an interest account. Decreasing demand for crypto and increasing withdrawals decreases its price.
3). Regulatory Changes
Cryptocurrencies were created to exist outside third-party interference. Bitcoin, the first cryptocurrency, was designed as a payment solution that allows people to transact directly without a trusted third party. As more people began interacting with digital assets and more crypto was developed, the need for crypto exchanges (providing convenient access to cryptocurrencies) rose.
Crypto regulation protects crypto participants from poor governance and malpractice of third-party institutions in the crypto space and ensures that investors are fairly treated ( even in cases of a hack).
Although it does not reduce investment risk, in the long run, regulation will ensure transparency in the crypto industry and improve crypto adoption.
How does the crypto market react to regulations?
The crypto market reacts in either direction depending on the type of regulation. For instance, in August 2017, there were reports of North Korean hackers targeting South Korean Bitcoin exchanges. By the beginning of September, news broke that South Korea was planning to impose stricter regulations on digital currencies. By December, more speculations rose that South Korea will be banning all cryptocurrency exchanges. In response, Bitcoin dropped 11% ($2,000) in value by January 2018.
4). Security breaches and hacks
Between 2011 to 2021, over 29 hacks occurred in the Bitcoin market with 1.7 million Bitcoin stolen. With the average price of BTC exceeding $20,000, this loss amounts to more than $22 billion. In 2022 alone, $3.8 billion of crypto was stolen through hacks. To reduce this, crypto investors are advised to store private keys offline. But how do hacks affect crypto prices?
Klaus Grobys, a professor of financial economics analyzed how volatility responds to hacking in the Bitcoin market. He found two effects in play: contemporaneous effect (where volatility and hacking occurred simultaneously) and delayed effect (where the volatility occurred some period after the hacking).
Bitcoin’s volatility increased on the day of the hacking and dropped to normal levels with no effect seen between day one and day four. On the fifth day after the hacking, volatility rose again. He also noticed that other cryptocurrencies respond to the hack, but only in delayed effect.
5). Media coverage and hype
In a 2014 study that analyzed the link between media attention and the value of cryptocurrencies, the result indicated that a 1% increase in the number of articles mentioning Bitcoin rose BTC returns by 30 basis points and a 1% increase in Bitcoin Google search rose its returns by 50 basis points.
Social media sentiment and hype can move crypto prices in either direction. It is an important predictor of crypto valuation but not all social media messages have an equal impact.
In July 2020, the DOGE price rose as a result of Dogecoin-pumping TikTok videos that were trending at the time.
In February 2021, Tesla and its founder, Elon Musk announced that they bought $1.5 billion worth of BTC and the company would start accepting payments in bitcoin. Following this statement, BTC broke its all-time high of $44,000. Two months after, Tesla reversed its decision to accept payments in Bitcoin stating environmental concerns about its heavy energy use. This dipped BTC’s price by 15%.
A few days later, in response to a tweet, Elon Musk said Tesla would sell its crypto holdings or may have already done so. This pushed the BTC price to its lowest level since February 2021. Between May and June 2021, Elon Musk tweeted that Tesla only sold 10% of its holding and will resume accepting the crypto once there is confirmation of 50% clean energy usage by miners.
6). Availability of exchange and liquidity
Liquidity is a measure of how easy it is to exchange an asset for another asset or a fiat currency without causing a significant impact on price.
Cryptocurrencies that are listed on exchanges are considered more liquid than those that are not because there is a ready pool of traders willing to exchange the asset.
Liquid crypto is stable and less prone to price manipulation. Since there are sufficient traders ready to exchange the asset, a single trader or group of traders cannot manipulate the price for their profit. The lack of market participation in an illiquid market leads to volatility, long waiting periods, and slippage. Slippage occurs when the amount the buyer is willing to pay is significantly less than the seller’s asking price.
7). Investment and trading by institutional investors
Institution traders are financial organizations made up of professional traders that trade/invest on behalf of other people. Examples include private equity firms, pension fund managers, and mutual fund managers.
In the first decade of existence, cryptocurrencies were dismissed by institutions, however, this narrative is changing. In the 2021 study conducted by Fidelity Digital Asset, 7 in 10 institutional investors expect to invest in crypto assets soon and more than half of its 1,100 respondents revealed that they already own crypto investments.
The increased institutional investment will provide a stabilizing force for cryptocurrencies although it is unlikely to drive volatility completely. For instance, if crypto is underpriced, institutions can use their large orders to drive the price up and do the same when assets are overpriced.
Also, the institutional investors will increase trading volume which attracts more investors, hence increasing liquidity for the market.
8). Development and implementation of blockchain technologies
The development and introduction of blockchain technology like the metaverse, NFT, DeFi, Dapps, and Decentralized exchanges have increased crypto participation; 12 million people attended the 2020 Travis Scott in-game virtual concert held on the metaverse.
Implementation of blockchain technology increases the likelihood of widespread adoption. For instance, the metaverse and crypto are concepts that co-exist. Transactions in the metaverse can only be carried via digital currencies.
Advancements in blockchain technology will also lead to a spike in crypto prices. After Facebook rebranding announcement, MANA token, SAND, and Enjin coins saw 44.6%, 21.5%, and 10.8% pump in price respectively. Also, the AXS coin had a 24-hour gain of 7.8%.
9). Adoption and Usage
Crypto adoption is not a matter of if it will happen but when it will happen. As of 2023, global crypto ownership sits at 420 million (a 190% increase between 2018 to 2020). Over 22 million people own cryptocurrency in Nigeria (this is 10.3% of the population). In 2021, Nigeria witnessed a 2,467.2% spike in the number of users.
An increase in crypto adoption increases the demand for digital assets and their price. The 2021 crypto bull run resulted from an increase in crypto participation after the Covid-19 pandemic and adoption by Governments and institutions.
10). Competition from other cryptocurrencies
In the competition among cryptocurrencies, network effects play an important role. A positive network effect occurs when the value of crypto increases with the number of users.
Cryptocurrency gains more value (and price increases) as more people use it. In 2014, Litecoin was the second largest crypto after Bitcoin. But as more people began engaging with Ethereum (launched in 2015), its value grew and is currently the second largest crypto.
Network effect results in winner-take-all dynamics and convergence to a dominant player. Altcoins move in sync with Bitcoin’s price. This is because apart from being the first cryptocurrency, Bitcoin is responsible for over half of the entire crypto market cap.
The underlying concept of these factors is how they affect crypto demand and supply. If a regulation, market sentiment, economic events, or a new blockchain technology increases crypto demand, then we can expect a bullish response from the market.
But if the Government bans cryptocurrencies or their exchanges, negative media hype trends, or hackers disrupt a crypto’s underlying technology; stealing crypto from wallets or increasing the minting supply, the crypto price will drop.
This is not financial advice. All information on this website is for educational and entertainment purposes only.
Emmanuella Elenbalu is the Content Manager at Coinsem. She is passionate about cryptocurrency, investment, and learning new things.
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