The Crypto Seesaw
If you have been following along with the evolution of Bitcoin and cryptocurrency you have noticed wild swings enough to make any investor sweat. Price fluctuations exceeding 10% per day are not uncommon. Bitcoin, considered to be the crypto-mothership, is often viewed as a more stable coin. However, it has increased over 1,900% in 2017 and fell over 70% during the first few months of 2018.
Traditional assets such as stocks, bonds, and real-estate, experienced incredibly low volatility over that same time period. Throughout 2017, the volatility index (vix) on the S&P 500 averaged just 11.09, while the daily average from 1990 – 2018 has been around 19. When comparing the crypto markets to traditional assets what specific differences are causing this extreme volatility?
Discovering the Value of Cryptocurrencies
Traditional investors often try to apply the same principles of valuation to cryptocurrency as they do to other investments. At the base level, the most glaring difference between a cryptocurrency and a stock (equity), is the equity. When you own a stock, you own part of the underlying company, which hopefully is generating profits and paying dividends.
Most equity valuation methods involve fundamentals such as cash flow, profit margins, revenue, dividends, etc. When it comes to valuing cryptocurrency, it is hard to apply these same principles.
When you own a cryptocurrency, you most often own access to a network or a platform. For example, owning Bitcoin gives you the ability to use the Bitcoin network to transact value with other wallet holders. Other coins and tokens may give you access and benefits within a platform. This could be a gaming platform, a trading platform, a storage platform, or any other platform where users could be incentivized to use the platform or network.
Some investors would argue that there is no fundamental or intrinsic value within cryptocurrency. There is no product or tangible good to fall back on in the event of a failure or dramatic price decline. During the dot com collapse many companies failed as they lacked working products, while Microsoft and others survived as their products had relevant real-world use cases.
So how do you apply valuation principles to a still immature market where there are relatively no fundamental to base valuation on? What does this have to do with volatility? This is part of what market participants are trying to figure out and one of the reasons why prices are fluctuating so dramatically. Blockchain powered cryptocurrency and applications are relatively new technologies and real-world applications are still being developed. The market is working to discover the true value of this technology.
New School Fundamentals
How do you value a cryptocurrency? In addition to the value real world application and mass adoption will create, market participants are working to determine the fundamentals of cryptocurrencies and blockchain applications. Investors are using metrics such as:
- Coin supply
- Inflation or deflation rates
- Number of participants (wallet holders)
- Number of nodes in the network
- Number of transactions over time
- Utility (use cases) of the coin or token
- Company/team/ organization behind the coin
These metrics could be considered to be some of the fundamentals of cryptocurrency and investors are using these metrics when it comes to selecting coins. As the market matures and becomes more efficient, price discovery will take place and volatility may decrease. For now, hold on as participants attempt to figure out what this tech means!
While the fundamentals of cryptocurrency and blockchain technology are still being discovered, there are other factors contributing to the volatility of the crypto markets. Not all of these factors are positive for participants.
Market manipulation is thought to run rampant within cryptocurrencies. The anonymous nature of cryptocurrencies and decentralized trading platforms makes it attractive for pump and dumps.
Some platforms and cryptocurrencies have been outright scams. Other projects simply fail to deliver due to unforeseen circumstances causing abandoned coins with little or no trading volume.
A Young Market
Perhaps the largest variable contributing to the volatility of the crypto markets is the markets maturity level. Cryptocurrency markets are very new. While more and more participants are entering the markets daily, the number of participants in the crypto markets still pales in comparison to traditional markets. While 60% of Americans have heard of Bitcoin, less than 5% have actually transacted in the cryptocurrency. This number is less than 1% when applied to altcoins. Compare this to over 50% of the population that is invested in traditional assets such as stocks and bonds.
Markets that contain a lower number of participants tend to be more volatile. Spreads between buyers and sellers remain high in illiquid coins. This is one of the reasons why we often see smaller altcoins fluctuating much more than Bitcoin and the major cryptocurrencies. Even small orders have the power to move the market more than just a few percentage points.
As more participants enter the crypto markets, spreads may tighten and lead to a decline in overall volatility. However, as long as there are markets with few participants, it can be expected that volatility will remain as coins come and go.
The ups and downs of the crypto market can be a deterrent for some and to others. Factors such as low number of participants, large spreads, unknown use cases, unfamiliar fundamentals, and undesirable activities all play into the extreme volatility of crypto markets. As the market matures and participation increases volatility may decline to levels familiar to traditional asset classes. For now, the crypto seesaw continues as investors work to determine how cryptocurrencies fit into their portfolios.