Why do cryptocurrencies fluctuate?

The cryptocurrency market is notoriously fluid. It has demonstrated the capacity to gain as much as $13 billion dollars in the space of an hour.

 

Compared to other currencies and even the stock market, this capacity for rapid and extreme change is unusual. Many experienced investors have hesitated to get into the cryptocurrency market because they lack an understanding of the market forces that create this fluidity and what to expect from the market as a result.

There are many reasons for cryptocurrencies’ violent price fluctuations. These include a limited user base, variable public perception, reactionary investment practices and inconsistent government attitudes toward taxation. Many of these factors will be familiar to consumers who have invested in the stock market. Others, such as the changing taxation rules, may be entirely new. Taking the time to understand how these influences act on the cryptocurrency market independently and in combination can prepare consumers to make the best possible decisions when investing in digital currencies.

Limited User Base

Recent developments in the cryptocurrency market have made significant strides toward making digital currencies easier and more practical to use in daily life. As these new technologies become more common, the number of consumers entering the cryptocurrency market will continue to grow. For the moment, however, digital currencies remain a relatively small portion of the global financial market as a whole. Some investors may incorporate this knowledge into their cryptocurrency investment strategies.

As in any market, the lower the total number of asset holders, the greater the impact each asset holder has. For example, imagine that there are 20,000 units of a particular digital currency in circulation. If all of those units are owned by a total of 100 people, then each consumer will hold, on average, 200 units. If those units are held by a total of 500 individual consumers, then, on the other hand, each consumer will hold only 40 units each. Now imagine that one investor wishes to “cash out” his or her units for some reason. Cashing out 200 units of a currency at once will have a drastically larger impact on unit availability and price than cashing out only 40 units.

Even investors who are not cashing out but simply using cryptocurrency as a way to transfer large sums of money across borders and from one fiat currency to another can inadvertently cause noticeable market fluctuations if their transactions monopolize a large portion of available tokens. Until cryptocurrencies gain widespread acceptance and user rates rise enough to spread currencies more thinly among users, the individual users’ actions will continue to have unnecessarily high and potentially unsettling impacts on the market as a whole.

Public Perception

Although cryptocurrencies often function as substitutes for fiat currencies, their values are not fixed by government oversight agencies. Where the Federal Reserve, the Treasury and other federal agencies regularly take action to control the value of the dollar, for instance, no such external manipulation is applied to cryptocurrencies.

As a result, the cryptocurrency market fluctuates strongly with changes in the public’s perception of both the digital currency market in particular and larger economic trends more generally. Like the stock market, cryptocurrencies often take a sharp hit when the consumers find reasons to be pessimistic about the economy or their own financial stability. Likewise, the digital currency market routinely experiences upswings in line with stocks when consumers feel positive about current financial trends.

Regular attacks on cryptocurrencies in the media by regulatory agencies and traditional financial institutions routinely expose potential investors to negative ideas about digital currencies. Almost as regularly, the release of a new cryptocurrency or related innovation captures the public’s imagination and interest. These cycles of conflicting media coverages further contribute to the market’s instability.

Digital currencies can also be affected by public perceptions of the stability and value of national fiat currencies. As investors’ trust in default fiat currencies wanes, they become more likely to invest in alternatives such as cryptocurrencies. It is not only the fiat currency of investors’ own nations that count, in this respect. The cross-border applicability of cryptocurrencies has led many individuals and businesses to look to digital currencies as a mediator for loans and other financial tools when a nation’s currency is experiencing high inflation.

 

Reactionary Investment Practices

Cryptocurrency investments are not completely immune from loss. Computer systems can fail, hackers can attack and fraudulent activity can rob consumers of their investments. Inevitably, these events receive high-profile news attention. Alarmed investors who did not appropriately prepare for or guard against these types of events often react swiftly and with outsized panic. They may sell all of their tokens or pull them all out of circulation into offline “cold storage” to protect their assets. Both the dumping and pulling off the market of digital currency tokens strongly and immediately impacts supply, demand and the pricing of tokens.

These behaviors and their impacts on the market are not new. They have been part of the expected dynamics of stock markets for decades. Most investors who work with a financial advisor are warned about these possibilities in advance and coached to “stay the course” when unexpected events take place. Few cryptocurrency investors receive the same market-balancing advice. This leads to increased reactionary practices and larger ups and downs in the market in response to noteworthy events.

Inconsistent Taxation Rules

State and federal level rules on how cryptocurrencies are taxed vary wildly. Some cryptocurrencies are classified as money for tax purposes, while others are deemed “property.” This seemingly minor differentiation has potentially enormous repercussions for consumers’ year-end accounting and tax rates. Ever-shifting tax rules related to cryptocurrencies can drive consumers to make drastic changes to their holdings on short notice as they try to remain in compliance with local laws or try to avoid massive taxes when laws change. Uncertainties about where they stand on the subject can also contribute to negative perceptions and anxiety about cryptocurrencies. These attitudes directly feed into reactionary investment decisions, which can prompt market fluctuations.

Announcements from government agencies and news media about potential regulation and governmental interference in the digital currency market may spark sell-offs as consumers attempt to protect their holdings from seizure or loss.

 

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