Why are Cryptocurrencies volatile?
Bitcoin, the most popular cryptocurrency, is not yet recognized as legal currency by any government. However, any person can buy, hold or sell and even trade cryptocurrencies, subject to rules and regulations in their countries. Buying cryptocurrencies is similar to buying stocks – Investors can purchase bitcoins through cryptocurrency exchanges and store them in their digital wallets like we store equity shares in Demat accounts. When bitcoin was launched in 2009 it had no official price since it wasn’t being traded. However, when the first exchanges began to appear, a price developed. From just a few cents in 2009, bitcoin was priced at USD 1,000 by end of 2013. The prices of cryptocurrencies are tracked by ‘Cryptocurrency Exchanges’ who take an average of prices by other exchanges and the results of trading activity on their platform. This is the reason why, the prices of cryptocurrencies on different platforms at the same point of time differ slightly similar to equity markets where we experience different prices of the same stock on NSE, BSE and other exchanges.
One of the most important aspects of ‘Bitcoin’ in particular is that the supply of bitcoin is restricted to 21 million. This supply unlike fiat currency cannot be increased by printing notes or mining in this case. With the limited supply, the number of transactions and trades that occur with cryptocurrencies are limited, as compared to equity stocks and foreign currencies. If you are an equity investor, you would have noticed small-cap shares often go into one direction and hit the circuit for back to back days. Such phenomenon is rarely seen in the case of mid to large-cap stocks, except when exceptional news or rumour spreads because the volume of trades in such shares is high – i.e. a large number of buyers exist and at the same time, a large number of sellers willing to sell, which is not the case with small-cap stocks.
Cryptocurrencies are currently similar to small-cap stocks, as the volume of trades is low. When the volume of transactions is high, it is difficult for one person to sway the market, however, with lower volumes it is easier. Besides, news and rumours surrounding cryptocurrencies are high, especially about their regulation and legality across the world. There are situations of panic selling and elated buying when the cryptocurrency markets go frenzy over speculations or even tweets by business celebrities, in support or against the cryptocurrencies. There is no regulator, no upper circuit or lower circuit rules, no central authority keeping details or KYC of people buying and selling. Although exchanges are proactively keeping details of their traders, however, this is only the case with new customers. Many bought and hold bitcoins for a long time and there is no public knowledge of their identity. This is one reason why cryptocurrencies are volatile. Bitcoin which was trading at USD 18,870 on December 1, reached a peak of USD 63,237 on April 15, more than a 235% gain in approximately five months. And suddenly, when China declared a ban on cryptocurrencies, it tumbled down to USD 34,742 in a single day. There are no limits to the rally and also no limits to the collapse.
The second reason for the volatility of cryptocurrency is a pretty obvious one – liquidity. You can invest in bitcoin at any time, you exit at any time and the transactions are fast and easy. Thus, anybody with a good amount of money can enter and exit the market at any point in time. Since there is no regulatory authority to overlook as in the case of bulk deals and block deals that occur at Equity Stock Exchanges, cryptocurrency markets can be easily manipulated. Further, the owners of the bitcoins are anonymous, as there are ‘bitcoin giants’ holding a huge number of bitcoins who can sway the market (or have already done that) in a way that would profit them. In brief, low volumes and high liquidity is a perfect breeding ground for a manipulative market.
Blockchain technology and the Cryptocurrency ecosystem is revolutionary – it can change the entire financial world and make it more efficient than ever before. However, there are several problems with the current version. Let’s discuss a few of them.
- The miners who are auditors of the blockchain are also empowered with authority to accept or reject the changes in the bitcoin network. With a majority of miners located in authoritative countries like China who can announce a new law any day and force the companies to share the transaction details with the Government, makes other countries vulnerable as every mining node, simply the computers, have the entire history of the transactions, irrespective of their location. Data privacy is already the subject of this century, will we be able to protect it? With powers in hands of miners, if more money is brought into the crypto market, will we be able to keep the miners in check?
- There’s more to miners – what if a group of miners decide to rebel against the others? What if there is no consensus amongst the miners? Mining needs technology and infrastructure which not every country can afford. What if one day a powerful country decides that it would shut down all its mining centres? Will the Cryptocurrency network survive in such situations. The reason why each country has its currency is to retain control of its economy and not leaving it to the realms of other countries. One global currency can lead to manipulation by powerful countries, if not kept in check. What would happen in situations of wars and conflicts, is a question without trusted answers.
- Mining requires infrastructure backed by electricity. The electricity generation across the world isn’t clean and eco-friendly or through renewable sources. Most of the mining in the hub of China is backed by thermal electricity generation. The paper currency does not impact the environment as much as the mining may affect the same.
- While Cryptocurrency as legal tender is far from foresight, as an investment as well poses a lot of questions and one major criticism is its intrinsic value. Gold is backed by tangible metal which can be seen, possessed and stored. Equity, bonds, and debt instruments are all backed by assets. A key premise of any kind of investment is the asset by which the investment is backed, – land, for this reason, is, therefore, considered a solid investment. However, cryptocurrencies are not backed by any real asset and it is difficult to attach a value to them which leaves it entirely to the demand and supply and makes it too risky as a long term investment – not something that you can plan your retirement on.
- Cryptocurrencies as a short investment have made people filthy rich and have also eaten up the retirement funds of many others. The unregulated market is manipulated by bitcoin giants who can dump bitcoins at any time and buy them back when the market is beaten to the corner. It’s almost a vegetable market where if you are vigilant and lucky you will find the best vegetables, else the crowd is usually circulating the loudest.
- It’s unlikely that the Government would give up its power to control money and let the money chase the market with minimum interference. While the idea of cryptocurrency is tempting, every government would eventually land up issuing its own ‘Central Bank Digital Currency (CBDC) which may or may not be backed by blockchain technology but will serve the purpose of digital transactions. Digital Yuan is already up there and we would most like to see Japan, Russia, the United States, India and others come up with digital versions of their currencies, circulated by the Reserve Bank and thus, private cryptocurrencies may not be allowed to exist or allowed with heavy curbs.