What Causes Cryptocurrencies To Fluctuate?
Cryptocurrencies have gained traction recently as a viable alternative to the widely-accepted fiat currencies. However, it has its demerits in the form of volatility in its prices. After going through this post, you will have an understanding of what causes cryptocurrency to fluctuate.
Many countries have begun the process of framing appropriate legislation and regulations for cryptocurrency. The day is not far away when you might be able to order almost all of your day-to-day necessities via cryptocurrencies. On the other hand, cryptocurrencies have proven to be a viable investment instrument, generating massive returns for early adopters. However, there’s one aspect that makes new investors skeptical about investing or trading in cryptocurrencies, which is volatility.
Over time, one can observe the fluctuation of the most volatile cryptocurrency, Bitcoin. For example, in September 2021, the value of one bitcoin was $41,412. In October, it jumped to $61,374. Today, it is around $45,635. This chart should help you visualize the volatility.
So, what exactly drives the volatility in the prices of cryptocurrencies? Let us examine what causes cryptocurrency to fluctuate, which would help you better understand how it works and why it makes for an excellent investment instrument even after its volatility.
Why Do Cryptocurrencies Change Value? – Understanding the Reason Behind the Volatility
Before focusing on the volatility of cryptocurrencies, it is important to understand that cryptocurrencies do not operate in a regulated environment like fiat currencies or government-backed exchanges. Cryptocurrencies derive their value elsewhere. Due to the fixed supply, cryptocurrencies are immune to inflation. Hence, they derive their value from market sources.
The following points explain the aspects that drive cryptocurrency’s volatility:
The prices of a commodity depend on its demand and supply position. For example, if the demand rises faster than the supply, the price increases, and vice versa. Similarly, cryptocurrency values vary according to the demand and supply position. If the demand is more, the prices go up. Alternatively, if supply exceeds demand, the price goes down.
The cryptocurrency supply mechanism is well known because each cryptocurrency publishes its Tokenomics. For example, Bitcoin has a pre-determined maximum supply of 21 million. On the other hand, Ether does not have any supply cap. Therefore, some cryptocurrencies resort to burning tokens to prevent a mismatch in the supply and demand position.
Today, the demand for cryptocurrencies, especially Bitcoin, is high because of higher adoption and the active participation of institutional investors. So, the demand has outstripped the pace of creating new bitcoins.
The demand-supply position is a significant driver to determine the most volatile and the least volatile cryptocurrency.
Cryptocurrencies are produced through mining, a computational process that consumes massive computing power. One needs expensive and sophisticated equipment for mining the top cryptocurrencies today, such as Bitcoin. The leading cryptocurrency technologies like Bitcoin and Ethereum use the Proof-of-Work (PoW) system, where miners get incentives for mining cryptos.
The production cost has increased tremendously over the years. For example, in 2009, miners used to get 50 BTC for mining one block. Today, the rate has come down to 6.25 BTC. The mining pools today use sophisticated equipment. All these factors contribute to the cryptocurrency’s pricing. However, miners are required as long as there is demand for cryptos. Therefore, the prices fluctuate.
Scarcity is another crucial reason why cryptocurrencies change in value. The most popular cryptocurrencies, such as Bitcoin and Ether, are traded on all popular crypto exchanges. Smaller tokens, on the other hand, do not have this privilege.
Furthermore, trade volumes also influence cryptocurrency prices and add to cryptocurrency volatility. As we discussed earlier, the steady supply of any commodity raises its value in the long run since it is anticipated that demand will likewise grow. Because there are only a few coins in circulation, this produces scarcity. Some cryptocurrencies even have a burning mechanism, implying that a portion of the coin supply is destroyed, reducing the availability, and making it scarcer.
When Bitcoin was invented in 2009, it did not have any competition. As of Feb 2022, there were over 10,000 cryptocurrencies. However, not all cryptocurrencies enjoy sufficient trading volumes and popularity. Thus, there is intense competition among cryptocurrencies to survive in the market. As new competitors gain momentum, it affects the competition and causes price fluctuations.
Recently, Elon Musk tweeted that he would not be selling his crypto holdings, including Bitcoin, Ether, and Dogecoin. Within minutes, Dogecoin attained its swing high of the past five days. An earlier tweet in January 2022 stated that Tesla would accept cryptocurrency as payment for their merchandise. As a result, Dogecoin’s value increased by 10% within a day. Thus, like a negative rumor around a company can bring down its stock price, the same is the case in the world of cryptocurrencies, where such internet influencers trigger such volatility.
Cryptocurrencies work on a system of internal governance. Some cryptos have introduced governance tokens that give holders a say in any project’s future. For example, Ethereum is updating its network from a Proof-of-Work (PoW) system to Proof-of-Stake (PoS), rendering its expensive machinery redundant. Automatically, it will impact Ether’s pricing.
Though cryptocurrencies work in a deregulated environment, governments worldwide have started putting forth provisions to regularize them. However, there is confusion as to which entity should regulate cryptos. For instance, the Securities and Exchange Commission wants to categorize cryptocurrencies as bonds and stocks in the US. In contrast, the Commodities Futures Trading Commission equates cryptos with commodities like gold.
Various countries are exploring regulatory impositions on cryptocurrencies, including taxing gains from crypto trading. Besides, products like ETFs and futures contracts offer more access to cryptos for investors. Speculations around such aspects give rise to cryptocurrency volatility.
No single factor determines the value of cryptocurrency, but several factors, as discussed above, are the reason behind cryptocurrency volatility. However, in the long term, one can notice that the value of the most famous cryptocurrencies has only risen. Thus, if you’re striving to be a successful crypto trader, you must be well-versed with the answer to the question, why do cryptocurrencies change value? But, if you want to be a long-term investor and want to compound your crypto portfolio, the best way to go about it would be to hold your crypto assets through a crypto savings account, like the one offered by Pokket, that allows you to safely “hodl” your cryptocurrencies, and make passive income through interest on your holdings as well.