5 Reasons Why A Crypto Market Crash Could Happen

Understanding the causes of crypto crashes can help you cope with them better.

Last Updated September 21st 2021

6 Min Read

It has been an unpredictable year for crypto investors. After Bitcoin’s value accelerated by 300% in 2020 and reached an all-time high in April 2021, crypto trading volume on popular exchanges like Coinbase, Binance, Kraken, and Bitstamp fell more than 40% in June.

Some analysts point to China’s recent attempt to crack down on cryptocurrency trading as a possible reason for the bear run. Others consider crypto volatile for several reasons - from an overall lack of centralization to the recent controversy around the environmental impact of mining coins and supporting digital transactions on a large scale.

Regardless of the reason for crypto’s long-standing reputation for instability and ongoing turbulence, investors deserve to know what crypto’s volatility is all about, why crypto crashes and what it means for their portfolios. So here are the main reasons why a crypto market crash could happen.

But before that, let us understand the concept of volatility.

Crypto And Volatility

When it comes to putting money anywhere but the bank, many people fear the potential ups and downs. In other words, the volatility that their investments may experience.

In basic terms, volatility is the regular up-and-down movement in the value of an asset. That asset competes with its own average, meaning that the current up or down movement is judged against its average up or down trend line.

Collectively, the world has come to understand the costs of volatility. People know what a market crash looks like. Investors willing to take risks can do well with crypto if they can tolerate regular ups and downs.

So while a traditional investor might prefer a slow and steady rate of return on investments, a crypto investor might embrace swings in the pursuit of massive returns.

Volatility can be the enemy for one investor and the source of hope for another. So as crypto becomes more common, conversations around volatility are becoming more complex.

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5 Reasons For Crypto Volatility and Crashes

1. Heavy Market Sentiment

Market sentiment influences the prices of digital assets positively and negatively.

The first and perhaps most important thing to consider about digital assets is that they have no intrinsic value. This means that we cannot quantify them through traditional valuation methods such as discounted cash flows. And although Bitcoin is often compared to gold as a store of value, it does not have any physical presence.

While there are several growing use cases to crypto, there is still no clear value to attach to the token prices. Thus, the currency's movements are more susceptible to sentiment and narrative. We have already seen how the power of sentiment can create much volatility across traditional stock markets in 2021. For example, the GameStop (GME) short squeeze in January was caused by retail investors who coordinated on social media to buy a certain stock collectively. They did so to boost its price.

This freedom for investors to communicate and invest according to their beliefs, which has long been a facet of cryptocurrency markets, shows that sentiment is changing finance across the board. Currently, the ecosystem is largely populated by retail investors. However, institutional money is beginning to tap into the narrative. But sentiment can work both ways.

While crypto prices can rocket on a whim, they can also fall heavily for seemingly little or no reason. Moreover, without being pegged to a tangible value like in gold, these changes in sentiment can affect token prices in a more drastic way than their traditional stock market counterparts.

2. Lack of Regulation

The lack of legal foresight can cause confusion and, by extension, lead to price corrections.

All cryptocurrencies are built on distributed blockchain technology. While the technology is complex, its fundamental meaning is not. Blockchain technology can decentralize assets like Bitcoin and other coins. However, since blockchains are spread across many different machines, cryptocurrencies do not have a single centralized location. Thus, it is difficult for established regulatory frameworks to control them.

This is not to say that governmental regulatory efforts to stem the growth of cryptocurrencies like Bitcoin do not affect sentiment surrounding the value of coins. They do. There are many instances of a cryptocurrency's growth being cut by a government tightening its policies on crypto. For example, recent restrictions imposed by China contributed to a period of severe volatility in BTC prices.

But cryptocurrencies are naturally freewheeling assets. No international border or central agency governs them. This presents a problem for policymakers accustomed to dealing with clear-cut definitions for assets.

US SEC Chair Gary Gensler recently told a House committee there are gaps in the system. He pointed out the need for legislation to specify which regulator should oversee crypto exchanges. Gensler mentioned that the SEC has "taken and will continue to take our authorities as far as they go."

This means that popular cryptocurrency exchanges such as Coinbase and Binance might find themselves spending millions of additional dollars to ensure they are compliant.

Lack of regulation creates confusion on both an individual and an institutional level. The absence of clarity can cause significant price volatility and market crashes.

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Crypto asset investing is highly volatile and unregulated in some EU countries. No consumer protection. Tax on profits may apply.

3. Fragile Investors

Novice investors are likely to be scared by the price fluctuations and panic sell, causing crashes.

Most cryptocurrencies, including Bitcoin and Ether, are purely digital assets with no backing of any physical commodity or currency. In essence, this means their price is determined entirely by the laws of supply and demand. Without any other stabilizing factor, like government backing, many reasons may lead to a fluctuation in demand or supply.

Anyone with access to the right equipment has the know-how can mine cryptocurrencies. They are not backed by the standard tools used to assign value to money. Hence, investors can find it hard to trust in them. Unlike real estate or the stock market, this market is not seen as needing expertise.

So many part-timers invest in it with the hope of making quick gains. But, sometimes, when that does not happen, they lose patience and withdraw from it. This frequent involvement and withdrawal also cause volatility.

4. Media influence

Like it or not, media headlines can have an immediate impact on crypto prices.

The term FUD (fear, uncertainty, and doubt) is used across several topics, and the crypto community has adopted it to denounce what supporters see as the intentional spread of misinformation. (Conversely, skeptics write off the term as a defense mechanism for investors to brush off negative news.)

Whether it is a case of FUD or a genuine piece of bad news, headlines that directly or even indirectly concern crypto can scare investors into panic selling on a scale that can trigger a period of significant volatility.

There is no shortage of headlines behind the wild fluctuations in Bitcoin prices. Stories such as the bankruptcies of crypto exchanges. Mt. Gox in 2014 and Yapian Youbit in 2017 shook investors. In addition, the well-documented use of BTC in drug transactions via Silk Road resulted in an FBI shutdown of the marketplace back in October 2013.

5. Emerging Market

At the end of the day, crypto is still an up-and-coming market.

Cryptocurrency is still an emerging market, gaining rapid popularity. However, despite all the media attention, this market is still minuscule compared to traditional currencies or even gold. This means even smaller forces (a group of people holding large amounts of crypto coins) can influence the trade. Even if they sell only a few coins, it would be enough to crash the whole market.

Bottom Line

There is much uncertainty about how the crypto market will take further steps toward regulation, insurability, security, and stability. For now, investors interested in cryptocurrency should know that they are their own best asset. The wise approach is to research, track investment performance and base any choices on an overall portfolio strategy rather than getting lost in the stress and uncertainty of frequent market upturns and downturns.