Many factors drive price fluctuations in the Bitcoin spot rate on cryptocurrency exchanges. Volatility is measured in traditional markets by a volatility index known as the Cboe Volatility Index (VIX). More recently, tools for measuring the volatility of Bitcoin and other cryptocurrencies have also become available. Among the most popular of these is the Bitcoin Volatility Index, known as BitVol, which aims to track the expected 30-day implied volatility of the world's leading digital currency by market cap.
Historically, Bitcoin's value has been quite volatile. In a single day in May 2021, the price of Bitcoin plunged by about 30% before recovering to be down about 12%. But why is Bitcoin so volatile? Here are just a few of the many factors behind Bitcoin's volatility.
Bad News Hurts Adoption Rate
News events that scare Bitcoin users include geopolitical events and statements by governments that Bitcoin is likely to be regulated, as well as moves by prominent individuals and companies. For instance, tweets by Tesla Inc. (TSLA) CEO Elon Musk suggesting his company would no longer accept the cryptocurrency as payment for its vehicles may have prompted the massive sell-off described above. Bitcoin's early adopters included several bad actors, producing headline news stories that spooked investors.
El Salvador made Bitcoin legal tender on June 9, 2021. It is the first country to do so. The cryptocurrency can be used for any transaction where the business can accept it. The U.S. dollar continues to be El Salvador’s primary currency. Other Latin American countries are reportedly considering similar moves.
Other headline-making Bitcoin news over the history of the cryptocurrency's existence includes the bankruptcy of Mt. Gox in early 2014 and, more recently, that of the South Korean exchange Yapian Youbit. Still, other news stories that shocked investors include the high-profile use of Bitcoin in drug transactions via Silk Road that ended with the FBI shutdown of the marketplace in October 2013.
All these incidents and the public panic that ensued drove the value of bitcoins versus fiat currencies down rapidly. However, Bitcoin-friendly investors viewed those events as evidence that the market was maturing, driving the value of bitcoins versus the dollar markedly back up in the short period immediately following the news events.
Bitcoin's Perceived Value Sways
One reason why Bitcoin may fluctuate against fiat currencies is the perceived store of value versus fiat currency. Bitcoin has properties that make it similar to gold. It is governed by a design decision by the developers of the core technology to limit its production to a fixed quantity of 21 million BTC.
Because that differs significantly from fiat currency, which is dynamically managed by governments that want to maintain low inflation, high employment, and satisfactory growth through investment in capital resources, investors may allocate more or less of their assets into bitcoin as economies built with fiat currencies show signs of strength or weakness.
Uncertainty of Future Bitcoin's Value
Bitcoin volatility is also driven in large part by varying perceptions of the intrinsic value of the cryptocurrency as a store of value and method of value transfer. A store of value is the function by which an asset can be useful in the future with some predictability. A store of value can be saved and exchanged for some good or service in the future.
A method of value transfer is any object or concept used to transmit property in the form of assets from one party to another. Bitcoin’s volatility at the present makes it a somewhat unclear store of value, but it promises nearly frictionless value transfer. As a result, we see that Bitcoin's value can swing based on news events much as we observe with fiat currencies.
Large Currency Holder Risks
Bitcoin volatility is also to an extent driven by holders of large proportions of the total outstanding float of the currency. For so-called Bitcoin whales—investors with BTC holdings in the tens of millions or more—it is not clear how they would liquidate a position that large into a fiat position without severely moving the market. Indeed, it may not be clear how they would liquidate a position of that size in a short period of time at all because most cryptocurrency exchanges impose 24-hour withdrawal limits far below that threshold.
Bitcoin has not reached the mass market adoption rates that would be necessary to provide option value to large holders of the currency.
Security Breaches Cause Volatility
Bitcoin can also become volatile when the Bitcoin community exposes security vulnerabilities in an effort to produce massive open-source responses in the form of security fixes. This approach to security is paradoxically one that produces great outcomes, with many valuable open-source software initiatives to its credit, including Linux. Bitcoin developers must reveal security concerns to the public in order to produce robust solutions.
It was a hack that drove the Yapian Youbit exchange to bankruptcy, while many other cryptocurrencies have also made headlines for being hacked or having stashes of cryptocurrencies stolen. As an early example, in April 2014, the OpenSSL vulnerabilities attacked by the Heartbleed bug and reported by Google security's Neel Mehta drove Bitcoin prices down by 10% in a month.
Bitcoin and open-source software development are built upon the same fundamental premise that a copy of the source code is available for users to examine. This concept makes it the responsibility of the community to voice concerns about the software design, just as it is the responsibility of the community to come to a consensus about modifications to that underlying source code as well. Because of the open conversation and debate regarding the Bitcoin network, security breaches tend to be highly publicized.
High-Profile Losses Raise Fear
It is worth noting that the aforementioned thefts and the ensuing news about the losses had a double effect on volatility. They reduced the overall float of Bitcoin, producing a potential lift on the value of the remaining Bitcoin due to increased scarcity. However, overriding this lift was the negative effect of the news cycle that followed.
Notably, other Bitcoin gateways looked to the massive failure at Mt. Gox as a positive for the long-term prospects of Bitcoin, further complicating the already complex story behind the currency’s volatility. As early adopting firms were eliminated from the market due to poor management and dysfunctional processes, later entrants learn from their errors and build stronger processes into their own operations, strengthening the infrastructure of the cryptocurrency overall.
High-Inflation Nations and Bitcoins
Bitcoin’s use case as a currency for developing countries that are currently experiencing high inflation is valuable when considering the volatility of Bitcoin in these economies versus the volatility of Bitcoin in USD. Bitcoin is much more volatile versus USD than the high-inflation Argentine peso versus the USD.
That said, the near-frictionless transfer of bitcoins across borders makes it a potentially highly attractive borrowing instrument for Argentines, as the high inflation rate for peso-denominated loans potentially justifies taking on some intermediate currency volatility risk in a Bitcoin-denominated loan funded outside Argentina.
Similarly, funders outside Argentina can earn a higher return under this scheme than they can by using other debt instruments, which when denominated in their home currency can potentially offset some of the risks of exposure to the high-inflation Argentine market.
Tax Treatment Lifts Volatility
According to the Internal Revenue Service (IRS), Bitcoin is actually considered an asset for tax purposes. This has had a mixed impact on Bitcoin's volatility. On the upside, any statement recognizing the currency has a positive effect on the market valuation of the currency.
Conversely, the decision by the IRS to call it property has had at least two negative effects. The first was the added complexity for users who want to use it as a form of payment. Under the new tax law, users would have to record the market value of the currency at the time of every transaction, no matter how small. This need for record-keeping can understandably slow adoption because it seems to be too much trouble for what it is worth for many users.
Secondly, the decision to call the currency a form of property for tax purposes may be a signal to some market participants that the IRS is preparing to enforce stronger regulations later. Very strong regulation of the currency could cause the adoption rate of the currency to slow to the point at which it is not able to achieve the mass adoption that is critical for its overall utility in society. Recent moves by the IRS are not clear about their signaling motives and have therefore been giving the Bitcoin market mixed signals.