Epic highs and tremendous losses have plagued the cryptocurrency market since it came on the financial scene in the first decade of the twenty-first century. The concept of money with no inherent value or physical existence can be confusing to many people. In this article, data-driven investor Daniel Calugar explores why digital currencies elude stability and what that means for investors.
Digital currencies bear unique challenges compared to fiat money in that they only exist in the digital domain. There are no paper bills or metal coins to represent cryptocurrency; rather, the value is but an amount logged in a digital ledger. And, even the ledgers upon which virtual currency is recorded can be complex in that they don’t exist in a single database. Instead, these distributed ledgers are spread out across multiple databases in diverse locations.
There is no doubt that the relatively new and reasonably complicated concepts that make up the essence of cryptocurrency contribute to the instability of its value. The fewer people that participate in buying and selling any asset class, the more potential exists for wide fluctuations in value. When large numbers of investors participate in a market, such as blue-chip stocks, the result is reliable stability. Unfortunately, digital currencies have not yet won that level of participation.
There are valuable advantages of cryptocurrency, such as the ease of transferring funds without relying on or paying fees to a third-party facilitator like a bank. However, many potential investors perceive that the most significant reason anyone would use a digital currency is for illegal activities and tax evasion.
Institutional investors are also reticent to participate in the cryptocurrency market because they are, in many cases, the very institutions that virtual money is designed to exclude from transactions. If Bitcoin was designed to cut out the banker middle man, the bank is not likely to promote its use.
Many non-technical investors don’t understand blockchain – the technology upon which cryptocurrencies are traded and recorded. They often believe that virtual currency is susceptible to cybercrime and hackers. While there are some risks – be it with virtual money or fiat money – blockchain is very secure.
Fewer personal investors, virtually no institutional investors, misperceptions about security, and no regulation all create an environment where the value of a cryptocurrency is highly susceptible to rumors, fads, trends, and social media hype. Naturally, this instability means more risk, but risk is not always a bad thing.
For investors, risk can also mean opportunity. Cryptocurrency is a volatile asset class which means the price is likely to rise and fall quickly and without any perceivable or predictable reason. Therefore, risk-averse investors should probably not invest heavily in cryptocurrencies. Still, for those investors looking for potentially huge gains and are willing to assume additional risk, digital currencies may be very attractive.
Cryptocurrencies are here to stay, and as they build trust and gain popularity among mainstream investors, we can expect them to become less volatile. However, it is safe to assume that they will not achieve the level of stability enjoyed by major stocks, government bonds, and mutual funds unless they become subject to regulation and oversight – which, of course, defeats the purpose of cryptocurrencies.