Will Crypto Crash (Again)?

Will bitcoin and the broader crypto market crash (again)? Or crash farther? I think the place to start thinking about this is why are crypto markets so volatile in the first place? And perhaps more importantly, is that volatility a bad thing?

I believe there are a few reasons for all the volatility in crypto markets. We’ll start with the most obvious ones and work our way to the least obvious.

1. Lack of agreed upon valuation methodologies

Buying a stock is buying a piece of the future earnings of a company. Equity analysts all agree that a discounted cash flow analysis is the proper method to value equity in a business, even if they disagree about what factors should go into the model.

In crypto, there is no agreed upon valuation methodology and it’s likely that the valuation models that do exist are misleading if not flat out wrong. As a result, price is much more sentiment driven, with positive sentiment driving price up more aggressively and negative sentiment driving price down more aggressively than in other markets. There is no benchmark like P/E ratio to bound these movements.

This is compounded by the fact that compared to a market like U.S. equities, much more of the crypto market is made of retail investors with less experience that are more likely to make emotional decisions — selling at the bottom and buying at the top.

2. Whale “splashing”

Because the distribution of ownership among many crypto assets is very concentrated compared to other assets, it’s easier for large individual holders (so-called whales) to move markets through buying or selling in large quantities — “splashing.”

We’ve seen these sort of movements contribute to volatility in the past . For example, the Mt. Gox Trustee selling $400 million worth of Bitcoin. Or, when early bitcoin holders that had become bitcoin cash supporters sold large amounts of bitcoin in an attempt to cause a “flippening” and overtake bitcoin in November 2017.

A subset of whale splashing are the infamous “Pump-N-Dump” groups where a group of whales coordinate to bid up the price of a certain token causing other investors to flood in out of FOMO then sell at the top, fleecing unsophisticated speculators.

3. Liquidity (or lack thereof)

Compared to traditional markets like U.S. equities, most crypto markets are very shallow. Despite tremendous growth in 2017, total crypto market capitalization is still in the hundreds of billions of dollars, the size of a single company on the S&P 500 and much smaller than the S&P in its entirety ($23 trillion).

It’s also likely that the real daily trading volume for the volume of the crypto market is much smaller than current estimates suggest. There’s evidence that some major centralized exchanges may be lying about their volume statistics. For others, there are means, motive, and opportunity, though no hard evidence exists.

We know that the volume of decentralized exchanges is legitimate (though tiny and even then there could be wash trading to inflate volume statistics). Regulated exchange (GDAX, Kraken, Gemini) volume is likely to be real, but the rest of the volume reported by exchanges is doubtful at best.

The result is large amount of slippage, and thus volatility, even on relatively small trading volume. According to a study, “trading pairs of major cryptocurrencies like NEO and IOTA which boast market caps of over $3 [billion] can slip by more than 10% merely with a sale of $50,000.”

The prior three reasons why crypto markets are so volatile, should improve over time. Better valuation models will be developed, token distribution will become less concentrated and as the market cap of the space grows, liquidity will improve.

4. Programmatic supply

The volatility of Bitcoin and the crypto market more generally are a result of the fact that the supply (and thus the monetary policy) of crypto assets is determined programmatically.

For any typical commodity, a change in demand will cause a change in production.

If you grow avocados and the price of avocados goes up 100%, you (or someone else) will grow more avocados in the next season, driving the price down.

If supply increases and decreases alongside demand, the change in price will be much milder.

Compare this to a scenario like most cryptocurrencies, where the supply schedule is programmatically determined and there is no producer able to respond to price changes.

Because the supply schedule is fixed, more demand has to result in higher prices.

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5. The end of “volatility debt”

The most interesting reason for crypto market volatility is a result of cryptocurrencies more decentralized and permission-less nature.

When human central planners engineer systems, one of their goals tends to be to keep volatility low.

People like stability rather than volatility. It’s hard to sleep at night when your net assets could drop by 10% before you wake up, or your job could disappear tomorrow, or your only source of food could disappear.

However, there is an inescapable relationship between the complexity of a system and its volatility.

Historically, our world was far less connected and thus simpler than it is today. This meant there was less potential volatility

A single caveman with a spear could do relatively little damage compared to a modern-day terrorist with an atomic bomb, chemical weapons, or cyber attack capabilities.

On the flip side, the leverage to help others given to an individual today is greater than it’s ever been. Bill and Melinda Gates have saved millions of lives, a feat that was simply impossible before the 20th century. No one entity has ever had that much leverage.

The financial system is no exception to this increased volatility. Compared to financial systems of the past, the modern financial system is highly complex and interconnected.

One of the lessons from modern complexity science research is that you can’t control the amount of volatility within a system without adjusting how complex it is. You can only control how that volatility is expressed over time.

One way to reduce the complexity of the modern financial system would be eliminating or more tightly curbing derivatives and leverage. The kind of volatility we saw in 2008 is only possible with lots of leverage and lots of derivatives. A few examples of this are:

• CDOs (collateralized debt obligations) that helped cause the financial crisis contained derivatives: Packages of bonds, within packages of bonds, within packages of bonds.
• CDS (credit default swaps) meant there could be a bond issuance with $100mm in bonds outstanding, but there was $1.5B in CDS sold or bought against it. The size of the derivatives market of an asset was many multiples of the underlying asset.

One option would be for policy makers to curb these levels of leverage and derivatives trading, but financial institutions heavily oppose this type of regulation because it would cut off a huge source of profits.

So the task for policy makers becomes, “How can we keep volatility low without actually reducing the complexity of the system?”

The correct answer is: You can’t. However, that doesn’t stop them from trying.

When policy markets try to engineer systems in such a way as to keep volatility low without actually making the system less complex, what they are really doing is simply delaying that volatility.

They are taking on “volatility debt:” Trading volatility today for volatility tomorrow. You might also call this “terming out volatility” or “terming out risk.”

The collapse of Enron, WorldCom, and CDOs caused volatility because the reality was hidden and distorted. Inevitably, this false perception came to the surface, and because there is so much extra leverage piled on top of it, the collapse was much worse.

The longer the scheme goes on, the worse the volatility debt becomes, because that many more decisions were made based on a false version of reality.

Taking on volatility debt is problematic because the damage caused by negative volatility is asymmetric.

The analogy I like to use is to compare three scenarios with equivalent amounts of “volatility.”

1. Jumping off a 1 ft wall 100 times
2. Jumping off a 10ft. wall 10 times
3. Jumping off a 100 ft. wall 1 time

If you jump of a 1 ft. wall one hundred times, it’s no big deal. Pretty much any able-bodied adult can do this.

If you jump off a 10 ft. wall ten times, it’s more stressful. Even if you’re in good shape, your knees are probably going to be sore, but you almost certainly won’t die.

If you jump off of a 100 ft. wall one time, well, you won’t be jumping off it again.

Lots of little crashes in a system can keep it healthy. Attempting to explain American democracy to other European aristocrats, Alexis de Tocqueville wrote in 1840 that elections were mini-revolutions. Instead of letting tension build up over decades and end in violent revolution, democracy created a natural release valve in the form of elections.

“In America, that revolution is made every four years in the name of the law.”

By delaying volatility, governments were more likely to end in violent revolutions rather than peaceful transitions.

In the same way, delaying volatility in financial markets can lead to a cascading effect making the eventual fallout worse.

Bitcoin’s genesis is rooted in this understanding of modern financial markets. In the genesis block of bitcoin, Satoshi Nakamoto embedded:

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks

This comment reflected Satoshi’s belief that the 2008 global financial crisis had been the equivalent of jumping off a 10 ft. wall, only to be saved by taking on more volatility debt. Letting the system unwind would have been painful but probably not fatal. What about the next time when it’s a 100 ft. wall? I think Satoshi wanted Bitcoin to allow for a way to escape that fate.

The volatility in the crypto market has the effect that investors are getting thrown off smaller walls more frequently. Since investors are constantly getting thrown off, they don’t have time to accumulate volatility debt.

This is good for investors because it urges caution. Getting thrown off a ten ft. wall is a reminder to be cautious but doesn’t kill you. Typically investors start investing a small amount in something they don’t understand.

Even if someone bought the top of the market in December, as long as they only put in something like 1% or 2% of their net asset value, it’s not that big of a deal.

A 70% loss of 2% of your portfolio is 1.4% of your total portfolio, which is very manageable.

By contrast, having half of your retirement portfolio tied into the “very low volatility” housing marketing in 2008 was full of shadow risk: The low volatility was seen as a sign of safety rather than a warning sign that volatility was accumulating in the system.

Or as Mark Twain said, “It’s not what you don’t know that hurts you, it’s what you know for sure that just ain’t so.”

There are a lot less concerns that there is built up or suppressed volatility in the crypto markets, and, in the long run, I think that will prove to be a good thing.

Taylor Pearson is the author of The End of Jobs and writes about entrepreneurship, history, complexity and blockchain technologies at TaylorPearson.me. Sign up to receive his popular newsletter.

If you’re looking for more about blockchain and cryptocurrency for business,click here to access my personal resource lists of where I’ve found the best and most reliable information.