The cryptocurrency market is unlike anything we've ever seen. Whereas the stock market and its historic annual gains of 7% (including dividend reinvestment) is the traditional source of wealth creation, the aggregate value of all virtual currencies combined catapulted higher by more than 4,500% between Dec. 31, 2016, and Jan. 5, 2018, to $835 billion. In just 53 weeks, investors who had stuck around were privy to a lifetime's worth of gains.
However, such massive gains over such a relatively short period of time is bound to create some volatility. For example, between April 2013 and the end of 2017, bitcoin has had 20 separate instances where its price has dropped by a minimum of 22% from a recent peak.
By comparison, the broad-based S&P 500 has had 35 corrections of 10% or more, when rounded to the nearest whole number, since 1950. In other words, the stock market tends to correct about once every two years, whereas bitcoin has a substantial move lower about every two to three months.
This week has seen one of the wildest snapbacks in the history of cryptocurrencies. After briefly touching an aggregate market cap of $754 billion on Jan. 13, digital currency valuations collapsed by $304 billion, or 40%, by midday Jan. 16 to $450 billion, according to CoinMarketCap.com.
You might be wondering what on Earth could erase more than $300 billion in perceived market value in only three days' time. Let's consider four likely reasons cryptocurrencies have been eviscerated this week.
1. South Korea can't make up its mind on regulating cryptocurrencies
Perhaps the most front-and-center headline ties to South Korea's flip-flopping regarding its stance on cryptocurrencies.
It was first reported a week ago that South Korea was planning to shut down all of its domestic crypto-trading exchanges, which would, of course, be a major blow to the decentralized market. Popular virtual currencies Ripple and Ethereum generate a good chunk of their daily trading volume from South Korea. Then, a few days later, South Korea walked back threats to ban cryptocurrency trading. As of Tuesday, Jan. 16, the possibility of a ban was once again on the table. No one really knows what to expect, which is why investors have headed for the exit.
What is worth noting, as Forbes pointed out, is that the South Korean government's intention may not be to outright ban cryptocurrencies, so much as to ban anonymous transactions. For instance, the South Korean government is requiring bitcoin traders to use their real names to protect their citizens from fraud, theft, and deception. Though this cuts at the very heart of the cryptocurrency movement, it might be the only way crypto trading continues in South Korea.
2. China is cracking down even harder on virtual-currency trading
China, one of the fastest growing countries in the world, has also taken a dislike to bitcoin and cryptocurrencies. This past summer, China's government announced that it'd be banning initial coin offerings, which are how virtual coins go public, and would also be shutting down domestic cryptocurrency exchanges. The country also limited bitcoin mining, which can be a very energy-intensive process.
Now, according to a recent Bloomberg report, Chinese authorities have plans to block domestic access to centralized trading platforms, as well as offshore cryptocurrency trading platforms. In short, China is aware that virtual currency trading still exists despite its best efforts to curb it domestically, and it now plans to step up enforcement by purposefully blocking access to certain sites and platforms.
Bloomberg also suggests that Chinese regulators plan to target individuals and companies that provide market-making and clearing services for centralized trading.
3. Stop-loss orders wreaked havoc on digital currencies
One of the primary reasons cryptocurrencies have done so well is because the crypto market isn't "fair." It naturally creates an incentive for buying since there's virtually no incentive for long-term pessimism. For the average investor on a decentralized exchange, your only real options are to buy, sell, or hang on to your investment. Unlike traditional equity markets, there isn't access to short-selling opportunities or options allowing a pessimist to place their bet against a cryptocurrency. This tends to push crypto prices higher since few people are making money if prices are falling.
Nevertheless, profit-taking can wreak havoc on digital currencies from time to time. As such, investors may choose to place stop-loss orders on their investments, signaling that they're only willing to lose a certain percentage. The problem is, these stop-loss orders can create a short-term cascade to the downside if too many of them start getting hit. For example, a stop-loss cascade on the GDAX exchange drove Ethereum's price from $224.48 to $0.10 (no, seriously, 10 cents!) in roughly one second on June 21, 2017.
If there is good news, stop-loss-induced cryptocurrency plunges tend to be very short-lived. Why? Again, the market creates incentive to buy. Once the stop-loss cascade ceases, which usually happens within 24 hours, buyers return and usually push valuations higher.
4. Retail investors wore their emotions on their sleeve
Lastly, keep in mind that retail investors, not institutional investors, are doing most of the cryptocurrency trading. With the exception of bitcoin, which can be traded through futures contracts, and perhaps soon by exchange-traded funds, the only way to purchase and sell cryptocurrencies is through a cryptocurrency exchange. Traditional institutions haven't been willing to purchase virtual coins through these channels, leaving retail investors in charge.
The issue with this is simple: Retail investors are far likelier than institutional investors to wear their emotions on their sleeve. In essence, it means they're liable to overshoot to the upside when things are good, and to the downside when things aren't looking as good. The accelerated selling over the past three days might just have chased panicked cryptocurrency investors to the exit, which only worsened the selling pressure.
Until institutional investors get involved, or access to crypto markets expands to more traditional channels, this type of volatility could prove quite common.