Bitcoin Meets Mr. Market

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By Steven Lord
August 20, 2014

The selloff in Bitcoin that began in late July has accelerated in recent days, and it reached a fairly extreme level even by Bitcoin standards. As of late Monday afternoon, bitcoin was trading for roughly $453, according to Coindesk’s aggregate price index, down from nearly $600 a little over a week ago. Depending on the exchange, prices reached well below $400 per bitcoin in what is being termed as the digital equivalent of the “flash crash” that befell the equity markets a few years ago.

These are the lowest levels since spring of 2014, despite increased merchant adoption and a rosy (the BitLicense notwithstanding) long-term outlook for the digital currency. What’s going on?

For all its disruptive characteristics, bitcoin is still subject to all the same market rules as any other traded asset, especially because it is so illiquid. Generally, when an asset is thinly traded, pressure on one side will cause exaggerated movement in the opposite direction. Because of this, large holders are often able to maneuver pricing in a favored direction simply by pushing buy or sell orders into the market at whatever level, and in whatever volume, necessary to move the market. This is not manipulation per se – it’s just simple market mechanics, and it happens in everything you trade – stocks, bonds, currencies, commodities, baseball cards, you name it.

Plus, the ecosystem’s fractured network of exchanges, each with their own inside market, makes Bitcoin even more susceptible to wide price swings. Since there is no centralized market maker (think NYSE specialist), no one consolidates bids and asks across all exchanges and manages order flow to result in the most efficient execution. As bitcoin enthusiasts have learned since last week, there is sometimes value in having a market maker around.

Moreover, bitcoin is gaining an increasingly institutional investor base. These participants demand more sophisticated trading strategies, and have a lot of capital to throw around. Accordingly, several exchanges (most notably Bitfinex and BTC-E) have offered margin trading and short selling since the end of last year, which have in turn exacerbated price volatility.

As any trader will tell you, margin can be your best friend, or your worst enemy. It allows you to use borrowed money to buy something using very little of your own capital, thus gearing any price movement in the underlying asset. However, if the price of that something goes against you, the equity – i.e. your money in the trade – can be rapidly erased. This is generally displeasing to the person who lent you the money, and can quickly lead to a margin call – the forced selling of the whole position in order to cover the debt.

In financial markets, margin is famous for creating downward spirals. Forced selling, of course, naturally depresses prices further, which in turn causes more margin calls, forcing further selling, etc. In a tight market like bitcoin, this kind of thing also gets around, which tends to result in everyone piling onto the same side of the canoe and making the whole thing tip over.

Looking at the trade data from yesterday, margin calls were almost certainly behind the worst of the volatility. Not coincidentally, the greatest drops and the highest volumes were seen on the two exchanges – BTC-E and Bitfinex – that have aggressively touted margin trading. Between the two of them, Bitfinex and BTC-E accounted for a whopping 71% of all USD/BTC trading volume in the past seven days. The rout was most evident at BTC-E, which briefly printed trades at just above $300 per bitcoin before recovering. This would not be the first time margin trading on BTC-E has briefly torpedoed the bitcoin-USD price; something similar happened this past February.

Added to all this is the pressure of good old-fashioned selling. Bitcoin 2.0 startup Ethereum recently raised some $14 million worth of bitcoin in a sort of crowd-financed seed round, which it openly plans to liquidate in order to pay bills and develop its platform. Companies like Dell and Overstock are now accepting bitcoin in increasing amounts, very little of which is likely to remain in BTC for very long. In some ways, the greater the merchant acceptance of bitcoin, the greater the selling pressure will be – at least until those businesses can begin paying their bills in BTC.

Strategically, this kind of volatility is part of the bargain when dealing in new, illiquid markets. Trading in digital currency is still very much in its infancy, and there are few bumpers on the bowling lanes. What has happened in bitcoin over the past few days would have been very familiar to the early pioneers in the nascent, unregulated, no-holds-barred U.S. stock market of the early 1900s. With little of the trading infrastructure developed over decades in more mature markets, Bitcoin trading is essentially a giant, over-the-counter open bazaar. This presents both opportunities and risks.

We’re on record as saying increased use of derivatives will help reduce volatility in bitcoin pricing, and we’re sticking with that assertion. Over time, derivatives like options, futures, swaps and even trading techniques like margin and short selling will all give investors the ability to hedge risk and increase liquidity, thus removing the need to sell bitcoin outright whenever lower exposure is desired. This will eventually smooth trading into narrower ranges, but it will take time. Until then, these techniques will add to volatility, not take it away.

The other side of the proverbial coin, however, is that price can be advantageous when they occur in something with such long-term promise. Opportunistic investors have already taken advantage of the swoon, and we expect the BTC/USD will recover a good deal of lost ground over the next several days. If you were a believer in BTC at $650 a few weeks ago, you are certainly one at $450. Tellingly, Coinbase has already delayed filling buy orders until Friday, citing higher than normal buy volumes.

And through it all, adoption continues apace. In the last 24 hours, 5,870 new users were created to Blockchain’s My Wallet service.

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