Bitcoin Price Swoon Illustrates Volatile, Illiquid Nature of Trading Market
Currencies / Bitcoin Oct 07, 2014 - 01:06 PM GMTBy: Submissions
Steven Lord writes: The recent drop in the price of bitcoin has remindedkeepcalm many industry participants, particularly those that arrived within the last year, of the inherent volatility associated with new, immature and illiquid markets. While a clutch of bitcoin skeptics, including such luminaries as economist Paul Krugman, have touted bitcoin’s drop from the $600 range on August 1st to intra-day lows near $280 on October 6th as proof of some sort of inherent flaw, the truth is that such volatility is neither new for bitcoin nor terribly germane to its continued adoption.
However, it is indicative of greater participation in bitcoin markets by sophisticated, experienced traders and speculators. Unlike the bitcoin traders of a few years ago, these folks are armed with increasingly powerful tools such as algorithms and first-generation bitcoin derivatives that enable leverage. At the same time, liquidity is still thin by virtually any standard – in the three days through October 6th, a total of 1.507 million BTC changed hands on the world’s top seven exchanges by volume, or just shy of $500 million at current prices. While the largest spike in bitcoin trading volume since March (and one of the largest on record), it is still a drop in the proverbial bucket for most globally traded asset classes.
In addition, bitcoin trading is heavily fragmented across a number of commercial exchanges, making true market-wide price discovery and order transparency difficult, which in turn exacerbates the impact of large trades and makes it easier for experienced traders to use techniques like phantom orders to maneuver the price.
Meanwhile, a large proportion of bitcoin trades are crossed completely off the tape, so to speak. They’re handled OTC through an unofficial cadre of individuals and companies active as brokers and, to an increasing extent, market makers. As with the early days of institutional stock and bond trading, these market participants are acting purely in self-interest, something that with stocks and bonds eventually led to the establishment of regulated broker-dealers, exchanges and market makers with a legal obligation to maintain an orderly market.
One thing the recent volatility will not do, however, is slow bitcoin’s rate of adoption, or even remotely impact the very tangible technology benefits of the blockchain. It may slow the steady supply of bitcoin coming from miners and the growing number of merchants who accept it – both have a strong incentive to convert BTC to fiat currency in order to pay their bills – but this is not considered to be a large portion of daily trading volume. It would be a net positive for the price, anyway.
The greatest impact of continued price weakness will be on miners, especially those who have recently invested a lot of capital into extremely fast, dedicated ASIC-based systems. In this respect, bitcoin mining is just like “real” mining of precious metals and other commodities. Typically, the number of mines expands rapidly when the price goes up, while every mine with high operating costs is out of business if the price goes down. In this way, the conventional mining industry ultimately self-corrects, reducing or expanding supply as prices rise or fall.
Bitcoin mining is fundamentally different in this respect. The amount and speed of new bitcoin mined is essentially fixed (for now) at 25 new BTC every ten minutes or so, and this does not change based on how many miners are active. Instead, only the difficulty associated with solving the math necessary to mine is altered. The fewer miners, the easier the math, and vice versa, but the rate of BTC supply growth remains the same. The concentration of most bitcoin mining into large industrial pools and reliance on expensive ASIC chips suggests a large portion of the mining community may now be operating at a loss.
Ultimately, the price swoon since the start of the summer is a reminder that despite its disruptive nature and transformative benefits, bitcoin itself is a fairly immature and illiquid market that is attracting a rising number of sophisticated traders who know a good opportunity when they see one.
Our suggestion: don’t buy the sky-is-falling hype, as it most certainly is not. Bitcoin’s price movements are interesting, and potentially very profitable, but the price is ultimately not a reliable indicator of the technology’s future. Instead, such volatility merely illustrates that the bitcoin market remains thin, easily manipulated by large orders and emotion, and is subject to little regulation.
For an increasing number of savvy traders, that’s a dream come true.
By Steven Lord
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