Why is Bitcoin so volatile? It's immature!

Formatted post: https://bitconsult.co/2017/12/08/act-your-age-not-your-blocksize/

Act Your Age, Not Your Blocksize – The Immature Bitcoin Infrastructure

Introduction
Technically, Bitcoin as been around for 9 years. However, it wasn’t until 2017 that Bitcoin started to garner serious interest from investors. Coinbase has added over 1 Million users so far in 2017, with an astonishing 100,000 signups in a single November day.

If you’ve tried to create a Coinbase account or check your balance this week, you’re likely familiar with Coinbase’s own “Blue Screen of Death”.

Credit - @alistairmilne
Coinbase is a professional company with serious venture capital backing. Their website is the gateway for many U.S. investors looking to buy their first coin, and they stand to make a significant amount of money by facilitating BTC transactions. But even with VC backing and customers begging them to take their money, Coinbase is struggling to scale with Bitcoin’s explosive growth.
In today’s post, we’ll look into the fledgling Bitcoin exchanges and show how these immature systems affect Bitcoin’s price.
Bitcoin Exchanges
Currently, there are a few dozen reputable Bitcoin exchanges. Here’s a look at the top ten:

There are a few items of note here. First, where’s Coinbase?! Well, Coinbase is actually backed by an exchange called GDAX. If you have an established Coinbase account, you should start using GDAX. GDAX has lower fees (0.25% vs. 1.5% for market orders) and more options than Coinbase. Similar to many online stock brokerages, GDAX allows users to enter market, limit, and stop orders. Plus, you get those cool red and green price candlesticks. To start trading on GDAX, simply follow the instructions on their website to link your Coinbase account.
Second, the exchanges all trade at different prices! Today, the range is quite wide. Looking just at the top 10 exchanges, there is a $4,200 difference between the highest priced exchange (Coinone) and the lowest priced exchange (Bitfinex). Typically, when an identical good trades for different prices on multiple exchanges, ambitious investors will buy on the cheap exchange and sell on the expensive exchange to make a profit. This is known as arbitrage.
So, why is there no arbitrage here? Bitcoin is an easily transferrable digital asset, after all. While it’s true that Bitcoin can be easily transferred between exchanges, there are still some roadblocks to large scale arbitrage. The exchanges with the highest prices are Coinone, Korbit, and Bitthumb. All of these exchanges are based in South Korea, a country with strict currency transfer laws. Sure, you can create a Bittumb account, transfer your BTC from GDAX, and sell for Korean Won (KRW), but how will you cash out? Well, you’d have to transfer the Won to your Korean bank account and then wire the money back to the States. In addition to raising a whole lot of red flags with the U.S., you’d also get your account frozen by South Korean authorities once you cash out more than $10K.

As for the U.S. exchanges, some trade lower or higher based on their overall reputation. Price could also be affected by whether or not the exchange allows margin trading, which can pump up the price. Finally, each exchange sets their own limits for daily withdrawals and deposits, so there is a limit to how much arbitrage a single person could do.
The point of all this arbitrage talk is to highlight that Bitcoin trading is broken up between several exchanges, and that has an effect on liquidity.
Liquidity
Order Books
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price. A liquid market has plenty of buyers and sellers looking to make deals close to the current market price. Buyers and sellers place limit orders which are commitments to buy or sell assets at a given price. Below is a snapshot of Apple’s common stock order book.

From this small snapshot, it can be seen that there are a lot of buy orders (bids) and sell orders (asks) right around the current market price of $169.48 per share. Do you want to buy 2,700 shares ($457K USD) at market price? If so, your order would execute at $169.49 per share and your order would barely made a dent (+.006%) in Apple’s share price. Apple represents one of the most liquid stocks on one of the most liquid markets (Nasdaq) in the world. Also, if you want to buy Apply shares, you really only have one choice, Nasdaq. Apple currently has over 5 billion shares outstanding. Sure, some are in the hands of long term holders with no intention to sell, but there are plenty of shares being traded at all times.
With Bitcoin, things are a little different. Unlike Apple, trading takes place on many exchanges, meaning that the buy and sell orders are split between many order books. Because of this, large market orders can consume a large portion of the book. If you spend a couple of minutes watching GDAX, you’ll see hundreds of trades executing at different prices, as there simply aren’t that many bitcoin for sale at a given price. Take a look at the current order book. If you wanted to buy 28 Bitcoin (about the same $450K USD as the Apple example), you’d end up buying all of the sell orders (listed in red) in this screen shot and then some. This would end up moving the price more than $100, or .6% This is 100x the percentage move of the Apple buy! Keep in mind too that we’re comparing to a single stock, and Bitcoin is an entirely new asset class!

Market Orders
If an exchange has a thin order book, market buys and sells will have a huge impact on the price. This is compounded by the fact that many users set stop-orders to buy or sell Bitcoin at market when BTC hits a certain price. Many users set stop-sells below the current market price in order to protect gains. If a large market sell hits the books, the price will plummet and often trigger stop sells, which further drive the price down. To make the situation worse, many exchanges allow margin trading, where users borrow money to trade. Margin trading requires that traders maintain a certain balance. If a trader’s balance falls enough, their position could be liquidated through a margin call. Combine margins, stop-losses and large market sells and you’ve got a recipe for volatility.
If you hold a big position in any asset (stock/Bitcoin) you have to be careful how you sell. Usually, when a large player exits a stock position, they’ll sell slowly exit by using limit orders or spreading market orders out over several days. Many large holders in the Bitcoin community do not have trading experience. This is why we sometimes see huge market sells that eat up the entire order book. This has caused more than one “flash crash” this year.

The characteristics listed above are not unique to Bitcoin, as evidenced by multiple Nasdaq “flash crashes”. What is unique to Bitcoin, however, is the instability of the exchanges themselves. Due to rapid user growth, many exchanges cannot handle all of the trades taking place on their systems. For exchanges like Coinbase/GDAX, the transaction traffic is made even worse by the sheer quantity of market orders placed on Coinbase, where there is no option to set limit orders and build the book. At times of high traffic, the exchanges can even go offline, which you may have seen today.

That big gap with no candles? That’s the 20 minutes or so that GDAX crashed today. When the exchange is down, users cannot enter orders and are left wondering if any standing orders have been executed. This can be extremely frustrating, especially for new users.
Supply
Demand for Bitcoin is high right now. Many retail investors are making their first investments and large banking firms are taking Bitcoin more seriously as futures launch later this month. Supply, however, is low. There are currently only 16.7 Million Bitcoin in existence as of today. There will only ever be a maximum of 21 million. Not only is this much less than the 5 billion Apple shares mentioned above, the number of Bitcoin actually trading is much less.

Bitcoin traded at pennies or fractions of a penny for many years. Bitcoins were given away by early adopters in an attempt to increase the adoption rate. With such a low value, many users were careless with their Bitcoin, and they were not properly protected. Private keys were lost and hard drives were thrown out that contained thousands of Bitcoin. Because of this, there have been many studies to determine how many Bitcoin are “gone forever” in order to get a better idea of what the actual supply is. A popular estimate is that 4 million Bitcoin are effectively lost, or cannot be spent. Let that sink in. 4 million of 16.7 million Bitcoin are lost. That’s almost 25%!!!
In addition to being lost, many Bitcoin are in the hands of true believers, who hold their Bitcoin in cold storage and have no plans to sell. Some are tied up in the Bitcoin Investment Trust (GBTC), a popular way to own Bitcoin in a retirement account. It’s hard to estimate how many Bitcoin are actively traded on exchanges, but it may only be a couple of million. Divide those between a couple dozen exchanges and you’ve got a supply problem.

Market Cap
A popular way to measure the value of Bitcoin is through its market capitalization (market cap). Just like with a stock, market cap is calculated by multiplying current price ($16,000) by total supply (16.7 million coins). Using this formula, Bitcoin’s market cap comes out to around $267 Billion. It’s important to note, however, that this does not mean that $267 Billion has been invested into Bitcoin. This number simply means that there are 16.7 million coins and the last traded price was $16K. This is an important distinction because many people use market cap to determine Bitcoin’s potential price.
A popular theory is that 1% of funds held in offshore bank accounts may flow into Bitcoin as it gains traction as a store of value. There is currently over $40 trillion held in offshore bank accounts. 1% of this number is a staggering $400 Billion. Some analysts decide to set Bitcoin’s market cap at $400 Billion, divide by 16.7 million coins, and come up with their price target of $24K per coin. This is a lazy analysis that makes no attempt to determine the effects of $400 billion dollars actually “flowing in” to Bitcoin. As we saw above, Bitcoin’s price is volatile due to its limited supply and thin order books. If a large player wants to create a substantial Bitcoin position, they will make a significant dent in the order book. Below is a snapshot of GDAX’s full order book.

This is called a market depth chart and it helps to visualize how much BTC can be purchased at a certain price. The right side of the book represents limit sell orders. It can be seen in the chart that 5,000 BTC can be bought at less than $20K/coin for a total of $94 million. If a $94 million position were opened, the price of Bitcoin would rise over 20% to $20K. Just imagine what the effect of $900 billion would have on the market.
Conclusion
Bitcoin interest is picking up, and many new users are frustrated by the wild price swings and instability of exchanges. Most of the Bitcoin infrastructure is new, and exchanges are scrambling to handle the influx of new users.
Bitcoin is an extremely volatile asset due to its limited supply and segregation over multiple exchanges. It’s important for new users to be aware of Bitcoin’s volatility, and to invest only what they can afford to lose. When it’s time to enter or exit a large position, do so over time! Buying in thirds is a recommended strategy.
Are you looking for investment advice, or ways to better protect your Bitcoin? Contact us for a consulting session!