A violent correction in Bitcoin on the 5th of January may have unnerved those who bought near the recent top (i.e. within the last week), but means little in terms of the bigger picture. The 10% or 20% daily swings are extremely rare in established currency and commodity markets, but are, unfortunately, a fundamental feature of Bitcoin in its present form. The following factors, in our view, contribute (and will continue to contribute) to the persistent volatility of BTC:
- Bitcoin market is extremely illiquid. Yes, we’ve all heard that the market cap of all issued Bitcoin had exceeded $15 billion (and you should read this Coindesk article to better understand what it means for Bitcoin, specifically). But the measure we all should be paying more attention to, is daily transaction volume, standing at a meagre $100-$200 million, on average, during the last 12 months. The volume passing through major exchanges (the only pools of meaningful liquidity for BTC) is even less impressive $10-40 million per day. These charts also illustrate that any price correction, whether yesterday or on the 21-22 June 2016, immediately causes a spike of trading volume on exchanges, which brings us to the next point.
- There are no market makers (or other reliable pools of liquidity). In a more traditional commodity or securities market, one would normally find market makers providing the bulk of liquidity to the market participants. To be sure, market makers are rewarded for performing this valuable function. Sooner or later someone (big mining pools?) will become such market maker(s) on the blockchain; and surely, many Bitcoin traditionalists will cry foul at such an obvious attack on the blockchain’s decentralized nature. But without any meaningful providers of liquidity blockchain will remain volatile.
- Lastly, the microstructure limitations of blockchain, and specifically, the limited rate of block-building, directly contribute to periods of tight liquidity. This is, unfortunately, a self-perpetuating process, as market participants base their decisions on that fact. This pattern of behavior serves to further exacerbate any liquidity shock, way beyond what we normally observe in established markets.