Bitcoin price swoon illustrates volatile, illiquid nature of trading market

The recent drop in the price of bitcoin has reminded 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 $275 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.

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