On January 1st 2017, Bitcoin opened up at $973.37. In the span of 11 months following, Bitcoin grew 2000% and topped out at a price of $20,000 - and, to say the least, it caught the majority of people off guard. As expected, many were skeptical knowing that extreme gains of that magnitude are obviously a bubble, but for some the potential for profit was too difficult to ignore. Bubbles are complex and notoriously unpredictable because they are “unseen” or “unmapped”, hence the term “bubble”, so you can see through them but the edges are only visible at the perfect angle. However, there is one thing that all bubbles have in common: Greed. But the greed of whom? The emotionally driven investors? Or the unseen forces in the Cryptoverse?
The great big bubble:
In 2017, I was 18 and in my last semester in high school. As expected, Bitcoin was the last thing on my mind. That is until May rolled around and one of my close friends had mentioned that he was buying Bitcoin with his paychecks while we were at work one day at the local golf course(we were caddies). Respecting how mature my friend was financially compared to myself, and admittedly slightly envious, I went home and created my first Coinbase account. After deciding that Bitcoin was a little out of my budget, I decided Coinbase’s newest, more affordable, coin would better suit my investment. My choice was a less popular coin called Litecoin sitting at $19.01 and I had decided to throw, what I thought was a substantial amount of money at the time, $700 at it for 36.8 coins to see if it would grow. To say that I was shocked when my initial investment had grown from $700 to just over $11,000 when I sold in mid December later that year would be an understatement. I was officially lost in the sauce in Cryptocurrency and was ready to go all in on it for the rest of my life.
That was until witnessing the pop in 2018 when all the people who were still high on their investments were left shrugging their shoulders and wondering what happened. To this day, as prices have yet to come close to reaching all time highs again, that same question rings just as true and is one of the most controversial ideas in Cryptocurrency. With one side thinking it was driven by legitimate value and demand for the technology, while others think that the purpose of it may have been far more malicious than that. So what is it? Is it the value of the networks? Or is it manipulation by a few powerful hands?
The value of the Network:
Currency is usable if it is a store of value, or, put differently, if it can reliably be counted on to maintain its relative value over time and without depreciating. In many societies throughout history, commodities or precious metals were used as methods of payment because they were seen as having relatively stable value. Rather than require individuals to carry around cumbersome quantities of cocoa beans, gold or other early forms of currency, however, societies eventually turned to minted currency as an alternative. Still, the reason many examples of minted currency were usable was because they were reliable stores of value, having been made out of metals with long shelf lives and little risk of depreciation.
In the modern age, minted currencies often take the form of paper money which does not have the same intrinsic value as coins made from precious metals. Perhaps even more likely, though, individuals utilize electronic currency and payment methods. Some types of currencies rely on the fact that they are "representative," meaning that each coin or note can be directly exchanged for a specified amount of a commodity. However, as countries left the gold standard in an effort to curb concerns about runs on federal gold supplies, many global currencies are now classified as fiat. Fiat currency is issued by a government and not backed by any commodity, but rather by the faith that individuals and governments have that parties will accept that currency. Today, most major global currencies are fiat. Many governments and societies have found that fiat currency is the most durable and least likely to be susceptible to deterioration or loss of value over time.
Scarcity, Divisibility, Utility and Transferability
Aside from the question of whether it is a store of value, a successful currency must also meet qualifications related to scarcity, divisibility, utility and transferability. Let's look at these qualities one at a time.
Key to the maintenance of a currency's value is its supply. A money supply that is too large could cause prices of goods to spike, resulting in economic collapse. A money supply that is too small can also cause economic problems. Monetarism is the macroeconomic concept which aims to address the role of the money supply in the health and growth (or lack thereof) in an economy.
Successful currencies are divisible into smaller incremental units. In order for a single currency system to function as a medium of exchange across all types of goods and values within an economy, it must have the flexibility associated with this divisibility. The currency must be sufficiently divisible so as to accurately reflect the value of every good or service available throughout the economy.
A currency must have utility in order to be effective. Individuals must be able to reliably trade units of the currency for goods and services. This is a primary reason why currencies developed in the first place: so that participants in a market could avoid having to barter directly for goods. Utility also requires that currencies be easily moved from one location to another. Burdensome precious metals and commodities don't easily meet this stipulation.
Currencies must be easily transferred between participants in an economy in order to be useful. In fiat currency terms, this means that units of currency must be transferable within a particular country's economy as well as between nations via exchange.
To assess Bitcoin's value as a currency, we'll compare it against fiat currencies in each of the above categories.
Bitcoin Compared Against Fiat Currencies:
When Bitcoin was launched in 2009, its developer(s) stipulated in the protocol that the supply of tokens would be capped at 21 million. To give some context, the current supply of bitcoin is around 18 million, the rate at which Bitcoin is released decreases by half roughly every four years, and the supply should get past 19 million in the year 2022. This assumes that the protocol will not be changed. Note that changing the protocol would require the concurrence of a majority of the computing power engaged in Bitcoin mining, meaning that it is unlikely.
The approach to supply that Bitcoin has adopted is different from most fiat currencies. The global fiat money supply is often thought of as broken into different buckets, M0, M1, M2, and M3. M0 refers to currency in circulation. M1 is M0 plus demand deposits like checking accounts. M2 is M1 plus savings accounts and small time deposits (known as certificates of deposit in the United States). M3 is M2 plus large time deposits and money market funds. Since M0 and M1 are readily accessible for use in commerce, we will consider these two buckets as medium of exchange, whereas M2 and M3 will be considered as money being used as a store of value. As part of their monetary policy, most governments maintain some flexible control over the supply of currency in circulation, making adjustments depending upon economic factors. This is not the case with Bitcoin. So far, the continued availability of more tokens to be generated has encouraged a robust mining community, though this is liable to change significantly as the limit of 21 million coins is approached. What exactly will happen at that time is difficult to say; an analogy would be to imagine the U.S. government suddenly ceased to produce any new bills. Fortunately, the last Bitcoin is not scheduled to be mined until around the year 2140.
21 million Bitcoins is vastly smaller than the circulation of most fiat currencies in the world. Fortunately, Bitcoin is divisible up to 8 decimal points. The smallest unit, equal to 0.00000001 Bitcoin, is called a "Satoshi" after the pseudonymous developer behind the cryptocurrency. This allows for quadrillions of individual units of Satoshis to be distributed throughout a global economy.
One of the biggest selling points of Bitcoin has been its use of blockchain technology. Blockchain is a distributed ledger system which is decentralized and trustless, meaning that no parties participating in the Bitcoin market need to establish trust in one another in order for the system to work properly. This is possible thanks to an elaborate system of checks and verifications which is central to the maintenance of the ledger and to the mining of new Bitcoins. Best of all, the flexibility of blockchain technology means that it has utility outside of the cryptocurrency space as well.
Thanks to cryptocurrency exchanges, wallets and other tools, Bitcoin is transferable between parties. While it takes vast amounts of electricity to mine Bitcoin, maintain the blockchain and process digital transactions, individuals do not typically hold any physical representation of Bitcoin in the process.
Generally, Bitcoin holds up fairly well in the above categories when compared against fiat currencies. So what are the challenges facing Bitcoin as a currency?
One of the biggest issues is Bitcoin's status as a store of value. Bitcoin's utility as a store of value is dependent on its utility as a medium of exchange. We base this in turn on the assumption that for something to be used as a store of value it needs to have some intrinsic value, and if Bitcoin does not achieve success as a medium of exchange, it will have no practical utility and thus no intrinsic value and won't be appealing as a store of value. Like fiat currencies, Bitcoin is not backed by any physical commodity or precious metal. Throughout much of its history, the current value of Bitcoin has been driven primarily by speculative interest. Bitcoin has exhibited characteristics of a bubble with drastic price run-ups and a craze of media attention. This is likely to decline as Bitcoin continues to see greater mainstream adoption, but the future is uncertain.
Bitcoin's utility and transferability are challenged by difficulties surrounding the cryptocurrency storage and exchange spaces. In recent years, digital currency exchanges have been plagued by hacks, thefts and fraud. Of course, thefts also occur in the fiat currency world as well. In those cases, however, regulation is much more settled, providing somewhat more straightforward means of redress. Bitcoin and cryptocurrencies more broadly are still viewed as more of a "Wild West" setting when it comes to regulation. Different governments view Bitcoin in dramatically different ways, and the repercussions for Bitcoin's adoption as a global currency are significant.
The needs of the few:
Bitfinex and Tether:
A forensic study on bitcoin’s 2017 boom has found that nearly the entire rise of the digital currency at the time is attributable to “one large player,” although the market manipulator remains unidentified. Finance professors John Griffin and Amin Shams, instructors at the University of Texas and the Ohio State University, analyzed over 200 gigabytes of data for the transaction history between bitcoin and tether, another digital currency.
The professors’ study found that tethers being traded for bitcoins revealed a pattern.
“We find that the identified patterns are not present on other flows, and almost the entire price impact can be attributed to this one large player,” Griffin and Shams wrote. “We map this data across both blockchains and find that the one player or entity is behind the majority of the patterns we document.” Griffin and Shams were able to follow the clusters of data to a source: “One large account at Bitfinex.” The digital currency exchange Bitfinex is one of the largest in the world. The study found that, through Bitfinex, the single player was able to manipulate demand for bitcoin via “extreme” flows of tethers.
The manipulation occurred as bitcoin rose to an all-time high of nearly $20,000 in late 2017, the study found.
“One of the SEC’s top worries is that crypto is subject to manipulation. This study appears to lend credibility to that argument,” Cowen analyst Jaret Seiberg said. The study comes after an analysis published earlier that year that 95% bitcoin spot trading is faked. The survey, created by cryptocurrency asset manager Bitwise for the SEC, found that only $273 million of about $6 billion in average daily bitcoin volume was legitimate.
While the study doesn’t identify the manipulator, the professors suggest those running Bitfinex either knew of the operation or were even possibly assisting the scheme. Bitfinex’s general counsel Stuart Hoegner told the WSJ that the study “lacks academic rigor,” saying that “it is the global rise of digital currency that has driven the market’s demand for tether.” Both Bitfinex and Tether Ltd., the company that controls tether, are owned and operated by the same people.
The action started on a single exchange: Bitstamp, where the dollar price of bitcoin suddenly dropped more than 18 percent in a matter of minutes. The CoinDesk Bitcoin Price Index, a composite of several market feeds, recorded a 6 percent drop as a result.
Bitstamp was, at the time, one of three spot markets used as equal components in the bitcoin price index for BitMEX, a crypto derivatives exchange domiciled in the Seychelles that operates one of the most liquid bitcoin derivatives markets, the XBT/USD perpetual swap. BitMEX's other two bitcoin index components are Coinbase Pro and Kraken. Of the three, BitStamp's reported volumes are lowest.
The BitStamp price drop wasn't random. It was caused by a large bitcoin sell order, placed well below the market. The resulting downward pressure triggered auto-liquidations of long positions in the hundreds of millions of dollars on BitMEX. Traders with short positions on the exchange stood to benefit.
Novel market structures
In crypto markets, it's normal for investors to interact directly with the exchange – an ethos derived from bitcoin, which invites its users to transact pseudonymously, without intermediaries. On derivatives exchanges, accommodating this requires a rethinking of market structure.
On traditional derivatives exchanges, brokers and clearinghouses manage the risk that a large price move will bankrupt one side of a trade. All participants have an incentive to make good at settlement, so they can trade again tomorrow. On the largest crypto derivatives exchanges, it is possible to trade directly under one account today and another tomorrow. This unfettered access and pseudonymity is part of the story of these exchanges' rise to become the most liquid markets in crypto.
To cover settlement risk, BitMEX and other large crypto derivatives exchange operators use auto-liquidiation. For example, if the index price drops far enough below an open long position, the exchange automatically liquidates that position, to settle the trade. Excess proceeds from auto-liquidations are stored in an insurance fund. If auto-liquidation falls short of settlement, the insurance fund kicks in. If the insurance fund's earmark falls short, auto-deleveraging occurs, unwinding both sides of the trade.
Liquidity is a subjective term, meaning an investor's ability to move a reasonable volume of an asset, without an undue price shift. It is related to market depth, measured by the worst price an order will hit at a certain size limit.
In crypto, market depth is fragmented among dozens of the largest exchanges, and hundreds more in the long tail. Even in crypto's blue-chip assets, bitcoin and ether, pools of liquidity are scattered, which makes them more shallow. This situation may be worsening. Bitcoin's bid-ask spreads have widened on most of the largest exchanges in 2019, indicating decreasing market depth according to one tracker of composite data.
Exchanges that are part of price discovery infrastructure are thin enough that a large-ish order will move the price. And, as we will see below, derivatives markets can be far more liquid than the spot exchanges that help determine the price of their underlying assets.
What happened May 17, 2019?:
The chart above presents a second-by-second account of what happened on the Bitstamp BTC/USD spot market in the early morning hours of May 17, UTC. Each point on the chart is the minimum, or best, ask price offered in each minute's snapshot of orderbook data, which is provided by CoinRoutes. The size of the point indicates the quantity of the order.
The action began at 3am UTC, with a sell order roughly 6 percent below the market price and hundreds of times larger than the norm on the exchange at that time. As that order fulfilled available bids, the ask price moved lower, dragging the market price down until it reached $6,276, at which point the selling stopped. A chronological calculation shows the sellers sold about 2,905.7 units of bitcoin, in aggregate at about $2.5 million below what they would have realized at a bitcoin market price of $7,700. At the same time, over $200 million in long positions were being liquidated on BitMEX, according to skew.com. If it was manipulation, it returned up to an 80X multiple over what the manipulators put at risk. The whole thing was over in about 10 minutes.
Although controversial, it’s pretty evident that manipulation is certainly a factor in Bitcoin’s value as well as the Cryptocurrency market as a whole. But for what purpose? Cryptocurrency has become a tool for the rich to get richer by taking advantage of the hopes of those who missed out. Therefore 2017 was potentially designed to create an illusion of rapid substantial gains. Afterwards, significant volatility is used as a method to play with investor’s emotions. Rapid upward movements create FOMO, Fear Of Missing Out, to make you feel like you’re going to miss out on parabolic gains. Sequential dumps are designed to take the money you invested to get in that “run up”.
A daunting yet undeniable fact is that the Cryptocurrency markets are becoming increasingly more centralized. The vast majority of money flows into the top 10-25 coins by market cap, thus centralizing the flow of money into the more “valuable” coins, rendering it much easier to abuse and take advantage of. Lesser known, the exchanges where the vast majority of investors onboard from are now some of the biggest “bag holders” in the industry. Exchanges like Coinbase, Binance, and Bitfinex all own some of the largest wallets of the most popular coins today. This opens up the door to significant potential for malicious intent by exchanges when manipulating the value of coins and the volume, in their best interest. $7,000-$10,000 is an extremely emotional level for Bitcoin as it is often seen as the make or break price range. As Bitcoin has consistently hovered around this range for 2019 and now going into 2020, lends credence to the idea that maintaining interest in the coins by keeping the price at critical Bullish/Bearish price levels, could guarantee an eternal flow of money into the markets. With knowledge of the upcoming movement, and a stake in the coins of interest, this method could act as an infinite profit loop generating income for exchanges for as long as the buyers play along. If investors begin to lose interest, they create a drastic pump in the price, acting as a revolving door that investors are trapped in as long as they invest their emotions.
The solution to the problem is just that, don’t invest on your emotions. If you can avoid investing your hope along with your money, then they lose their edge on the market. Once their edge is lost, the market can maybe one day fall into better hands again like they used to be when technologists were investing in something they truly believed in. While Market Makers can manipulate the price, they cannot manipulate the underlying value of the networks they are built on. Over the last year and into the beginning of this one, recognition of the technology over the price is finally gaining more popularity raising optimism that eventually Blockchain can return to a state of innovation rather than inflation. One day the hype will all fade away when they move onto the next scheme, and on that day Blockchain can return to what it was as a liberator for those who value it for what it is and don’t care for the monetary value it attracts. Until then, the price will always change, but the reason it’s valuable to us will not. Blockchain is entering a new decade of change and innovation. I’m choosing to invest my confidence in those who believe in the purpose and the project, how about you?