Consider this before buying Bitcoin for spec.
When Bitcoin becomes a tool of finance pros, the entire market could collapse in 10 minutes making them millions and leaving you broke…
The market micro-structure that results from Bitcoin being conceived by crypto-mathematicians and not economists or markets experts results in a vulnerability not present in traditional currency markets.
The Bitcoin is a unit of digital currency with scarcity controlled by the complexity of an iteration of a recursive computation. Output of each iteration is archived on independent non-centralized servers (a process called “mining”) and the validity of the output is readily ascertained with a negligible fraction of the computational work required to perform an iteration.
It would seem that Satoshi Nakamoto never intended his crypto-currency to be a speculative instrument because the Bitcoin protocol makes an obvious priority of the validation process at the express (if not intentional) expense of liquidity: to prevent double spending or double-mining (forking) the Bitcoin transaction protocol requires at least 10 minutes to compute.
The resultant effect on Bitcoin market microstructure should be obvious, then.
Say a Bitcoin market participant should choose to sell a large volume of the currency. Because each transaction is broadcast to a network that is — by design and necessity — public and publicly observable, the entire market could become privy to such an event and would have a significant time window (at least 10 minutes) during which to pull their bids so as not to get run through by the anticipated downward price action. Therefore, the asymmetry in the time required to transact (minutes) versus the time required to cancel a bid (seconds) will precipitate a liquidity drain in the face of a large seller.
As would happen in any currency market (digital or traditional) there will be a bandwagon effect. However, we can expect the Bitcoin price action to go parabolic or exponential due to the non-instantaneous nature of each transaction giving bidders an insurmountable time advantage over aggressive (bandwagoning) sellers.
Of course it could be argued that the same effect is possible to the up-side as well. However, because the majority of Bitcoin market participants seem to be un-sophistocated (or at least poorly capitalized relative to the central banks that dominate traditional currency markets) most likely sellers are profit-taking (ie, removing risk) whereas buyers are ‘risk-on’. So, the large-seller effect described above can be expected to be both the more pronounced in magnitude of price move and more devastating in terms of wealth destruction.
If you or anyone you care about plans to buy Bitcoin for spec, expect the inevitable avalanche and take a moment to educate yourself or him/her about how to use a limit cover order in conjunction with a stop-loss order (in one-cancels-other or OCO configuration). And expect severe slippage on the stop-loss price.
Thank you for reading and good luck!
About the Author:
Ezra Rapoport (@HFBondsTrader) is a Harvard grad with a bachelor’s degree in Electrical Engineering and Computer Science. He was undergrad at the same time as the Winklevoss twins. He is currently a Wall-Street trader specializing in US Treasury debt products and high-frequency market micro-structure.
