Liquidity, manipulation & bitcoin
While the bitcoin seems to be in trouble as hopes of a steady rise have been dashed, many are wondering whether the 2017 run up is not due to coordinated manipulation. The very serious Journal of Monetary Economics devotes an article to manipulation in general (Volume 95 May 2018, Pages 86–96), and Bloomberg announces that the US Department of Justice has launched a criminal investigation on the subject (“Bitcoin-Rigging Criminal Probe Focused on Tie to Tether”, 20/11/2018, Bloomberg.com). Even if it is quite certain that cryptographic currencies (and tokens) are heavily manipulated (I wrote about this before), the question of whether there is a tangible reality behind bitcoin is becoming more and more relevant.
That the value of bitcoin is arbitrary is no longer a matter of debate. Its value is the value that two participants are willing to transact upon. No more, no less. It is also difficult to believe that such an energy-intensive “proof of work” protocol is sustainable in the long term, despite real innovation in the field of distributed consensus (“Byzantine fault tolerance”).
So what’s left? The usable information provided by the bitcoin market is actually very limited. Price manipulations are such that it is very difficult to measure what could constitute the real added value of bitcoin, and finally give it a place in the sun: its liquidity.
What is the liquidity of a financial asset — physical or digital? In plain English, liquidity is the property of an instrument that makes it possible to buy or sell it in large quantities, easily, quickly and without impact.
To illustrate this very pragmatic definition, first of all an example of something that is not liquid: real estate. Anyone who has ever faced the problem of an acquisition knows very well that a real estate transaction is a complex, long and not always successful adventure. More fundamentally, real estate is illiquid because a seller is never assured to find a buyer easily, quickly without making a substantial effort on price. And vice versa.
Qualifications of “easily and quickly” are quite intuitive. Let us focus for a second on the notion of impact. When we talk about financial transactions, the impact is the price change induced by a buy or a sell order. Intuitively, the larger the size, the more expensive the purchase will be. Every investor who has ever looked at an exchange’s order book knows this.
[NB: this situation is counter-intuitive. If 1kg of sugar costs €5, everyone expects a wholesaler to make an “effort” if someone were to buy 100kg at once. This mechanism is called a “reverse auction”: bigger quantities command a lower price. Do financial assets have an intrinsic characteristic that disqualifies them from a behaviour otherwise widespread in the economy? The answer to this apparent paradox lies in the following distinction: the supply curve of an economic agent should not be confused with its utility function.
The supply curve describes the quantity of a good that an agent offers on the market as a function of the unit price of that good. With few exceptions, this curve is upward sloping: the higher the price, the higher the quantity offered (and of course conversely for the demand curve). A price is formed when a buyer’s demand curve intercepts a seller’s supply curve.
The utility function governs the behaviour of an agent. In the case of the sugar wholesaler, his utility function will typically be the profit of the trade, which he will try to maximize. He will accept a discount as long as his profit is assured: a higher quantity at a slightly degraded price can nevertheless guarantee a larger total profit than a smaller quantity at a higher price.]
Bitcoin could represent a truly new segment of financial markets if it were a new source of liquidity.
This source would be uncorrelated to traditional assets since the value of bitcoin has no reason to vary in line with other asset classes. This is great news for traders around the world, insatiably looking for liquidity. It is this quest that lead them to take a close look at bitcoin. Add a little volatility and the recipe is ideal: here is a new asset, which moves a lot and can be traded abundantly. The fact that its value is arbitrary is of no concern. Need we be reminded that no one knows the exact price of a stock?
In this analysis, the real question becomes the following: what is the real liquidity of bitcoin? Is it possible to buy a large quantity of bitcoins easily, quickly and without impact? In truth, no one really knows. Endemic manipulation makes it impossible to get a clear picture. Is there a reliable and independent source of research on this issue? I venture the following idea: the crypto eco-system would have much to gain in organizing the necessary transparency to allow this issue to be examined — this is the only way for institutional investors to enter the dance.