- Part 1: there is no single “price,” the market is horribly inefficient
- Part 2: Know Your Customer/Anti-Money Laundering laws
- Part 3: Bitcoin is not a Ponzi scheme! It just works like one
Public discussion and media coverage of Bitcoin makes certain assumptions:
- Bitcoin has a price, that you could expect to buy or sell it around.
- Bitcoin is like buying a share in a company, or a commodity like gold — the market works the same way.
- Bitcoin is liquid — it’s reasonably easy to convert your money to Bitcoin, and your Bitcoin to money in your bank account.
None of these are true.
How much is a bitcoin worth?
I’m looking at the CoinDesk Bitcoin Price Index. At this moment, it says $19699.46. Whoops, it’s ! Now it’s ! And so on.
This number is marketing for Bitcoin. It’s meant to give the impression that Bitcoin is a solid tradeable object with an orderly market structure, that you can meaningfully price it down to the cent, and that all this is fine and sensible. But this is an illusion.
The singular “price” of Bitcoin doesn’t exist — it’s a made-up number. It’s not a number you could expect to exchange a bitcoin for — it’s an average of the last sale price on a bunch of exchanges. (CoinDesk’s index uses Coinbase, Bitstamp, itBit and Bitfinex. Followers of crypto will have just exclaimed “what!” at that last one.)
If you look at the spread between exchanges — the different prices for one interchangeable bitcoin — you’ll see spreads of hundreds of dollars, and in volatile moments it can be in the thousands.
Quoting a number like “$19699.46” to seven significant figures when your data’s got a 5% spread would get your high school physics teacher slapping you upside the head. It’s entirely deceptive. It should say something like “$19,700 plus or minus $500 depending,” and that line graph should be a thick grey bar.
“Market cap” is even worse. It’s literally just whatever the last price was, multiplied by the number of tokens in existence. This is a bogus number that’s not actually applicable to anything — it’s not money that was put into the crypto, it’s not a realisable value like a company market cap, it doesn’t affect prices — it’s just an easily-calculated splashy-looking number that looks good in a headline. Trading is so thin in any crypto, even Bitcoin, that you could never realise a fraction of the number. It is literally just marketing.
Why is Bitcoin like this, though? Why isn’t the price a reasonably usable number?
Isolated islands, posing as a continent
In normal securities trading, if a share is listed on multiple exchanges, orders will often be applied via smart order routing — so that a given buy or sell order is in the context of all the order books for that stock. This avoids liquidity fragmentation — where the various exchanges’ order books are unnecessarily isolated from each other, making each a separate trading pool, thus more volatile and harder to trade in. This is easy because, unlike bitcoins on exchanges, the actual exchanges don’t need to hold the stock for a trade to happen.
This doesn’t work in Bitcoin — all trading is isolated on each individual exchange, and the bitcoins are actually there on the exchange. This is a recipe for huge volatility and wide discrepancies in price.
Furthermore, in normal securities trading, spreads in pricing between exchanges tend to quickly equalise through arbitrage — buying on one exchange to sell on another, at a profit. This pulls the price up on the first and down on the second.
The structure of the Bitcoin market is such that this doesn’t work very well. If you want to profit from spreads in the price of Bitcoin, you need to:
- Buy some Bitcoin on one exchange.
- Withdraw it from the exchange — let’s assume you send it directly to the second exchange’s Bitcoin deposit address — and confirm this transaction on the blockchain (at least 10 minutes’ delay), with at least a $25 transaction fee if you want it confirmed in the next block or two. Double that if you want to be sure.
- Sell it on the second exchange.
The delays — ten minutes to over an hour — and fees add enough friction to generate the spread between exchanges, even if you assume everyone’s using trading bots as quickly as possible.
So each exchange operates as an island. The “price” number doesn’t apply on any of the island exchanges.
What’s life like on one of the islands?
What “unregulated” means in practice
When you buy normal securities or commodities, you assume that the trading environment is regulated sensibly, and that the exchanges keep to the rules set by law and, fundamentally, won’t mess you around.
You can’t assume this at all in crypto trading. This is what “unregulated” means.
The important thing about securities regulations is that every single one is there because someone ripped a lot of people off that way. They ensure market integrity. So even investors who understand high risk — and what it means when we say that cryptos are ridiculously volatile and not backed by anything — may not be fully aware of the degree to which the trading environment itself is part of the threat model in cryptos.
(One glaring example was the 2016 collapse of iGot in Australia, which hit a lot of small-time retail investors: “I just assumed that since they’re in Australia there would be some sort of safety net or regulation or something like that — bare minimum — where he could be accountable for his actions.”)
There are various shenanigans that are banned on real securities exchanges for good reason, but are standard in crypto:
- wash trades — where you trade with yourself, to pump the price up or down, or just create the illusion of trading volume. You could literally do this in the Bitfinex trading engine quite recently.
- spoofing — where you place a large order to create the illusion of market optimism or pessimism, and cancel as soon as the price gets anywhere near it. This is endemic on Bitfinex and Coinbase/GDAX.
- painting the tape — like wash trading, but with two or more participants. Mark Karpelès admitted in court that he had been using the “Willybot” to pump up the Bitcoin price on the Mt. Gox exchange during the 2013 Bitcoin bubble.
- front-running — where an exchange operator takes advantage of a buy or sell order before other customers can.
- insiders with access to the database trading on their own exchange — Bitfinex officers trade on the exchange themselves. They state that they avoid conflicts of interest, but there is no oversight or transparency on this.
The US Commodities and Futures Trading Commission has listed many of these (PDF) as specific problems that are notably worse in the Bitcoin marketplace than in other markets:
Beyond their practical and speculative functions, the emergence of these nascent markets has also been negatively marked by a variety of retail customer harm that warrants the Commission’s attention, including, among other things, flash crashes and other market disruptions,52 delayed settlements,53 alleged spoofing,54 hacks,55 alleged internal theft,56 alleged manipulation,57 smart contract coding vulnerabilities,58 bucket shop arrangements and other conflicts of interest.59 These types of activities perpetrated by bad actors can inhibit market-enhancing innovation, undermine market integrity, and stunt further market development.
Because inside the exchanges is the Wild West, the interface between exchanges and the world of regular finance is stringently regulated. This causes tremendous problems for getting actual money out of exchanges, as we’ll see in part 2. And does questionable things to send the price up …
Next time: why it’s hard to get actual money from the exchanges into your bank account. A little bit KYC/AML, a little bit oddly-advantageous incompetence, a little bit dubious practices.
Update: Not letting through any more comments about how you cashed out so it must be OK!! That’s nice, but you know lots of the new retail investors are having trouble, and that’s a problem worth talking about. (Except the guy below who claimed he cashed out of Bitfinex two months ago, that’s not a statement you get to make without a great deal of supporting information.)
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