Why bitcoin is so volatile

In order to sell Bitcoins in bulk, one must transfer them to exchange, but this incurs a major risk for the seller, namely that the exchange may be hacked and the bitcoins lost forever. Also there isn’t much liquidity on the exchanges, and in fact much less liquidity than meets the eye, which I will explain shortly.

According to Forbes, nearly 4 million Bitcoins are lost forever. But the number is greater than that. Hacked/stolen Bitcoins are effectively ‘lost’ even if they are in one’s possession, because people with stolen Bitcoins are unlikely to take the risk of uploading them to an exchange and having their identity revealed either during the verification process or when they try to deposit and withdraw the fiat currency from a bank account. Stolen Bitcoins have to be sold gradually, off the exchanges. Between the Mt. Gox hack and the Bit Finex hack, but also numerous smaller heists, an estimated 1 million additional Bitcoin are ‘lost forever’, bringing the total to 5 million.

Second, many of the early Bitcoin holders, who acquired hundreds or thousands of coins in 2010-2013, are unlikely to sell in bunk on the exchanges, or if they do so, sell gradually. Many of these early adopters plan to hold indefinitely.

The problem is, although Bitcoin as of 11/30/2017 has a ‘market cap’ of $157 billion, making it larger than than IBM, the liquidity is very poor relative to its size. This means if if just a handful of the early adopters try to cash out on the exchanges, it will push the price down a lot–way more percentage-wise than someone selling the same dollar amount of IBM stock. But by the same token, it does not take much buying to push the price up.

For example, I estimate $10.6 million of IBM at the present price of $154 (70,000 shares) must be sold to make IBM fall 1% instantly. By comparison, looking at GDAX (a Bitcoin exchange) only about $600,000 of Bitcoin needs to be sold to make Bitcoin fall 1%.

To understand why Bitcoin is so volatile, when someone buys or sells a stock, all the orders get routed to a single ledger. But with Bitcoin there are many exchanges and ledgers, because the the trades are spread among many exchanges. Whereas there is a single chart for IBM stock that represents all transactions, there are a dozen or so charts for Bitcoin, one for each exchange. And they they are all highly correlated, as you would expect them to be. So if someone places a large order on one exchange, the others will mirror it, which means effective liquidity is divided by the number of exchanges. This works to the upside too. A way to fix this would be to split the transactions evenly among all majors exchanges, executing all the orders at once, instead of only at a single exchange, but most large traders don’t do this. Signing up for 8 or so different exchanges and splitting the Bitcoin among them would be a big hassle.