A look at the forces driving bitcoin down 23 percent in one week

By Michael Carney , written on August 18, 2014

From The News Desk

The price of bitcoin continues to fall sharply as crypto-bulls scramble to understand the seemingly arbitrary decline.

Prior to the last week, it had been since late May that the Coindesk Price Index closed a day below $550, with the price momentum remaining relatively positive (and atypically stable) in the nearly three months since. The local maximum during that time was $665 on June 3, and the low just $562 on June 25.

The predictability was a welcome change for a virtual currency market more accustomed to wild swings in price and emotion. Notably, this period included the seemingly positive news of Tim Draper buying nearly 30,000 formerly Silk Road bitcoins at an FBI auction, and a bitcoin startup's record $40 million funding for Xapo. More recently, we have seen (yet unconfirmed) rumors from the likes of the WSJ that PayPal is considering adopting bitcoin. Collectively, these headlines should have been enough to break bitcoin out of its $550 to $650 trading band in a positive way.

And yet, today, prices have fallen an additional 7 percent from its already depressed weekend close and 23 percent in the last week, reaching $457 as of this writing. So the question is, what's driving the price down?

There are several competing and potentially related theories. The most common explanation relates to the onerous Bitlicense proposed by the New York Department of Financial Services (NYDFS). A second explanation has do to with speculators who were betting on more rapid price appreciation getting caught trading on margin (debt) and being forced to sell their bitcoin holdings to cover losses.

As Rafaeel Daniel writes on his Matlab Trading blog, and further explains to Condesk, traders at Hong Kong's Bitfinex exchange bet heavily in July that the then imminent NYDFS regulations would have a positive impact on the bitcoin price. The result, however, was far more onerous proposed regulations than anyone anticipated, which were exacerbated by a similarly harsh approach from the European banking sector.

As a result, Bitfinex suffered an apparent flash crash on August 14 as these margin traders were forced to liquidate their more than $30 million worth of swap positions. As each successive trader sold large positions at a loss, it had a cascading effect on the price and subsequent investor behavior.

A third, less widely-cited theory is that growing numbers of merchant accounts means increased selling pressure in the marketplace as the majority of these accounts immediately convert the incoming bitcoin into fiat currency. Large merchants like Dell, Overstock, and Expedia have recently adopted bitcoin and are doing millions of dollars per month in combined commerce, in conjunction with a similar amount across the long-tail. It may be just a fraction of the monthly bitcoin transaction volume, but the perceptional effects of this selling activity should not be discounted.

As the bitcoin community is wont to do, sentiment remains largely bullish on the long-term value of the crypto-currency. Like in more mature trading markets, there is money to be made by savvy participants both as bitcoin's price rises and falls. With more capital and more sophistication entering this market, information is moving faster than ever. With the gap between these pros and the average Joes widening, and with most bitcoin traders lacking access to many of the tools commonly available in other markets, these rallies can move faster and last longer than we're used to seeing on Wall Street.

This is hardly the first time bitcoin has seen major price declines over a relatively short period of time. Similar sell-offs happened during the first half of the year following regulatory clarifications in China and the more recent Mt. Gox implosion, reaching a recent low of $360 on April 10. And yet the prices have rebounded dramatically since.

The crypto-currency regulatory landscape remains as uncertain as ever, with governments representing primary and secondary global economies still wading through how they will deal with this new financial technology. Until this shakes out, it's a fair bet that bitcoin's price will continue to Yo-Yo. The only limits on the virtual currency's potential highs and lows are the perception of its value held by traders in the market. With bitcoin's future still impossible to chart, that means more uncertainty is likely on the horizon.