The Bitcoin Price Dilemma

by Rick Johnson

By December 2017 Bitcoin had dropped a whopping 21% from its yearly highs – reached only four weeks ago.  But an asset still worth around $15,000 may not be the end of the world, or is it?

Everyday the forces of supply and demand drive markets of all types, where economic theory suggests that elasticity is directly proportional to the perceived value of that asset.  In other words, a merchant may decide to charge $20 for a Snickers Bar, but he may find sales weak as buyers reject that asking price.  For goods and services, price ultimately seeks that equilibrium determined by a wide number of factors giving the buyer “shopping power”. However in the financial markets, the issue of pricing   is a bit more complex, especially in the case of Bitcoin and other cryptocurrencies.

While we are being sold that perhaps our government may be too dependent on regulation, some of these regulations or protections are actually effective and important.   To be specific, it was discovered long ago that market assets such as stocks, could be susceptible to price manipulation. Most people don’t fully grasp the concept of “shorting” a stock, let alone the mechanics of price manipulation. Not to imply the price of Bitcoin is being manipulated, but to drive home the point that fair value and market driven asset prices are at the core of why “regulated exchanges” exist.

Here’s a basic example:  If I owned 50,000 shares in XYZ Widget Company purchased at $10 per share, what is to prevent me from offering to buy 10 additional shares of XYZ stock at $12 per share? If another person sells me 1o shares at $12 per share, then it could be factually reported that the price is now $12 per share. No harm no foul right?  Well, let’s say the person who offered to pay $12 per share also had 50,000 shares of XYZ Widget Company.  Now let’s say these were the only two trades made the entire day. Clearly, a potential conflict of interest arises whereby these two large shareholders could be  “bidding up” the stock of XYZ Widget company to drive up the value of their own portfolios.

How could such a thing be prevented in a massive global stock market?  It’s called “transparency”.

Within our regulatory structure, a record of stock purchasers and sellers are recorded at what are called  “exchanges” and “broker-dealers”.  It is this record that publishes all of the transaction information for the entire world to see. If two large shareholders of a small stock started posting higher prices, it wouldn’t take Sherlock Holmes to conclude there may be games afoot. Now for arguments sake, let’s create another scenario whereby instead of just two large shareholders bidding up prices, there are hundreds or thousands of buyers bidding up prices.

This quantity is known as “volume” which logically we can conclude represents a more reliable market  to represent fair value of the stock. While large shareholders still stand to gain, rising prices derived  from market volume carries far more legitimacy. Further, all of these purchases would be on-the-record  by exchanges and broker-dealers as a proven deterrent against manipulation and fraud.

So what does all of this have to do with Bitcoin? Some of you have already figured it out. Bitcoin is NOT  a transparent asset. While the romanticism of a rogue asset created outside of our economic regulations  may seem pretty darn cool, the trade off is the opaqueness, or lack of transparency. The lack of transparency can be assumed to be directly proportional to risk and asset volatility.  One can argue      the point that Bitcoin is acquired and traded all over the world and thus significant volume must exist. Again these are assumptions which at the end of the day are all relative to other global assets.

If size matters we could compare the one-day volume of  Tesla stock option contracts traded, to Bitcoin futures contracts traded at the CBOE and the CME combined.  Survey says… the ONE DAY volume of Tesla stock options contracts traded is at least 20x times the number of Bitcoin futures contracts traded at the CME and CBOE combined.  Thus despite all of the news hype,  that’s not a whole lot of volume by any stretch of the imagination.

Is Bitcoin and the cryptocurrency revolution an advancement in science…absolutely! Is it a glimpse into the future of a new alternative to commerce and trade…only time-and volume, will tell.

Additional Information:

Bitcoin Basic Facts

More on Bitcoin Futures

Bitcoin and Ethereum Prices

Motley Fool on Futures