Why price does not reflect fundamentals, Part 96

A bit more than two weeks ago, on March 12, 2020, the cryptocurrency markets — led by Bitcoin — experienced the most significant single-day price drop in seven years, as the price of Bitcoin fell below $4,000 for a brief amount of time.

This drop happened in two phases, the second being about 13 hours after the first. Kyle Samani of Multicoin Capital provided an insightful post laying out the steps that led to such a significant price reduction. I suggest you read the entire article (or listen to the interview he conducted with Laura Shin on the Unchained podcast), but here’s Kyle’s summary:

The quick summary: the Bitcoin and Ethereum networks—in their current forms—cannot operate at global scale. During times of crisis, they become so congested that arbitrageurs cannot keep prices in line across venues, causing massive dislocations on individual exchanges. Massive dislocations on a single exchange (BitMEX) caused Bitcoin to dip below $4,000 for 15-30 minutes; however, this would not have happened if the market operated correctly.

If you do not have time to read the entire piece, here is the jist of what happened:

  • An initial sell-off, potentially motivated by the overall decline in the global economy, triggered an initial drop in price. We’ve seen these types of drops before — Bitcoiner’s are used to 10-20% fluctuations on a regular basis. However, due to the significance of this drop, there were additional ripples in the market as a whole.

  • With this initial sell-off, many traders who were leveraged long — perhaps as much as 25x-50x — were forced to liquidate their collateral on exchanges, led primarily by BitMEX.

  • These mass liquidations led to an additional sell-off, since a large amount of Bitcoin was now being sold on the market.

  • With significant spreads between what people were willing to sell BTC for and what they were willing to buy it for, market makers were hesitant to provide liquidity (as they typically do), due to the overall uncertainty in the market. This lack of liquidity only worsened the situation.

Meanwhile, arbitrageurs — those who make money by buying BTC on one exchange and selling on another exchange at a higher price — also tried to capitalize on the situation, leading to a surge in the amount of BTC being transferred between exchanges. This increased traffic congested the network. In addition, miners — now seeing the price of BTC was less than their cost of mining — began to shut down their mining operation, which only further congested the network (since fewer block producers lead to slower network operations).

This congestion only made it more difficult to provide much-needed liquidity, exacerbating the problem.

While it’s difficult to necessarily prove that all these events definitively caused the price drop(s), this seems to be the most likely sequence of events.

Key takeaways

There are two important takeaways that blockchain participants should take away from this situation:

First, is that we are still in a very immature market. While Bitcoin has been around for more than a decade, and various exchanges have been around for nearly as long, we are still a long way away from a truly functioning cryptocurrency economy with the infrastructure built out in a manner that can generate full trust in the market. Serious investors look at the situation described above and likely laugh about the number of mechanisms that could have been put into place to avoid this outcome. (Kyle Samani wrote a follow-up to his original post, laying out ways we could fix what occurred).

While many cryptocurrency investors believe projects should be up and running in just a few months with mass adoption coming shortly afterward, this episode should serve as an example that we still have a long way to go. The fact that the critical infrastructure surrounding cryptocurrency is still not yet reliable, despite years of building, should serve as proof that we are still in the early innings.

The second takeaway is the fact that basically none of the events on March 12 had anything to do with the fundamentals of Bitcoin or any other cryptocurrency project (perhaps with the exception of MakerDAO, which had it’s own issues as a result of the price action). Other than the initial sell-off — which was motivated by outside events — the various steps that led to such a significant and immediate price crash were outside the scope of the question: “Is Bitcoin a good investment over the long-term?”

The fact that traders who were over-leveraged got eaten for lunch was essentially the contributing factor to such a price plummet; because a handful of people needed to make more money trading Bitcoin (by borrowing money via leveraged trading), there was a price crash far more significant than we have typically seen.

Fundamentally, nothing changed with Bitcoin, ICON, Ether, or dozens of other projects that continue to go about their business each day, building and growing.

While many can’t help but look at the price of a token and immediately conclude that it represents fundamentals (“the price is down, the project must be struggling!”), this episode should be a lesson against that sort of evaluation.


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ReliantNode @ReliantNode
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