Here's why bitcoin is extremely volatile

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In early January, Bitcoin came within a whisker of topping its all-time high of $1,165.89, reached on November 30, 2013. Then it promptly fell off a cliff, plunging by 29 percent between January 4 and January 6, following warnings issued last week by the Chinese central bank to the country’s three largest Bitcoin exchanges.

Where the price will finally stabilize remains an open question, as far as investors, traders and players in the market are concerned. For institutions and hedge funds that invest in alternative assets, the potential advantage that Bitcoin can diversify risk may be offset by such high levels of volatility.

Bitcoin’s recent plunge comes after a long bull run — with occasional hiccups — that began in September 2015, making it the best performer of any currency in each of the past two years, according to a veteran over-the-counter trader for institutional clients. Whereas trading in Bitcoin is still a long way from being a mature market, its ability to survive bouts of sharp volatility is itself a sign of underlying strength, the trader says. “Every day Bitcoin is around, it diminishes the prospects that it ever goes to zero, and at the same time, more and more people start looking at it as a legitimate asset,” he says.

In the past two months Bitcoin’s bull run turned into a stampede, as the price zoomed ahead by $442.29, or 54 percent, according to the CoinDesk Bitcoin Price index. From a November 3, 2016, close of $687.51, the asset’s price rose to $1,129.87 on January 4. On January 5, after testing its peak price again, it plunged 17 percent in a matter of hours and bounced lower over the next two days, to $819.38 on January 7. The price has been less volatile since last week’s low; it is currently trading near $904.00.

Traders say the People’s Bank of China sparked last week’s sell-off when it warned China’s three largest Bitcoin exchanges — BTCChina, OKCoin, and Huobi — to strictly adhere to state regulations limiting individual holdings. The warnings came as Bitcoin sailed past $1,000 and then $1,100. The central bank publicized its warnings in a statement released January 7 that also reminded the public that it views Bitcoin as a speculative asset.

Limiting ownership of Bitcoin is seen as part of China’s efforts to reduce capital flight and manage the orderly decline of its currency. As the yuan falls, Bitcoin rises — and vice versa. The linkage is in part because of the fact that leveraged trading volume on Chinese exchanges represents more than 80 to 90 percent of the global trading volume of Bitcoin, says Steven Lord, co-founder of the Modern Money Group, a consulting group, and who is also managing editor at FINalternatives.

Because Bitcoin’s low trading volumes make it “extremely illiquid,” changes in the yuan’s value “can have an outsize effect” on the price of Bitcoin, Lord says. Traders share this view. “It’s a huge driver of trading activity,” says one OTC trader.

Not everyone accepts the notion that China’s currency moves drive the price of Bitcoin, however. “If you talk to currency exchanges about it, they call that explanation B.S.,” says Peter Vessenes, co-founder of the Bitcoin Foundation and managing director of New Alchemy, a blockchain consulting group based in Seattle. Vessenes thinks the market is simply being manipulated by traders.

Still, in spite of its volatility, more investors have come to see Bitcoin as a safe haven, “meaning it can gain or stay steady in times of economic volatility,” says Pete Rizzo, editor of CoinDesk. The safe-haven effect was seen last year after the U.K.’s Brexit vote, and again after India began to remove some of its banknotes from circulation, Rizzo notes.

An OTC trader reports that the average daily trading volume for Bitcoin has benefited from a significant increase in Bitcoin-enabled cross-currency remittances. The use of Bitcoin for such transactions saves both time and money. It takes 72 hours and costs 10 to 15 percent of the transaction to do a currency conversion using banks, according to the trader. By contrast, it can take less than two hours and cost only 1 to 2 percent of the transaction when it is executed using Bitcoin. The volume of trading involving foreign exchange payments enabled by Bitcoin “is only going to increase,” he says.

Vessenes, however, remains bearish about Bitcoin. He contends that the continuing low average daily trading volume makes the digital coin vulnerable to 15 to 20 percent intraday swings and to the intrigues of price manipulators. “I can’t prove it, but it looks to me like it is all speculation,” he says.

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