Yesterday, I talked about Bitcoin being in a bit of a bubble. I should have been less specific. Because two of the other cryptocurrencies, Ethereum and Zcash, are also having a great time of it.



Extraordinary. But not quite as extraordinary as:



Just look at Zcash in the last 24 hours:

Zcash 24 hours 23 May 2017

It’s almost as though people discovered Zcash yesterday, slightly before 2 o’clock in the afternoon, GMT.

What is driving the bubble in cryptocurrencies?

If you search the internet, you’ll see a lot of news sites declaring that Japan’s new relaxed policy toward cryptocurrency is causing this upsurge. There is also mention of “ICOs” – which are “initial coin offerings”, in case you’re wondering. Apparently those have surged as well. And if you’re wondering how those have contributed to the price rise:

  1. Many of these new altcoins are not directly exchangeable for cash.
  2. They’re only exchangeable for bitcoin.
  3. So in order to cash in on a gain, you’d have to buy bitcoin.

Although you’d also then have to sell the bitcoin – so that should balance itself out, I guess? Unless people are happier to hold bitcoin instead of US dollars (or whatever).

But if you’re asking me, I think saying that “ICOs” have caused the price surge is almost the same as saying that the bubble has caused the bubble. Because that’s a symptom, mate. Because once a pricing bubble gets going, that’s it generating its own momentum:

  1. Something causes prices to start spiking in a sustained way;
  2. Some people notice;
  3. Those people buy the asset in question, driving the price up more quickly;
  4. Other people notice;
  5. Those other people buy into the asset as well;
  6. Thus setting off a demand-return-more-demand-more-return spiral;
  7. Which can then spill out to other related assets (in this case: ethereum, Zcash and the new altcoins).

But the spiral is incredibly fragile, because there’s this delirium vs loss aversion dialogue happening within investors all the time. As prices rise, people start to feel elated about this new investment, regretful of the fact that they didn’t buy more initially, and slightly more panicked about not cashing out already. The longer it continues, the more the investment is actually a straight-out gamble about riding the rising tide until it crests. And investors are progressively more vulnerable to spooking.

But something set off the price surge in the first place.

Let’s talk about Bitfinex

Bitfinex is a Hong Kong based exchange. It’s also massive. Some data from bitcoinity from the last 6 months of bitcoin trading:

Bitfinex from the last 6 months
That’s the total trade in bitcoin, broken down by exchange. Bitfinex is in orange. Just pay attention to the dropoff in the share of trade in April.
I can also give you a total for the last six months:

Total trade on bitfinex for last 6 months

So why is bitfinex losing market share?

Between April 13th and April 20th, the exchange made some announcements. This one, in particular:

bitfinex announcement

To summarise:

  1. Until further notice, Bitfinex (at that point, responsible for almost 40% of all global bitcoin trades) was no longer going to allow people to buy Bitcoin for real-world money (fiat money).
  2. In addition, Bitfinex was struggling to settle the sales of Bitcoin for real-world money.

So what happened?

Well, you’d think that the lack of buying would cause Bitcoin demand to fall off. But it seems that this was the least important part of the story: because there were other exchanges that could and would take your US dollars and exchange them for Bitcoin.

But struggling to settle the sales of Bitcoin for fiat money – now that’s more interesting.

The rational response for Bitcoin holders is to say:

  1. If I can sell my bitcoins on any exchange;
  2. But this exchange is struggling to settle those transactions especially quickly; then
  3. I’m going to expect to be paid a premium for selling my bitcoin on Bitfinex*.
    *I’ve been asked to just clarify this point. Here’s the important question: “If I could sell a bitcoin for $1,000 on an exchange where the money would clear instantly, or for $1,000 on an exchange which will take a while to pay you, if it pays you at all, which exchange would you use? Obviously, the first. New question: if the slower exchange quoted you a higher price of $1,200 – would you use it then? That extra $200 is the premium you’d charge (or expect) for engaging in a riskier sale. Hence: the price is higher on the riskier exchange.

Which is exactly what seemed to happen: Bitcoin prices started to spike on Bitfinex in order to compensate for the risk that the settlement might take longer than expected (or might not happen at all).

Two things at this point:

  1. The quoted “BTC:USD” price that everyone talks about is an average price drawn from across the exchanges; and
  2. It is technically possible to arbitrage by buying Bitcoin on one exchange, and then selling it on Bitfinex to secure the premium (which would drive up the price on the more transactable exchange).

So naturally, if there is a liquidity premium being added to the price of Bitcoin on the world’s biggest exchange by trading volume:

  1. The quoted “BTC:USD” price starts to spike; and
  2. You get people trying to arbitrage, increasing the level of the spike.

Also, if we’re to add another layer in here: as prices rise on the other exchanges due to arbitrage trades, the Bitfinex price has to rise faster than that (because the liquidity premium is still being added to the price of a Bitcoin being sold on Bitfinex).

And at this point, if you get newspapers reporting that there is a massive surge in Bitcoin prices due to, say, ‘increased demand for alternative currencies due to relaxed regulation in Japan’… Well then.

Bubble, anyone?

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at Or both.