Yesterday, the Bitcoin market crashed. During the worst of it, the virtual currency had lost 61 percent of its value from its intraday peak price of $266.
What happened? The trading platform was suffering some serious lag, sending the market into a panic that resulted in a big sell-off.
The big slowdown was initially pegged as a "distributed denial of service" (DDoS) attack, in which hackers use large groups of computers to flood a website with connections, such that no one else can connect to it. This happened to the world's biggest Bitcoin exchange, Mt. Gox, just last week.
ConvergEx Group Chief Market Strategist Nick Colas, one of the only Wall Street analysts who has taken an interest in Bitcoin, writes in a note this morning that the reason for these DDoS attacks is that hackers are trying to knock the virtual currency down in order to scoop it up at cheaper prices.
In a note to clients this morning, he writes:
Now here’s the weird bit: hackers attack the infrastructure (exchanges and wallets) around the core open source software because they want to BUY bitcoins at reduced prices.
Their idea is to sew some confusion in the market, shake out owners who have large gains and don’t want to lose them, buy in the resulting melee, and sell when things return to normal. It usually takes barely more than a day, seems pretty easy to do, and yields a big payoff.
Mt. Gox released a notification on its Facebook page overnight to the effect that yesterday's slowdown was not, in fact, due to a DDoS attack, but instead was a result of the rapid amount of new users that have flocked to the trading platform in recent days and weeks.
Whatever the cause, the key here is that the Bitcoin market has to transition to a state of lower volatility before it can really gain widespread acceptance. Days like yesterday don't do much to inspire confidence in the virtual currency from a wider group of consumers and investors.
According to Colas, "This is where bitcoin stops being a science project and starts helping anyone interested in capital markets or macro policy understand our world just a little bit better."
In his note, he brings up three points related to the volatility issue:
Trust is the keystone of any currency as well as the macroeconomic policies and support structures which surround it. Even if bitcoin fully recovers from today’s problems, it is still a black eye for the support structures around the core “Mining” process. The Fed has a lot more leeway for error – the dollar is still the legal tender of the U.S., for better or worse.
Volatility matters more than level. Recall our two trader’s aphorisms at the top of this note. Wild price swings are tough on humans; they encourage fear-based decisions which often prove ill-informed and expensive. Watching the churning volatility of the bitcoin market today, I had a new appreciation for the Fed’s controversial bond buying programs. The Fed knows that price volatility in capital markets is the true enemy of economic recovery after the storms of 2007-2008. By flooding the financial system with liquidity, they reduced the fears of another crisis. It just so happens that lower equity market volatility is tied to higher prices. But the real goal for the Fed – and one that it has accomplished in spades – is to dampen volatility so businesses, consumes, and investors don’t thrash about making fear-driven choices. This approach hasn’t been cheap, to say the least. But there’s no doubting that it has had its intended outcome.
Before today, Bitcoin had been an almost unalloyed marketing and investment success. Its central value proposition – anonymous, decentralized, open source code-based "Money" – appeals to a wide swath of the developed and emerging world. And there is still a lot of interest in leveraging the core infrastructure to provide a unique, secure, low cost payment system which works as well in Delhi as Dallas, Boston as Beijing. But every investor or entrepreneur who wants to take that journey needs to understand that the path will be far shorter and easier if bitcoin price volatility is much lower than what we saw today.
In short, whatever the cause of yesterday's sell-off – whether it was hackers trying to manipulate the market down or just a massive influx of new users – exchanges like Mt. Gox will have to figure out ways to mitigate volatility like that in order to attract a wider user base.
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