Matching our analysis, Bitcoin price plunged to near $500 BTC/USD today. That is if you were looking at the Bitstamp exchange price. BitFinex, on the other hand, saw $460 followed by a return to $500 only to slam down to $451 a few seconds later. Is this the result of some systemic error or perhaps manipulation being exercised via the BitFinex exchange? Could it be that some early adopters are cashing out, or perhaps the news? Far from it, as the following explanation will clarify.
BitFinex is one of the few major exchanges that offers traders the option of margin-based trading. The others are BTC-e and OKCoin, the latter recently having added more complex trading instruments like futures contracts as well as margin facilities.
Margin-based trading is far removed from the ordinary buy-low-sell-high trading that most Bitcoin and altcoin fans engage in from day to day. When someone trades "on margin" it means that they are required to commit an up-front cash deposit to fund a "margin account." This margin account then serves as collateral for subsequent trades they open in the market - whether the instrument is the price of Gold, Oil, the Eur/Usd exchange rate or the price of Bitcoin. Brokers typically entice traders to make sizeable downpayment by offering them the ability to leverage their trades.
An over-simplified explanation of how leverage works in practice goes like this:
Leverage is a multiplier on the size of positions a trader can open. So for example leverage of 1:2 allows a trader to open a position 2x the size of his margin account. A margin account balance of $100, today, would thus allow a trader to trade (not purchase) a BTC position worth $200 ($100 account balance x 2).
Contracts for Difference
However, the trade position does not involve direct buying and selling of the underlying asset (bitcoin) but is, instead, a bet made via an instrument called a Contract for Difference (CFD). Usually, a CFD instrument is based on its underlying asset, e.g. BTC/USD, the Bitcoin price in US Dollars, and will go up and down in sympathy with the underlying index price. Unlike those traders who buy actual bitcoins from exchanges such as Bitstamp and Cryptsy, traders who engage in CFD trading do not purchase bitcoins at lower prices with the hope of selling them at higher price.
Instead, via leveraged CFD trading, speculators can bet in both directions of the market - making the same amount of profit whether BTC/USD goes up $10 or drops by $10.
The Long and Short of Bitcoin
In trading parlance this is referred to as going "long" the market (betting on a price increase) and as "short selling" the market, in the case where one opens a CFD position betting that the market will go down. They cost the same, and their profitability is the same, but the fact that these bets are leveraged means that, should the market move against your bet, the losses on the position quickly multiply because the trade is leveraged. Therefore, even a minor $10 BTC/USD move against a modest CFD trade can cause the position to be "closed out" due to it exceeding the margin account balance. Moments prior to such a forced "closeout," the trader will receive a "margin call" from the broker's trading system, typically resulting in panic stricken closure of the CFD position - or risk having all of one's margin balance wiped out by forced position closure.
Bitcoins As Margin
Unlike regular brokers, such as those in the Forex and Commodities realm, who deal exclusively with fiat, BitFinex's margin funding facility is unusual in that they allow traders to fund their margin accounts using bitcoin. This compounds, then, the effect of positions in the BTCUSD CFD being forcibly closed or closed at a loss such as during a rapid price decline. As the BTC/USD price goes down, those traders holding long positions that are going deeper and deeper into loss, will eventually close their positions to prevent margin closeout- or be closed out. In either case the result is that their actual bitcoin holdings (serving as collateral in margin accounts) are claimed and sold.
Hence, the facility whereby BitFinex clients fund margin accounts using bitcoin means that in times of strong price moves the BitFinex volatility is compounded.
Add to this the fact that traders can short the BTC market via Contract for Difference bets and you should now have a better understanding of why the BitFinex and BTC-e exchanges often experience much lower prices during downtrends such as the one we saw today, even in the absence of any significant news.
Featured image by Shutterstock.