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When the Bitcoin price started falling 10 days ago, it took many by surprise because the digital currency had been stable for weeks, hovering around the $600 level. It has since slipped nearly 19%.
The Bitcoin community has been searching for answers to the price drop, and the most likely explanation is one that most seasoned investors will recognize.
You see, the main reason why the Bitcoin price is falling stems from misuse of an old market tool…
Why the Bitcoin Price Is Falling
Virtually all investors know that the worst stock market crash in history, the crash of 1929, was in large part caused by people buying on margin – borrowing money to buy stock.
As stock prices fell, such investors needed to dump their holdings quickly, as they were losing money they didn't really have. The panic selling triggered even more panic selling.
That's essentially what happened with Bitcoin last week, though on a far smaller scale.
The process seemed to have started as Bitcoin traders, particularly those using the Bitcoin exchange Bitfinex, borrowed money to buy Bitcoin in anticipation of positive news from New York state regulators. But the regulations weren't quite as friendly as many had hoped, and Bitcoin prices went down instead of up.
"Many traders were caught in large, leveraged, long positions entered in mid-July around $600 to $640 as can be seen from the change in open swap positions," Raffael Danielli, a quantitative research analyst at ING Investment Management who developed the theory, told CoinDesk. "It was just a question of time until those traders would hit the margin call if prices continued to drop."
As is usually the case, the Bitcoin price drop on one Bitcoin exchange, in this case Bitfinex, dragged down the Bitcoin price everywhere else.
Margin trading was also blamed for a "flash crash" on the BTC-e Bitcoin exchange yesterday. The Bitcoin price on BTC-e plunged from about $462 to $309 within minutes, but bounced back to above $450 just as quickly.
Bitcoin price volatility as a result of margin trading is a relatively new risk, as several Bitcoin exchanges, notably Bitfinex and China-based OKCoin, only began offering margin trading in June.
And unlike the major U.S. stock exchanges, Bitcoin exchanges don't have any "circuit-breakers" in place to halt trading if things start getting crazy. Issues like these are why the arrival of a U.S.-based, fully regulated Bitcoin exchange will come none too soon.
While any kind of crash in the Bitcoin price is unnerving, at least they're usually short-lived.
"We have seen crashes like this before and they follow a certain pattern – namely a sharp drop followed by a swift rebound to about a bit less than the previous level," Danielli said.
This pattern helps explain why Bitcoin investors are reacting the way they are to the recent Bitcoin price drop…