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...
When Bitcoin Prices Fall, It's Time to Buy
Despite this price tumble, Bitcoin investors aren't panicking - they're stocking up.
As of today (Tuesday), Bitcoin traders seemed to be taking advantage of the drop as a buying opportunity.
One reason for this reaction from the Bitcoin community is that by now, Bitcoin enthusiasts are used to the big price fluctuations.
"This is just how Bitcoin trades, for better or worse," Barry Silbert, the CEO of Bitcoin hedge fund operator SecondMarket, told The New York Times. "This is normal - par for the course."
Bitcoin does have a reputation for volatility. It started 2013 at $13.41 and rocketed to $1,147.25 on Dec. 4 before heading back down toward $500. This year the Bitcoin price has ranged from $360.84 to a high of $951.39.
But Bitcoin investors know that in the long run, the potential of the technology underlying Bitcoin - the blockchain that verifies and stores all the transactions - is where much of the value lies.
What's more, the powerful catalysts driving Bitcoin toward mainstream adoption have not changed. More merchants are accepting Bitcoin every day. Millions of dollars of venture capital continues to pour into Bitcoin startups.
And investing in Bitcoin will soon get much easier, as two Bitcoin funds - Silbert's Bitcoin Investment Trust (a Bitcoin hedge fund) and the Winklevoss Bitcoin Trust (a Bitcoin ETF that will use the symbol Nasdaq: COIN) are on track to be open to retail investors by the end of the year.
With so many supportive factors, agonizing over the latest drop in the Bitcoin price makes no sense. The Bitcoin economy is slowly gaining traction, but this is a years-long process and there have been, and will be, inevitable setbacks.
Since hitting a low of $448 the CoinDesk Bitcoin Price Index yesterday, the cryptocurrency recovered to about $478 in mid-day trading today.
For more Bitcoin news and insights, follow me on Twitter @DavidGZeiler.
UP NEXT: E-commerce giant eBay Inc. is very close to offering Bitcoin payment as an option - a high-profile move that will mark another milestone on the road to mass adoption of the digital currency. And when it goes live, other major merchants will face some major decisions...
- CoinDesk: Did Margin Trading Crash the Price of Bitcoin?
- The New York Times: Bitcoin's Price Falls 12%, to Lowest Value Since May
- CoinDesk: Price of Bitcoin Drops Below $400 in BTC-e Flash Crash
About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.