Why is Bitcoin tanking?

If you read CoinDesk, most of the news about Bitcoin is good. It’s been that way for months. More well known businesses are starting to accept it. Megacharity United Way now accepts Bitcoin donations. Various national governments are coming out with regulation which at least acknowledges that Bitcoin is here to stay. Venture capitalists are funding Bitcoin-related innovation all over the place. Even fiat-based hedge funds are starting to hold positions in Bitcoin claiming it’s a great way to diversify a portfolio.

With all this good news, why is the price of Bitcoin continuing to drop? If more people are using Bitcoin, shouldn’t the price get higher? What’s going on?

The most plausible explanation came from this article from CoinDesk about three weeks ago. Financial giant Citi weighed in on the matter.

First, it seems that Bitcoin miners are more prone to dump their freshly mined Bitcoin than they used to be. That is probably in part because the price of Bitcoin is much better than it used to be. When Bitcoins only traded for a dollar, it made a lot of sense to keep them. When Bitcoins traded for $1000 it made much more sense to sell them. Now that Bitcoins trade for a little over $400, it’s starting to head into that gray area. Some Bitcoin investors are starting to think it might be good to pick up a few more. They believe the price will go up in the future. Some miners believe that the price will drop even more before it starts to climb again so they may be thinking it’s best to sell now rather than later.

The mining issue is an interesting one. Those who are mining as a business (not a hobby where it’s OK to lose money) have some very interesting challenges. The first one is the fact that no matter what coin you are mining, if it is successful (as Bitcoin has been), its difficulty increases, and sometimes rapidly. This means that a brand new mining rig with x amount of hash power, while it might have seemed like a lot at the time it was purchased (or worse, preordered), could wind up producing next to nothing within months as newer rigs with ever higher hash rates come out and join the network. Because of this it is paramount to ROI on equipment as soon as possible. This puts intense selling pressure on the coin you’re mining which then means it’s going to sell for less and it will be more difficult to ROI on the resources spent mining it. Since most industrial miners are still mining Bitcoin, that means the selling pressure is on Bitcoin.

Those who are mining Scrypt coins have a similar issue, but with the added option that if the Scrypt coin you happen to be mining ceases to be profitable to mine you can switch to another Scrypt coin that is on the rise. It used to be that all new alt coins which used the same algorithm as Bitcoin (SHA256) were merge mined with Bitcoin, meaning their networks’ difficulty was the same as Bitcoin. NameCoin, IxCoin and Devcoin are all merge mined with Bitcoin. No one would ever think of mining any one of these coins alone–except for Devcoin which from the end user perspective is “mined” by writing and development.

I’ve noticed that this is changing. Some very new coins are using the SHA256 algorithm, and they are not merge mined with Bitcoin. This means that people who are sitting on a bunch of obsolete SHA256 ASICs might be able to dust them off and profit off a different coin, just like Scrypt miners can. Although I didn’t think it through in as many words, this is ultimately the reason I chose to invest in Scrypt mining technology rather than SHA256 ASICs. I simply am not willing to be stuck holding rapidly depreciating hardware all designed to chase a single coin that everyone else is after. Scrypt hardware depreciates rapidly enough even with several new coins launching each month.

The wide variety of Scrypt coins to mine may not matter so much in terms of alleviating the downward pressure on the Bitcoin price, though. While individuals such as myself do often mine single Scrypt coins, many of us spend most of our mining time in multipools which pay out in Bitcoin. Or we run our earnings through Cryptsy’s autoseller and get Bitcoins that way. In that case even though we’re using a different algorithm, practically speaking, we are still mining bitcoins, and we have the same ROI considerations, so we dump our Bitcoins.

Related to this is the fact that although certain things, notably the mining rigs themselves, can be purchased with Bitcoins, there are many related expenses which are still only payable in fiat. When I buy a new mining rig, I have to also buy a power supply unit and sometimes a Raspberry Pi. I buy those items from either Amazon or eBay and neither of those merchants take payment in Bitcoin. To buy these necessary accessories I have to sell my Bitcoins to pay for them in fiat. My data center also does not yet accept payment in Bitcoin, though they are working on it. So I have a rather large monthly bill which has to be paid by me selling off my Bitcoin earnings from mining activities.

The price heading south doesn’t help either. If I know my colocation payment due date is approaching and I’m worried that the price will drop even further I may sell today just to make sure I can pay the bill. Many Bitcoin and Scrypt miners also dabble into day trading. If that were my thing right now I’d probably be selling some Bitcoins with plans to pick them up cheaper in a few days.

The other possible cause that Citi brought up was the fact that when a merchant accepts payment in Bitcoin the merchant is likely to immediately dump the Bitcoins and pocket the fiat. There are several reasons for this. The first is that the merchant still has to pay most of his bills in fiat. The source of this selling pressure will be alleviated over time as more and more merchants accept Bitcoin and begin doing business in Bitcoin with each other.

The other cause has to do with what merchants consider to be appropriate risk. In the US, regulatory bodies view Bitcoin as a type of property–an asset. As such, it is considered (and rightly so) to be riskier and more volatile than a bunch of money sitting in a checking account. The merchant might accept Bitcoin payment for an item worth $200 today only to find that if he waits until tomorrow the amount of fiat he can get from that payment is only $150. It could also work the other way, but it’s a risk. In the US corporations are only allowed to have a certain percentage of their holdings in volatile assets. It would be the same thing if I were to pay for an item I bought using some stock I had. The merchant might be willing to accept it, but he would very quickly sell that stock. So when I pay for the item in Bitcoin the merchant quickly sells off the Bitcoin so as not to expose his corporation to more risk than is wise or even allowed.

Citi implied that merchants do not really have a choice in the matter. They must sell or they risk running afoul of regulation designed to keep them solvent. Even if they used Bitcoin to pay some of their own bills, they would most likely have to pay those bills very quickly after receiving the Bitcoins to do so.

Exacerbating this is the fact that even when a merchant can pay one of its bills in Bitcoin (and if it has the Bitcoins it would be motivated to use them rather than trade them to avoid trading and ACH depositing expenses), the bill is still counted in terms of fiat. So let’s say merchant A owes merchant B $100. Last December when Bitcoin was $1000 it cost 0.1 BTC for merchant A to pay the bill. However, when Bitcoin was $500, it cost merchant A twice that amount of Bitcoin, 0.2 BTC, to pay the same bill. If merchant A took payment in Bitcoin at $1000 and within a month the price tanked to $500 (and it’s not unusual for businesses to take 30 to 60 days to pay their invoices), then that same bill priced in fiat just got twice as expensive while the amount of BTC to cover it stayed the same.

I believe this is going to be an issue for as long as Bitcoin pricing is based on the BTC/fiat exchange rate. In that case the only advantage of paying a bill in BTC is to save on the expenses associated with exchanging as well as take advantage of the fact that it’s easier and cheaper to send BTC around than it is to send fiat around (this is especially true for international transactions).

In order to end the downward pressure on the Bitcoin price caused by merchants having to quickly dump any BTC they make in sales, merchants will need to start pricing their items in Bitcoin and maintaining those prices regardless of what the day’s exchange rate says. In other words, if I can buy a widget for 0.1 BTC today, I need to be able to buy it for 0.1 BTC tomorrow and next week and next month as well. When that happens, then I can think of what one Bitcoin can buy in and of itself, rather than having to consider today what $413.65 buys. This would mean that Bitcoin will have value as Bitcoin, and not merely in terms of its current fiat equivalent.

The very first merchant to choose to do this is going to be the one taking on the greatest risk. It will only be when other merchants follow suit that his risk is mitigated. I suggest the first merchants ought to be those who sell products which come with a high markup and which do not cost much per unit to generate. Digital products such as eBooks and computer games and other types of software come to mind, especially ones available by download where the process of selling it is completely automated. From there merchants who have lower margins can gradually start to offer their products for fixed Bitcoin prices.

Once products are priced in Bitcoin independently of the daily Bitcoin/fiat exchange rate, then Bitcoin will have reached an important milestone in its development as an actual currency (as opposed to an asset). And its price on all exchange rates will increase to reflect its new value.

Before mainstream merchants are going to be willing or able to price their products in Bitcoin, the daily exchange rate is going to have to get more stable. One way that this is going to happen is when hedge funds holding significant positions in Bitcoin begin to demand it. Some of them already are using an aggregation of the Bitcoin price from various major exchanges to determine their own buy and sell price. The possibility may even exist for them to buy and sell based on an aggregated price over time, especially if hedge funds represent a significant amount of Bitcoin buys and sells. Once the Bitcoin/fiat exchange rate settles down to a stable price then merchants will find it much easier to use fixed Bitcoin pricing. Nothing beats being able to tell a customer in person or over the phone: “That will be point one (0.1 BTC).”

And that’s when you’ll be able to buy or sell Bitcoin for $10,000 a pop.

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