What Bitcoin Might Tell Traders About Market Crashes

Bitcoin has started this week with a bullish breakout.

Photo: orkomedix/Flickr

Photo: orkomedix/Flickr

Bitcoin broke the interim resistance at $260 per coin yesterday. At the end of last week, the price started to cross above the cluster of 200-, 100-, and 50-hour SMAs. (simple moving averages) BTCUSD ended the week pushing at $256 but ended up in another consolidation for a couple of days.

As long as the price can hold above $250, the market should still be bullish this week.

Jonathan Donier and Jean-Philippe Bouchaud from Paris-based hedge fund Capital Fund Management have decided that it would be easy to foresee big crashes if one could monitor the actual thoughts and expectations of the investors. They turned to the Bitcoin market since it has a unique feature, it is still fairly young and exotic: traders place their buy and sell orders early and leave them there for all to see.

“Crashes have fascinated and baffled many canny observers of financial markets. In the strict orthodoxy of the efficient market theory, crashes must be due to sudden changes of the fundamental valuation of assets. However, detailed empirical studies suggest that large price jumps cannot be explained by news and are the result of endogenous feedback loops. Although plausible, a clear-cut empirical evidence for such a scenario is still lacking.

Here we show how crashes are conditioned by the market liquidity, for which we propose a new measure inspired by recent theories of market impact and based on readily available, public information. Our results open the possibility of a dynamical evaluation of liquidity risk and early warning signs of market instabilities, and could lead to a quantitative description of the mechanisms leading to market crashes.”

In a recent paper, Donier and Bouchaud found that Bitcoin market is predisposed to crash specifically when buying orders are infrequent, and estimated how much a typical-size selling order should move the price when matched with such buying orders. Using the method, Donier and Bouchaud were able to predict the size of the biggest 14 single-day drops in Bitcoin value between January and April 2013 to a high degree of accuracy.

Donier and Bouchaud employed a much more sophisticated mathematical analysis to estimate the likely size of a downward price movement as signaled by a default of buy-side demand. It turns out to be almost identical to a much simpler formula: market volatility divided by the square root of trading volume. The formula can be calculated purely from public data. If they are right, this measure should predict big market movements.

They believe that the formula reflects such fundamental mechanics of market behavior that it will hold predictive value even if everyone comes to understand it.

According to Wall Street Journal, Bank of New York Mellon Corp. is experimenting with Bitcoin. It views the digital currency as a potential new way to conduct financial transactions. However, the bank is still working through the challenges of using the open source technology, whose decentralized architecture differs from the traditional computer systems businesses run today.

BNY Mellon’s Chief Information Officer Suresh Kumar told WSJ: “We want to try it out to see the applicability of [Bitcoin] in our businesses.” Mr. Kumar said that the bank will test BK Coins, an internal codeword for Bitcoins, as company’s new corporate recognition program. Managers can now pay the hard working, well-performing employees in Bitcoins.

According to Mr. Kumar, if the pilot project is successful, then the idea will be expanded: “There is a big mindset change that comes with many of these new technologies. So if we can find a way to make it tangible, in a controlled environment like our internal employee recognition program, then we have a great opportunity to help our businesses better understand the potential value.”

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