Bitcoin Flash Crash – Naked Gun Part Deux

bitcoin

 

We first wrote about Bitcoin nearly two years ago, as it flash crashed for the first time in June 2011. Nearly two years later the online digital currency is again in the news in a major way, as it again has been subject to wild volatility rides and “flash crashing.” It did it again last week, when in the space of an afternoon, Bitcoin hit a new high at  $266 before plunging to $105, and then back up to stabilize at $172.

To refresh your memories, Bitcoins are a digital and decentralized currency. They can be used, similarly to Paypal and Visa, to make payments for commerce anywhere in the world, although unlike Paypal and Visa, Bitcoin transactions are untraceable. Many conjecture that the only users/players in the Bitcoin market are speculators, gamblers, and criminals attracted to the untraceable and anonymous nature of the transactions. Bitcoins are traded on digital for-profit exchanges, like Mt. Gox, very similarly to how stocks trade on for-profit exchanges in the US.

Recently, Bitcoins have also attracted the attention and backing of programmers and tech nerds savvy in the art of automation and algorithms. The Winklevoss twins, who successfully sued Mark Zuckerberg for an ownership share of Facebook (watch The Social Network), have announced that they are major Bitcoing investors and advocates.

Why do we even care about Bitcoins? It seems to that they are not something investors do, or should, play with. We care because recently we have seen many articles and claims that the wild volatility and price action in Bitcoin is because it is a marketplace traded by humans – i.e. the flash crashing and the volatility is due to human beings and their errors. We knew we had heard those claims before, when our stock market had its own Flash Crash in May 2010. Then, industry participants as well as the SEC erroneously and unfairly named a Midwestern mutual fund, and human error, as its cause.

And so we smelled manure and spin in the air and quickly did some basic research:

1)      You can watch the Mt. Gox order book here. That alone should convince you that the price action is algorithmic.

2)      Read these posts and comments about Bitcoin and High Frequency Trading on Redditt.

Some quotes from the above online discussion among programmers:

1)      Background: 29 year old, Bachelors with double major in hard computer science and mathematics, Masters in electrical engineering, PhD in mathematics. Have been employed in an algorithmic and high frequency trading (hereafter HFT) division of an investment firm for the last two years.

Although e-currencies are not new, Bitcoin is arguably the first to draw sufficient interest and investment to warrant short and long-term overwatch. The firm I work created seeder investments around the same time I began, and continues to do so in speculative markets. There is no inherent interest in the underlying vehicle (Bitcoin, Litecoin, etc), rather there is enough money and activity in it such that it can be exploited.

The volatility in the market is great from a HFT and algorithmic standpoint — especially over the last few weeks. We have been seeing 60%+ daily returns in the last few weeks, which has drawn sufficient scrutiny to warrant more senior traders assigned to it.

To my best knowledge, every firm with an algorithmic/HFT division has presence in multiple Bitcoin exchanges.

AMAA.

2)      “To what extent do you use quote stuffing, momentum ignition, and book fade?”

3)      Q: “How do you deal with such high transaction fee’s, and the fact you don’t get any rebates?” A: Private agreements with exchanges.

 

We could go on – feel free to read the whole discussion among programmers. This should leave little doubt that algorithmic and high frequency traders are at work in the Bitcoin market. Interesting also is the fact that one commenter claims that seeder investors are at work making markets like Bitcoin bigger, for the sole purpose of making these markets “algorithmically feasible”.

 

All they need in any market is for it to be big enough to throw real money at, and for there to be robust data. While price action in Bitcoin may not concern you, the pattern should. We hope that as HFT is exported globally to young markets and new asset classes that have real economic implications, appropriate regulatory authorities are prepared for what can happen. History is a great teacher.