Yesterday I was asked by CoinDesk for some comments on the recent drop in bitcoin prices.  At first I referred them to a good friend, Raffael Dannielli, who I worked with in China and who helped me on all three of my books.  Raffael wrote a very interesting post yesterday about margin trading squeezes: Bitfinex: cascading margin calls resulting in flash crash

Later I sent CD some comments for a new article they published moments ago.  They were not used, but may be of interest to readers here.

Why did prices fluctuate?  Making a testable hypothesis with prices is a crap shoot.

For example:

Hypothesis: “Prices declined because of negative news”
Test: “Look around for negative news”
Falsifiable: “Yes”
Potential falsification: “Finding bad news”
Truth status: “False” (there is bad news)

But it’s unclear if the news itself is leading it because it is hard to quantify and qualify; how do we know it is not manipulated via coordination by whales, Willy bots or exchanges?  And complicating matters, in the example above, you could do the same kind of “test” with good news.

Prices fluctuate and then news organizations try to make sense out of it by assigning news events to it to justify the movement, thereby ignoring that at the point of the price fluctuation there is often contradicting news.  However, in retrospect due to time constraints news organizations are left with presenting the news that “makes sense” to justify the price movement.  This does not mean that news has no influence, it is just that the market moves really fast in incorporating events. Even events that have not been reported in the news or are out of the spotlight for some reason.

This is one of the reasons why Coinometrics is trying to spearhead the Compare The Exchange (CTE) transparency effort, by surveying exchanges to find out what kind practices they implement.  Despite enormous amounts of scams and thefts over the past several years, the counterparty risk for Bitcoin exchanges is huge.  In one study published last year, between 2010-2013, 18 out of 40 exchanges shut down, some of which absconded with customer funds. And it does not seem to go away by itself: as long as an exchange has volume people will go there to trade and the exchange will have no incentive to improve.  One example is BTC-e, even though its management is obscure, people go there because of the volume.  As long as people still trade at them, exchange managers have no incentive to change.

While it is unclear what immediate impact regulatory compliance proposals such as Bitlicenses from New York may have on exchanges (e.g., are all fiat-based exchanges depository institutions?), in the long-run the first two generations of exchanges may be living on borrowed time. That is to say, if the first generation was Mt. Gox and, 2nd generation exchanges are Bitfinex and Bitstamp, then the rise of a 3rd generation, potentially regulated or consortium of “self-regulated” exchanges, could eventually implement some of the suggested CTE “best-practices.”