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Bitcoin stuck in downward spiral

With bitcoin prices trading back at levels last seen in early 2013, we look at the different factors and challenges that can affect this volatile ‘currency’.

Bitcoin machine with logo
Source: Bloomberg

What is bitcoin?

Bitcoin is a form of digital currency, created and held electronically. It was created in 2009 by an unknown person using the alias Satoshi Nakamoto.

The currency was created as an alternative to normal fiat currency and offered the user the option of purchasing online merchandise anonymously. In addition, international payments are considered to be easier and cheaper, as bitcoins are not tied to any country or subject to regulation.

Bitcoins are produced through a process called ‘mining’, and those who partake in the activity are rewarded by transaction fees and newly created bitcoins. Besides mining, bitcoins can be obtained in exchange for fiat money, products and services. Users can send and receive bitcoins for an optional transaction fee.

There is an upper limit of 21 million bitcoins that can ever be mined. At the moment there are just under 14 million bitcoins in existence, so it’s a market that does not have a great deal of liquidity. However, given that it’s ultimately a strange mix of currency and equity, volatility is something bitcoin traders will be very familiar with.

A volatile history

Much of the global interest in the virtual currency began in 2013 when the price rose by over 600% in the first quarter, rising to its record high of $1132 in late November of the same year. This led to many calling for a correction, if not a complete reversal, and the word ‘bubble’ was used extensively to describe the elevated price.

The trend since then has been on a downward trajectory, and we are currently seeing the price trading back at levels last seen in early 2013. Bitcoin has actually shed almost 50% since IG’s offering of the digital currency on 14 November last year, following fresh concerns regarding its legitimacy as a competitive alternative currency, as well as the more immediate impacts from a regulatory standpoint, with more red tape expected to follow. A drop of 30% has been recorded over the course of a single day. At the start of 2014, bitcoin was trading at as much as $1,000 a coin; today's value is just under a fifth of that.

Contributing factors

The year-long slide in bitcoin prices is now beginning to take its toll on those who invested in mining technology at a time when bitcoin prices were seeing double-digit gains. Bitcoin mining operations are running into the 'law of diminishing returns', as each mined bitcoin sees an increase in costs. With prices on the decline, miners are now seeing economies of scale eroded and the value of their operations falling. The result of these effects could further impact the value of the crypto-currency, with those miners forced into selling existing holdings in order to fund continued mining projects.

It’s not just the price that is beginning to wane; confidence surrounding the crypto-currency is also beginning to dwindle, following a series of successful hacking attempts on a number of large bitcoin exchanges, calling into question the security of the open-source network. Most recently, a Russian communications regulator has blocked access to website exchanges linked to bitcoin, stating that the crypto-currency ‘contributes to the growth of a shadow economy’.

A difficult currency to value

Given that the bitcoin network is still a very small community without a central governing body, such sharp price swings can and have become commonplace. As we have seen over the last 18 months, bitcoin prices can move wildly – both on the back of significant industry news and macroeconomic factors, and when driven purely by emotions-market momentum. It is a difficult ‘currency’ to value owing to its novelty and the fact that little data exists for analysis.

The good news is that IG clients are permitted to short bitcoin in the same way as one would expect from any of our derivative instruments. A low of $167.31 was witnessed in early trade today but the price has since recovered. With market volatility not just confined to bitcoin, the question is whether this level can remain supportive or if the downward spiral is set to continue.

Learn more about secure, flexible bitcoin trading with IG

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