The Bitcoin FlashCrash

If you are in finance, you know about the Bitcoin Flash Crash.  If you aren’t here is a chart.

What does it mean?

It means that Bitcoin is a highly speculative instrument.  Flash crashes happen every single day in lots of financial instruments.  Nanex does a good job putting data out on them.  As everyone knows, there was a flash crash that overtook the entire stock market in May of 2010.  Does that mean the stock market is a fraud? It lost close to 10% of its value in seconds that day.

The stock market has structural challenges that the SEC refuses to fix. Bitcoin’s marketplace has a lot of challenges too.  Bitcoin is unregulated, so there is a chance that the structural problems can be fixed.  It will just take the marketplace to come to a solution.  Free markets are really messy, and they take time to come up with the best solution.  In most cases, the decision made by the free market is better than the decision made by a central authority.

It was clear to anyone that has traded that Bitcoin’s market was inefficient.  When you can arb one exchange against another and make $100 per trade, the market is woefully inefficient.  But, it’s important to note that we are in very very early days of Bitcoin.

The flash crash makes another thing clear.  Running an exchange is hard.  If you want to run an exchange, it’s not about the profit.  It’s not about the volume.  It’s about offering a fair, easily accessible, transparent and efficiently run marketplace for your customers.  When flash crashes happen, they show that the exchange isn’t doing a good job of running their marketplace.

Running an exchange as a non-profit is fruitless as well.  There is no free lunch.  Even John Cochrane said as much yesterday on his blog when it comes to MOOC’s.  Even though you think they are free, they are not.  I have been a part of a non-profit exchange, and a for profit exchange.  The for profit model is better for the long run-although in the short run there are some difficulties.

There is a lot of back office infrastructure, and technical infrastructure that needs to be in place to have a decent exchange.  Then there are the software costs, and the human capital costs.  Exchanges aren’t something that you can hook up in your garage and run in the cloud.  Mt. Gox is learning a lot of the lessons the hard way.

Exchanges also need support ecosystems around them that they don’t necessarily own.  Banking, collateral, brokerage, data processing and many other functions.  These services are not free either.

Bitcoin is novel in that it has a transparent blockchain, but a blockchain is not a clearinghouse.  Clearinghouses ensure payments, and collections happen.  They charge margin.  They make sure enough margin is being charged so markets aren’t imbalanced.  Clearinghouses can make mistakes, but they are a stabilizing ho-hum force in the industry.  Simply having a blockchain is not.

The media is out with sensational stories about how Bitcoin is a fraud.  Tonight, our local news station will do a story on how drug leaders are using Bitcoin to launder money.  If they examined all public markets, and the banking industry, they’d see that drug leaders have been using traditional marketplaces to launder money for years.  Since 9/11 it’s gotten a lot tougher, but they find ways.

It’s clear to me that Bitcoin is pervasive.  It’s sticky.  If it wasn’t the market wouldn’t have recovered value so quickly.  There is value to Bitcoin in what it can do-but there isn’t any store of value today.  There is a difference.

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