Expect extreme volatility after latest bitcoin crash

Bitcoin has slumped 30 per cent since hitting a peak of over $3,000 last month. Gary McFarlane explains the drivers behind the latest crash.

A couple of days ago (16 July) bitcoin fell below $1,900 (£1,454) for the first time since May (it was over $2,400 last Thursday), as investors, traders and users fret about how the scaling issue that had dogged the digital currency for two years is resolved. The deadline for implementation of a fix that allows faster transaction verification on the blockchain, on which bitcoin runs, is 1 August.

There are three main software solutions vying for implementation, with the favourite for adoption being the so-called SegWit2x approach. This has the support of an estimated 80 per cent of 'miners' that do the heavy-lifting required to verify transactions. They do this by deploying ever-larger amounts of computer-processing power to solve the cryptographic puzzles to which each transaction is tied.

As each new block of transactions is verified it gets added to the chain. Miners are rewarded at the rate of 12.2 bitcoins per block ($24,000 at today's prices). Block size is currently capped at 1 megabyte and transaction times average around 10 minutes, although the most recent transaction time on the bitcoin blockchain is recorded as 20 minutes and 21 seconds at the time of writing.

In the world of financial transactions where transaction speeds can be often be measured in nano seconds, bitcoin clearly has a problem, hence the competing solutions. In order to handle more transaction and speed up verification times, bitcoin users can elect to pay transaction fees which undermine bitcoin"s claimed "cost-free" transaction advantage.

A number of exchanges including GDAX and OKex (international arm of major Chinese-based exchange OKCoin) are stopping bitcoin deposits and withdrawals in the days before and after the 1st August deadline, adding to the worries of market participants.

The sheer complexity of the technical discussions that are taking place and the shifting alliances therein, is spooking seasoned traders and investors, never mind the new entrants of the past few months. After the deadline, users and traders could be faced with a situation in which there are in effect two (or possibly more) different bitcoins - one using the old system and another using whichever scaling solution is adopted.

Ethereum, the second-largest digital currency by market capitalisation, had to introduce a so-called 'hard fork' in its software when a bug was discovered that allowed ether coin -the bedrock of the platform -to be syphoned out of the system. Today's less-traded Ethereum Classic continues to use the old protocol, although not all buyers are aware of the difference between it and the commonly traded Ethereum.

Regardless of whether there ends up being a fork in the blockchain code that underpins the bitcoin, the currency's watchers are also concerned that something might go wrong with whichever solution is adopted, thus adding to the already heightened risk factor given the rapid increase in valuation seen in the marketplace.

- Bitcoin reaches all-time high, but risks losing cryptocurrency crown to Ethereum

Bitcoin is currently trading at $2,039 on the Coindesk bitcoin price index, which is about 30 per cent below its $3,025 high registered on 11th June, while Ethereum has given up around 50 per cent of its value from its all-time high just above $400 to trade at $167 today.

Worries about the price appreciation in cryptocurrencies representing a bubble were underscored by comments from BlackRock's global chief investment strategist Richard Turnill, who told Reuters last week:'I look at the charts, and to me that [the price run-up] looks pretty scary.'

- 'Hassle-free' bitcoin trading see spike in interest from UK investors as volumes triple

Roy Sebag, chief executive of online gold exchange GoldMoney and a major bitcoin investor, said in a tweet on 10 July that he had sold most of his holding in the belief that the market had reached its top.

Spencer Bogart, head of research at Blockchain Capital, took an alternative view. He sees the price falls as an opportunity to build a position using pound cost averaging, tweeting on 16 July: 'I don't think there's value in focusing on day2day crypto price change. However, I do think it's a good time to start averaging into BTC.'

As bitcoin and other digital currencies struggle to find a floor, whatever your perspective on future price movements, until the scaling issue is resolved expect extreme volatility, even by bitcoin standards, to be the order of the day.

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