What caused the 28% drop in Bitcoin?

Bitcoin has dropped 27.3% from 8th November 2021 to 5th December 2021. It’s price of $67,582 USD on 8th November was an all-time high.

On this blog, I’ve constantly talked about Bitcoin being a good store of value. Gold of the internet. I’ve also talked about the inevitable crash of the USD. So why has Bitcoin crashed instead of the USD after inflation hit 6.2% in October 2021?

Obviously, no one can know the reason for the 28% drop. There might even be multiple reasons. But there are some theories:

  • Cryptocurrency exchanges run on the fractional reserve banking system
  • Cryptocurrency exchange lend Bitcoin to short sellers who then short Bitcoin
  • 1,000 people own 40% of Bitcoin

Cryptocurrency exchanges run on the fractional reserve banking system

Cryptocurrency exchanges like Coinbase act like banks. They buy Bitcoin and end up taking on transactions for more Bitcoin than they actually have. In short, they function on the fractional reserve banking system.

Take a cryptocurrency exchange ABC-X that owns 2 BTC. They have 10 customer accounts who buy and sell BTC without the platform. Only 1 (of the 10) actually transfers his Bitcoin out of the exchange into a wallet.

Let’s use an internally-decided reserve ratio of 10%. This means that despite only having 2 BTC, ABC-X is able to manage multiple transactions and give account holders the illusion that they own 2 / 10% = 20 BTC, despite BTC-X only having 2 BTC.

So how does this cause the price of Bitcoin to crash?

Therefore, when multiple people sell their Bitcoin at once, BTC-X will be forced to raise capital to repay its account holders. If BTC-X does not have enough capital on hand, they will have to actually sell some of their BTC reserves. Thus this causes the price of Bitcoin to go down.

This sounds bad. What can I do about it?

There’s not much that you can do about this. Cryptocurrency exchanges aren’t regulated like stock market exchanges and banks. There aren’t any rules in place to stop this. (i.e. Cryptocurrency exchanges can act like a bank despite not being regulated like one.)

There are 2 scenarios:

  1. Exchanges get regulated and are not allowed to use the fractional reserve system. This is unlikely but the best case scenario.
  2. Exchanges get regulated and are given a reserve ratio that they have to meet. This is more likely to happen. But probably only after a serious financial event has happened which forces the US government to take action.
  3. Exchanges never get regulated. In this case, the most you can do is to continue buying Bitcoin and moving it to a wallet ASAP. Treat exchanges as very big personal Bitcoin holders who buy and sell based off market demand in huge amounts, and who therefore have big influence over the market. This is not favourable but inevitable.

Cryptocurrency exchange lend Bitcoin to short sellers who then short Bitcoin

A lot of Bitcoin HODLers “invest” their Bitcoin using BlockFi because they earn an interest rate of 4.5% (at least for the first 0.1 BTC invested as of Dec 2021). After all, if you’re buying Bitcoin as a hedge and for the long-term, what good is it sitting around in a wallet doing nothing? Shouldn’t you at least lend it out and earn some interest payments in the meantime?

But there’s a problem with that.

What most people don’t know is that Bitcoin used by BlockFi is actually being loaned out and used by short sellers. There’s no other use for borrowing Bitcoin.

For those unfamiliar with short selling, it’s basically when an investor bets that an assets price will decline. Short sellers borrow Bitcoin and sell the borrowed Bitcoin immediately for the market price (say $60,000). If the price drops to $50,000, short sellers buy back into the market and return the borrowed Bitcoins, thus earning a profit of $10,000 per Bitcoin.

So how exactly does short selling cause a drop in Bitcoin

Well think about it. All short sellers do is:

  1. Borrow Bitcoin
  2. Sell Bitcoin immediately on the market

When Bitcoin is heavily shorted, there is a lot of Bitcoin being sold (i.e. Point #2). Therefore, the price of Bitcoin slightly drops. When a lot of investors notice the slight drop, a lot of investors panic and start to sell.

Therefore, this causes an even larger drop, which snowballs and ends up calling a huge drop in Bitcoin.

What can I do about this?

For starters, stop using BlockFi and stop lending out your Bitcoin. Next, understand that this is just part of any financial market. Short selling is normal and shouldn’t matter to anyone HODLing for the long-term.

1,000 people own 40% of Bitcoin

According to a Bloomberg study, 10,000 investors control 1/3 of Bitcoin in circulation as of Oct 2021.

While it’s difficult to know who owns Bitcoin since a user can own multiple wallets, where each wallet is linked to an infinite number of addresses, this is a good estimate to go by.

Since a significant amount of Bitcoin is owned by a few, any transfer of Bitcoin causes a huge movement in prices. Many investors follow the movement of large Bitcoin holdings from wallets to cryptocurrency exchanges very closely.

One example of thing happening is a movement of 94,504 BTC on 6th September 2019. This was about $1 Billion worth of Bitcoin. More details here.

In summary

To conclude, there are many factors that can cause Bitcoin to drop (or even crash). But as long as the mining process continues to be decentralised and belief in the blockchain’s security holds, ignore everything and keep HODLing.