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What Makes Bitcoin Exchanges Tick?

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Exchanges play a central role in the bitcoin ecosystem. In addition to facilitating trade, they set exchange rates between bitcoin and fiat currencies such as the US dollar or the euro.
Rates can vary widely from exchange to exchange (which is where the arbitrageurscome in) and from minute to minute (where the other traders enter).
By now, long-time bitcoin traders are well acclimatised to this volatile landscape. Take, for example, the wild price swings at the middle of this month. From a high of $596.00 on 8th August, the price tumbled 15% to a low of $503.96 just six days later.
But what makes bitcoin’s price move in the first place?

Intro: the order book

Let’s start by examining the inner workings of a digital currency exchange.
First, there’s the electronic order book, which keeps track of buyers’ and sellers’ interests. At every price level, this book records open ‘buy’ and ‘sell’ orders, including their cumulative sizes.
Often you’ll see order books displayed as tables showing open buy orders (known as ‘bids’) and sell orders (known as ‘asks’) at price levels below and above the last market price:
rate

The next trade in the example above will execute either at the bid of $96.281 in case of a seller stepping in, or at $98 if a buyer is willing to pay the ask; more on this later.
It’s important to note that transactions between sellers and buyers only occur if there are open bid and ask orders at the same price level.
You will never see this happen in an order book though, so there must be a piece missing in the puzzle. To better understand how exchanges really work, we also need to know about two basic types of orders.

Limit orders vs market orders

Orders in the book are all ‘limit orders’, meaning they will only be executed if anyone is willing to trade at the requested price level.
“Sell BTC 2.3 at $593.18″ is an example of a limit order asking for $593.18 per 1 BTC. “Buy BTC 0.32 at $592.03″ would be a limit order bidding for $592.03 per 1 BTC.
On the other hand, ‘market orders’ are orders without a price tag attached. For this reason they don’t show up in order books. Instead, they are immediately executed at the next best limit order in the book.
Traders who place market orders are eager to have their orders executed (‘filled’ in trader jargon) as fast as possible, so the price is secondary.

So, what makes price move?

Let’s assume for a moment that there are no matching limit and market orders at the exchange.
There are a lot of limit orders in the order book – as shown in the example above – but no market orders are triggering any transactions.
Clearly, the order matching engine is out of work. No transactions will take place and the exchange rate will stay at the price of the last transaction in consequence.
This will apply until the exchange receives a new market order, in which case one of two things will happen:
a) If there’s still enough limit order volume at the latest transaction’s price in the order book, the new market order gets filled at the same price as the last transaction again, so bitcoin’s price doesn’t change.
b) If there’s not enough order volume to fill the market order, the exchange will fill the rest of it using volume from the next best price level in the order book. In this case, the price changes to the next best price level and – volià – price has just moved.
So, the (very) short answer to the question would therefore be: buyers and sellers placing market orders do move price.
For more tips and tricks on bitcoin trading, check out Christoph’s previous primers onunderstanding price charts and spotting trends.  

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2 Responses so far.

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