The relation between Bitcoin Exchanges Reserves and Price
A review article based on the research paper of Lai T. Hoang, Dirk G. Baur
Cryptocurrencies are becoming increasingly popular in today’s technologically advanced environment. Bitcoin, the most well-known cryptocurrency, was established in 2009. Since its initial release and subsequent success, when its price surged within a few years, it has been the focus of several price prediction studies. These, on the other hand, are largely focused on the market and macro variables, completely ignoring the nature of Bitcoin — which is blockchain technology.
Using an exchange is the simplest way to trade a cryptocurrency. The trader has an online wallet that they utilize to make trades on such an exchange. However, these exchange wallets may encounter a variety of issues, ranging from the possibility of being hacked to the exchange shutting and/or fleeing with its clients’ money. As a result, many investors choose a private wallet. This wallet is not linked to any exchange, making it considerably secure. It enables the bearer to keep their Bitcoin secret and safe from internet threats.
If they want to trade their cryptocurrency again, they must send Bitcoin back to the exchange. This money flow can be followed, and the authors believe it may be used to forecast future Bitcoin returns and volatility. Private wallets are clearly preferred by traders and investors; only around 12% of Bitcoin in circulation is stored on exchanges, with the remaining in private wallets.
It may be believed that investors transferred their Bitcoin back to the exchange based on the higher amount of Bitcoin found in exchange reserves. In most circumstances, this indicates that they intend to sell. Price pressure is generated, which has a detrimental impact on the Bitcoin price.
Withdrawing Bitcoins into private wallets, on the other hand, most certainly signifies favorable long-term future returns, as investors intend to keep for an extended period of time. This indicates that long-term returns are only affected by declining exchange reserves, but short-term returns are influenced by both growing and decreasing bitcoin exchange reserves. Volatility is connected to swapped reserves in a beneficial way.
Hoang and Baur in their paper “Effects of Bitcoin Exchange Reserves on Bitcoin Returns and Volatility” attempted to capture and investigate this relationship between investors, Bitcoin exchanges, and blockchain; This study demonstrates that changes in bitcoin exchange reserves are adversely associated with both current and future bitcoin returns, supporting the notion that transferring bitcoin on exchanges indicates increasing price pressure and vice versa. We also find an imbalance between positive and negative reserve changes on bitcoin returns and volatility, which affects exchange reserves under extreme market situations. According to the findings, a sizable proportion of bitcoin investors hold their capital outside of exchanges and solely trade on exchanges. This demonstrates a unique aspect of bitcoin trading that does not exist in regular marketplaces.
In summary, the paper examines the interaction between bitcoin exchanges, investors, and the blockchain. It finds a negative relation between the daily changes of bitcoin exchange reserves and bitcoin returns. Extreme negative bitcoin returns are associated with increases in Bitcoin exchange reserves the next day, implying panic selling following market crashes. The reserves display an upward trend from the beginning of the sample until mid-2019 when they peaked at around three billion bitcoins. Subsequently, the exchange reserves gradually decreased to around 2.4 billion bitcoins by the end of the period. A decrease in bitcoin exchange reserves decreases any price pressure and positively affects both short-term and long-term returns.
The asymmetric effect indicates that positive changes of exchange reserves have a stronger impact on bitcoin volatility than negative changes. Bitcoin market capitalization exhibits the opposite pattern, i.e., it is positively related to returns on the same day but unrelated to returns from the next day. Other variables such as bitcoin liquidity do not show a clear relationship with bitcoin returns. Bitcoin reserves of Binance, Bitfinex, BitMex, and Poloniex exhibit decreasing reserves over time. A decrease in bitcoin returns is followed by an increase in bitcoin exchange reserves on the next day. The effect disappears for longer lags and for extremely good market conditions.
