Wednesday, November 01, 2017

CME futures should stop, drive Bitcoin price towards zero

The Bitcoin price has set new records above $6,500 and nothing seems capable of stopping it on its way towards the infinity. As you know, I think that the only justifiable price of it is zero and everyone who doesn't see it is a moron. The whole capitalization of over $100 billion is a measure of the people's irrationality, a herd instinct worshiping a virtual ill-defined brand. But as Keynes said,
The market can stay irrational longer than you can stay solvent.
So I am unlikely to bet and short the cryptocurrencies although I am very tempted.

Between November 13th and November 20th, Bitcoin may collapse or cease to exist due to the disputed fork. BTC should divide to a new BTC and B2X, one with a doubled block size. Bitcoin exchanges have different attitudes to the question whether they will give the users B2X at all, which of the cryptocurrencies will be called the Bitcoin etc. It's possible that no fork will take place at all. But it's possible that it will and any of the four possibilities – B2X will [not] survive and BTC will [not] survive – is possible.

So be sure to have your Bitcoins at a place where you can access both BTC and B2X – some exchanges won't allow you that. B2X futures are currently at $1,167, you don't want to lose that even if you managed to keep the remaining $5,400 of BT1.

I think that much of the price growth of BTC and BCH in recent days is due to the expected fork that the financially illiterate "Bitcoin traders" consider to be "dividends for free", being completely unaware of the ex-dividend price drop (note that the BT1, BT2 futures linked to in the previous paragraph do realize that the numbers should add up i.e. there will be an ex-dividend drop). This panic buying may be mirrored by panic selling after the forks. On top of that, the CME (Chicago Mercantile Exchange) group plans to offer its clients trading with Bitcoin futures by the end of 2017 (see press release).

And that could be a game-changer, I think. (Two Bitcoin real-time CME indices have been available since November 14th of the last year. See them now.)

One of the reasons why the Bitcoin "only went up" in recent years was that people could only express their "positive opinions" about it, not their "negative opinions". They could buy it and "go long" – and an increasing number of people have been absorbed to this cult and became "hodlers" – but the people outside the cult couldn't express their opinions at all. There was no effective way to "go short" the Bitcoin.

This non-existence of "shorting" is just a reflection of the dumb man's "Bitcoin economy" which is obsessed with the bound on the total money supply (i.e. with scarcity). The people in this cult don't realize that by issuing banknotes or bonds promising some money to be paid in the future etc. (which don't have to be "strictly" backed by the reserves), banks (both central and commercial banks) may effectively increase the money supply. All these processes are important when people or companies are capable of borrowing – and loans have been important in the economy for a long time. The existence of loans and bonds means that the "total money supply" is an ill-defined term (or one with many meanings, depending on what you count) and it's therefore silly to be obsessed with its value or with "scarcity".

But I haven't met a single Bitcoin (or gold standard) cultist who would be capable of understanding these basic points, regardless of how slowly they were formulated. These people simply have a hole instead of a piece of their brain.

Back to the futures trading. So even though a big majority of the people may think that the Bitcoin is basically worthless and a pure bubble, they have no effective ways to express their opinion in a credible way, to turn it into a profit opportunity. If you will be able to sell the Bitcoin futures, it may change.

The total capitalization of the Bitcoin is over $100 billion now – insanely enough, it beats the capitalization of numerous Dow Jones companies (which are pretty famous and actually produce something useful). Every day, about $2 billion worth of transactions involving the Bitcoin take place. The total amount of money that has actually flown into the Bitcoin is comparable to the capitalization although I think that this amount is significantly smaller than $100 billion – most of the Bitcoins were bought or obtained when they were much cheaper than $6,400.

This calculator already contains the futures for the next two months – that's what CME should offer soon, too

There's a nice extreme example showing the silliness of the high capitalization of such assets – a reason why it may overstate the actual amounts that have been spent. Two guys, Peter and Paul, create their cryptocurrencies. Each of them has 1 million coins in total. They agree to exchange 1 coin. Paul wants $1,000 for one PaulCoin and Peter wants $1,000 for one PeterCoin. Paul wants to buy one of Peter's coin and vice versa. They don't have any dollar cash right now (they spent the last $5 for a burrito) so they agree to swap these two coins. So there's been a consensual trade at the nominal price $1,000 per coin. Because both men own 1 million of such coins, they are dollar billionaires. In the good old times, when common sense was still the king, they would still have a trouble to buy the lunch tomorrow because everyone knows that they're broke. These days, everything is possible, however. ;-)

Those $100 billion is a lot of money but it's still just over 1% of the total value of the gold that has been mined and is possessed by all the people and organizations in the world – some $8 trillion. So $100 is a lot of money but it's still very small relatively to the world's "money supply", even "gold reserves", and similar things.

If the trading with the futures begins, how will it influence the Bitcoin price? Well, I find it much more likely that the futures will be used for shorting the Bitcoin. If you want to "go long" the Bitcoin, you have already had tools to do that in previous years. Most people in the world haven't used that opportunity which really means that "they wouldn't touch it" – they largely agree that the Bitcoin is worthless and the price growth has been a crazy bubble containing nothing but hot air.

By now, the Bitcoin is a very famous would-be currency – perhaps as famous as the Swiss franc – and the trading with the futures may attract much more money than the today's trades at Bitcoin exchanges etc. It's plausible that on the first day of the trading, much more than $2 billion will be traded, and most of these people may short the Bitcoin. This may induce a dramatic and very fast drop because when someone shorts the Bitcoin, he is effectively selling a Bitcoin he didn't possess – he had to borrow it. Shorting a Bitcoin means to sell a borrowed Bitcoin. When I started to write this text, I didn't quite understand how they will guarantee the borrowing and the existence of counter-parties but it's really simple and I discuss it under the line.

But if the trading behaves like any other trading with futures, lots of people who short it will mean an immediate downward pressure on the Bitcoin price. And because lots of people share the opinion that any positive price is an overestimate, the price may be pressured almost arbitrarily, i.e. towards zero. On top of that, these new trades may fill the Bitcoin blockchain with lots of transactions that will be a technical problem for the miners to confirm and lots of other bad things may happen. If some mess arises, who loses may depend on very technical details how the margin calls are realized and other things.

The miners may combine their tricks and attacks against the non-currency with the shorting of the Bitcoin. Much more money may be invested into these operations than the natural daily volumes. Because the Bitcoin price has often moved by 30% in a week, if this volatility is put on steroids, change by two orders of magnitude may become possible.

To say the least, the futures should reduce the price growth because people won't bet that the price in 3 months will be $10,000 – if they thought so, they could buy the Bitcoin for the spot price. So they will probably bet that the price in 3 months is at most close to the current spot price. And if the market is at least slightly rational – and it may fail to be – the movements of the spot price will mimic the movements of the current price of the futures.

Alternatively, the futures may attract new buyers who only want to buy things through regular financial institutions and the price may grow to $100,000 very quickly. If such a thing occurs, the tax authorities and regulators won't be able to ignore this stuff because giant amounts of tax evasion may be hiding there etc. Such an extra fast growth would probably speed up the efforts to ban the Bitcoin in most countries where the trading takes place, including the U.S., thus driving the price to zero as well. Also note that the futures are just weakly "linked" to the Bitcoins, so they effectively inflate the money supply (the effective number) of the Bitcoin and reduce the scarcity because the Bitcoin futures effectively act as new copies of the Bitcoin. Equivalently, you may talk about the buyers of the futures, Bitcoin bulls: every dollar spent on those futures is not spent on the "real" Bitcoin i.e. it suppresses the demand for the "real" Bitcoins. That's why I overwhelmingly prefer the prediction that it should drive the price towards the fair price, i.e. zero, but given the irrationality driving this whole industry, I am not certain about anything.

Many things may happen and extra profits are possible, much like the loss of almost everything. The trading of the Bitcoin has been extremely volatile – and that's what attracted many adrenaline-loving people – but it may become even more, and fatally, volatile with these new tools.

Linking of the two markets

Let me say a few explicit words about "what I consider basics of sanity" in trading in this system of coupled "real Bitcoin" and the "Bitcoin futures" market. The futures are associated with an expiration date. Let's take it to be April 1st, 2018. On that day, CME just "passively" reads the current price of the Bitcoin from some "real Bitcoin" markets and settles all the long and short futures positions in USD. I suppose that CME will be basically "neutral" (no position) on that day and all the time – it is only a broker that matches counter-parties, buyers and sellers of the Bitcoin futures.

Current "hodlers" of the Bitcoin (here is the thread that created the viral verb) obviously believe that the Bitcoin will be more valuable in April (rather distant future) than it is now – otherwise they would sell the Bitcoin. New Bitcoin bulls may either buy Bitcoins or the April 2018 Bitcoin futures. These two investment opportunities are at least overlapping so a dollar spent on the futures will subtract some fraction of a dollar of "demand for the Bitcoin" on the real Bitcoin market.

On top of that, you will have the new possibility to short the Bitcoin – which hasn't existed (except for some obscure small companies) so far. If you short the Bitcoin, you buy a negative amount of the "Bitcoin futures". You don't influence the "real Bitcoin" price so far – these markets are a priori separated in principle. But you will drive the price of the futures – the expected April 2018 price of the Bitcoin – down.

When this suppressed price gets low enough, it will be an arbitrage opportunity for the current "real Bitcoin" bulls. If the futures Bitcoin is cheaper than the "real one", it's even better investment to buy the "future Bitcoin" or "Bitcoin futures". In fact, it's a good idea to sell his "real Bitcoins" and buy the futures instead. So I believe that both of these groups – buyers and sellers of the Bitcoin futures – will push the balance of the supply and demand for the real Bitcoin in the "bearish" direction. Buyers of the futures will do so because they could be buyers of the real Bitcoins but they will be missing. And sellers of the futures will do so because they will push the price of the futures Bitcoin down and attract current hodlers to sell the Bitcoins and buy (go long) the futures Bitcoin instead.

If you think that there could be a loophole in this reasoning, let me know. ;-)

Of course, I can think of a loophole but it's a loophole of the type "the world has gone completely crazy" because it assumes something that looks like a logical contradiction but in the crazy world of cryptocurrencies, it may be considered logically consistent. Well, there might exist Bitcoin bulls – who must think that the Bitcoin will grow to a dominant currency of the world – but who have found the payment system of the Bitcoin too uncomfortable and that's why they haven't bought the Bitcoin yet. So they will be able to buy lots of the Bitcoin futures now. The Bitcoin futures will be growing rapidly and well above the current real Bitcoin price. And it will drive the real Bitcoin price up – by the reversed mechanism mentioned above. Some real Bitcoin holders will accumulate their positions in the real Bitcoin and hedge them by shorting the futures as counterparties. This loophole sounds comical because it's hard to imagine that someone may be convinced about a "huge, much bigger value of the Bitcoin in the future" if he has found the purchase of the Bitcoin too cumbersome so far (it sounds absurdly illogical because the main virtue of the Bitcoin is that it is present as the ultimate best payment system). But yes, I can imagine that there may be lots of such special crazy people, too, and in that case, the CME Bitcoin futures market could even accelerate the growth of the Bitcoin price.

Another loophole or alternative development is that the hodlers are so fanatical that they won't sell even if the futures indicate a vastly lower future Bitcoin price. But no one will really buy new real Bitcoins, either, because the futures are preferred. In that case, the trading volumes of the real Bitcoin may go to zero and the CME Bitcoin real-time values will become highly fishy and volatile, too. But I believe this scenario couldn't last for too long because some Bitcoin holders will realize that if one can't sell it, it's really worthless.

An excursion to the world of nut jobs

This Hacker Noon is an example of the hardcore loony "banks are evil" extreme leftists. He complains that the Bitcoin futures will be settled in the evil dollars, not in Bitcoins. That's a hilarious comment. In effect, he would want Forex traders to trade not BTCUSD but BTCBTC. But BTC/BTC, the ratio, is equal to one (just like USD/USD). So if you go long or go short this position, you still have no damn position at all. You get back exactly what you put in. I am sure that many boys in the kindergarten could figure this out but the extreme anti-capitalist loons like Hacker Noon cannot.

Some fiery discussions about the topic took place at Zero Hedge. Some of the posters get it. Others don't even understand that the futures market and the real Bitcoin markets are coupled by the arbitrage opportunities. And there are lots of anti-capitalist loons who see some fraud and manipulation behind everything that is traded.

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