Macaskill on markets: Bitcoin greed will overcome fear


Jon Macaskill
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An important step to confer respectability on trading in bitcoin and other cryptocurrencies was taken in mid December when analysts from Deutsche Bank highlighted the role played in the emerging market by male leveraged foreign exchange investors from Japan.

Their report gave a catchy name to a new investor type, ‘Mr Watanabe’, to distinguish the men who supposedly do this trading from the female Japanese equity retail investors stereotypically dubbed ‘Mrs Watanabe’. 

This helped to rehabilitate the image of bitcoin investors, who had been widely viewed as divided between criminals seeking to launder illicit earnings and libertarian IT specialists with a limited understanding of how markets work.

It also provided comfort to financial market professionals, ranging from bankers to fund managers, who would like to profit from the newly booming market in crypto-trading and have been driven to despair by the effects of a prolonged slump in volatility across established asset classes.

The potential pitfalls of bitcoin trading have been widely discussed. Theft is common, transaction costs are high and the chances of bitcoin being adopted as a widespread means of payment are falling not rising, as recent wild price swings make establishing its value more difficult. 

But this price volatility is the real lure for bankers and professional investors. 

Volatility is at or close to historical lows in every traditional asset class, which is squeezing returns in markets businesses for banks that can no longer take large proprietary positions. 

Bitcoin volatility in excess of 80% offers a tempting alternative to equity markets such as the S&P, where implied volatility as expressed in the VIX index was anchored around 10 for much of last year by stubbornly low realized volatility.

Both market structure and a veneer of respectability are required to give banks and funds the confidence to start making two-way prices in any new asset.

Futures contracts

Bitcoin started to see the emergence of market structure with the launch of futures contracts in December. 

The first contracts from CBOE (the former Chicago Board Options Exchange) did not herald the birth of a fully mature market. Volume was relatively low, with fewer than 2,000 contracts changing hands on most days in the first week of dealing. 

There was also a surprisingly large initial gap between the price of a bitcoin future expiring in January and the cash price as expressed on digital exchange Gemini.

But the important step for bankers and investors was the launch of bitcoin derivatives on a legitimate exchange with the blessing of a large regulator, the US Commodity Futures Trading Commission. 

And CBOE’s larger Chicago rival CME Group launched its own bitcoin futures designed to appeal to institutional investors a week after the debut of the first contract. 

Now that bitcoin derivatives have been legitimized, the establishment of a cryptocurrency trading market that seeks to exploit and explain divergences in prices can begin.

There is a vast information gap to be filled and new trading worlds to be created as the implications of wholesale cryptocurrency dealing are tackled. The lack of historical precedent will be no barrier to filling this vacuum.

Deutsche, for example, was quick to follow up its observation that leveraged retail FX investors in Japan are doing a lot of bitcoin trading by stating that this creates an elevated risk of failure for futures brokers in Asia.

This in turn implies that there is a greater need to hedge any credit and equity exposure to the brokers, and no doubt Deutsche and its fellow dealers will be ready to provide hedges in the form of default swaps or equity puts.

Big dealers will also be keen to provide details on the mechanics of cryptocurrency trading on derivatives markets, the implications for exploiting arbitrage and the tools to monetize these opportunities.

Bitcoin mining and trading had already become a subject of global fascination before the launch of futures contracts in December. Markets professionals added to this speculation by wondering if time-honoured attempts at price manipulation would be seen in the new bitcoin derivatives sector.

Futures arbitrage is much like the difference between tax avoidance and evasion. There are legitimate ways to exploit divergences between prices and there are also illegitimate ways to achieve a profit, such as “banging the close” by moving the level of an underlying reference before the settlement of a derivatives contract. 

It is not always clear what constitutes illegitimate trading of a reference for a listed futures contract and there is even greater ambiguity when it comes to over-the-counter derivatives trading.

Some of the banks that have been taking a prissy approach to the advent of wholesale bitcoin trading, as if loath to soil their silken gloves, are well known for historically using their dominance in flow fixed income OTC derivatives dealing to push prices in their preferred direction, for example.

New complications

Bitcoin will bring new complications to old challenges surrounding defining and policing market manipulation.

There are multiple existing exchanges for bitcoin cash trading, for example, and little sign of the consolidation that might be expected in a market with limited frictions. 

CBOE picked Gemini as the price reference for its futures in part because it requires bitcoin traders to provide proof of identity. CME took a different tack by using prices from four exchanges for its contracts, which also has the appeal of making price manipulation more difficult. 

The prospects for bitcoin mining are also uncertain, as is the proper nomenclature for creation of new digital units. Bitcoin farms – or banks of computers working to create new units – already exist in countries ranging from those with a reputation for ethical business practices (such as Iceland) to those that do not rank as highly (such as China).

Investment banks would be pleased if bitcoin miners – or farmers – start to behave like traditional energy and agriculture producers in hedging their exposure to future prices for their commodities. Banks once preferred not to judge the character of a paying client, but a new era of regulation is forcing them to know their customers better, which could prove difficult in the cryptocurrency world.

And with many banks seeking to profit from appearing both ethically and environmentally sounder than they were in the past, cryptocurrency trading presents an unexpected hurdle in the form of complaints that bitcoin farms are deeply energy inefficient.

It is therefore possible that banks that recently agreed to stop funding coal mining will find that a new digital market is also circumscribed by concerns about the environmental impact of actions by potential customers.

A more likely scenario is that cryptocurrency trading will continue its growth, led by bitcoin activity.

While banks seek to profit from client activity on this new trading frontier, they will also hope that new markets can be used to help to inject some volatility back into traditional asset classes. If funds start taking risks in uncertain cryptocurrencies, there are bound to be some trading mishaps and collateral calls against their other holdings, for example.

And it surely cannot be long before a hybrid market develops that offers a layering of cryptocurrency risk on top of exposure to old-school currencies, commodities, bonds or stocks.

Anything that provides some volatility to dealers and investors who have been starved of trading opportunities will no doubt be given consideration.