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| Activity and values of Bitcoins and cryptocurrencies continues to rise in unexplained ways. In 2018, where do we go from here? |
Bitcoin. Cryptocurrencies.
The mania reached peaks in 2017. An "investment" in Bitcoin a few years ago of about $1,000 reached values exceeding $18,000 as we approached the Christmas holidays, 2017. Swoons of volatility and uncertainty pushed that back to $13,000-plus and sparked greater discussion about digital currencies, blockchains, and the distributed-ledger technology that runs Bitcoin (and other digital currencies like Ethereum and Ripple).
Confusion still abounds. What explains 2017's surge in Bitcoin? What explains value? How should it be quantified? What is its purpose? Why are investors and traders willing to take such risks?
Regulators, bank supervisors, and government officials are huddling in conferences trying to determine what their roles should be. They watch, share views, analyze public data, observe the euphoria among some traders, but haven't taken action (beyond some overseers in a few countries)--partly because they aren't sure how they are empowered to do so.
Questions continue--in the media, in academic discussions, in financial columns and among traders, investors, technologists, politicians, regulators, and bank leaders. What does it actually mean to own Bitcoin? Is this flippant speculation? Does it represent real value? Does a catastrophe of some kind lie on the horizon? Could mishaps on a Bitcoin exchange trigger defaults and extreme events in the larger, global financial system? Will Bitcoin volatility trigger global systemic risks?
Rational traders approach the market as if value is based on not Bitcoin's purpose or usefulness today, but on prospects that it may have significant purpose and usefulness tomorrow--in periods to come. That purpose would be tied to the value of Bitcoin as
(a) a way of making payments (consumer and corporate, anywhere in the world),
(b) a storage of economic or investment value,
(b) a safe haven from unstable global currencies (a "flight to quality"), and
(c) a way of operating within a transparent system without intermediation or intervention by a central government or central bank.
Hence, Bitcoin's value (or the value of any meaningful cryptocurrency) is a function of those factors and the probability the coin or the system will achieve those goals.
But some traders aren't interested in such factors and merely want to speculate and take advantage of what ultimately is a speculative trading game.
In reality, combinations of both types of traders are involved in the market. The two factions have influence on the daily fluctuations in Bitcoin prices. Speculators are risk-seeking and will gamble to achieve high returns. Investor-traders who perceive there is a long-term purpose for Bitcoin and other digital currencies assess long-term value. They acknowledge uncertainty in achieving those long-term objectives in the way there are uncertainties in any risky investment.
In the current marketplace, however, speculators might be out-numbering rational investor-traders.
Instances of fraud abound and have been reported, and institutions and entrepreneurs devise ways to open up markets to new participants to invest directly (via a Bitcoin wallet) or invest indirectly (via exchanges). In the U.S., the Bitcoin ETF (exchange-traded fun) doesn't exist. At least not yet. An ETF offering must win approval of securities regulators, who will certainly take their time to determine whether it's a suitable investment from all classes of investors.
In a recent step toward legitimacy, in late 2017, commodity and futures exchanges announced they would unveil a new Bitcoin futures contract, an instrument that permits investors and traders to maintain a leveraged stake in Bitcoin values--a way to trade (or speculate in?) Bitcoin without having to enter into the blockchain system and owning the digital coin directly. A trader comfortable with uncertainty and volatility now has an opportunity to speculate with financial leverage. The trader doesn't have to buy the entire Bitcoin amount, but merely put up a margin deposit (financial leverage).
The Chicago Mercantile Exchange launched its product in December. To do so, it had to do preliminary value analysis and assess worst-case scenarios. (Exchanges and clearinghouses do this on an ongoing basis for each of the trading products they offer.) It had to measure and quantify price volatility and set up rules.
In doing so, it also had to establish and quantify "initial margin" (an amount the investor must put up in cash-equivalent margin to account for the maximum (short-term) loss the investor will experience within a defined time period). Unfortunately the CME has had to establish these margin requirements based on a limited number of years of trading data and without experience or scenarios of what could happen to Bitcoin values in extreme cases or "black swan" events. (It likely increased its worst-case calculations to account for the limited years of trading data.)
The CME is aware it is facilitating trading of all kinds in Bitcoin values and prices (investing, betting, gambling, speculating). It's also aware it will attract the most speculative of Bitcoin speculators because of the advantages of "leverage" in purchasing financial futures. And it will lure traders who will try to profit from the disparities in Bitcoin market prices and Bitcoin futures prices (arbitrage or basis trading).
The exchange/clearinghouse has established an initial margin of about 40-50% of the face value of a Bitcoin contract. Hence, to purchase a Bitcoin contract (for March settlement) at $13,000, the investor must deposit, say, $6,500.
If the price doubles, the investor makes $26,000- $6,500 (=19,500, or 300% of the deposit amount). If the price declines by half (as it likely could in this market), the investor loses everything (or 100%). Speculators might consider this trading opportunity a trade from heaven, notwithstanding the real possibility of losing all of the up-front deposit.
The exchange, of course, will have done significant due diligence to determine if the investor (operating through a registered broker/dealer) is financially qualified and capable of taking such risks. In reality, it's likely the trader would have also have other trading positions and assets (where gains elsewhere can offset Bitcoin-futures losses) (cross-product margining).
In the past year, government supervisors have begun to weigh in and render opinions. It's about time. Except in some places (like South Korea recently), no specific law or ruling has been enforced in the U.S., but they have begun to suggest where there could be problems or how they might act in certain circumstances. They have identified flaws in cryptocurrency systems and exchanges. They have called for protections for uninformed consumers or under-capitalized investors, and they have diagnosed whether cryptocurrencies are currencies or financial instruments and securities.
And there is the ICO.
On other fronts, government regulators are addressing this Bitcoin offshoot--initial coin offerings, where companies seek to raise funds by issuing new digital coins, specific to the company, similar to the way young companies issue new shares to the public to finance operations. Several ICO's have been done.
Now regulators are catching up. A primary questions looms over this activity: Is this a way for companies to finance the business without approval by securities regulators and without having to be subject to the same scrutiny and due diligence the SEC in the U.S. requires?
In early 2017 and in December, the SEC issued statements acknowledging that, to date, it has not approved any cryptocurrency or any ICO. Period.
It has reminded investors that if any person or institution who invests in a digital coin via an ICO and if there is expectation of a share of ownership or economic value from the earnings from the issuing company, the ICO offering might be deemed to be security under U.S. securities laws.
The SEC stated summarily: "(While) there are cryptocurrencies that do not appear to be securities, simply calling something a currency or a currency-based product does not mean that it is not a security."
The SEC's detailed notices suggest it acknowledges Bitcoins and the growing number of cryptocurrencies are here to stay. It joins a growing number of financial leaders and organizations that admit crypto-currencies, blockchains, and distributed-ledger technologies could refashion the global financial system in the way derivatives and securitizations vaulted into the middle of the financial world in the 1990's.
Acknowledging "We can't beat this, so let's wrap ourselves around the risks and do so quickly," the SEC, to its credit, offered a handy list of questions investors should to ask themselves when they decide to join this marketplace. They include such questions related to proper due diligence of the sponsor, use of proceeds, financial statements of sponsors, timely trading data, openness of the blockchain, threats of cybersecurity, and legal rights of investors.
On the other hand, crypocurrencies are here to stay unless some catastrophic collapse in values or some blatant fraud leads to a debilitating financial crisis. Industry leaders cringe about systemic risk: The risk that unexplained, unexpected volatility would lead to mammoth market losses, which could lead to credit risks, credit losses and the bankruptcy of significant participants, which could lead to losses among financial institutions and banks that interacted with or funded the bankrupt players, which could lead to a global standstill, which could lead to....
Such extreme events would likely halt popularity and expansion, but for a short time. Remember, derivatives, securitizations, mortgage securities and junk bonds spawned financial crises of various kinds years ago, but after periods of inactivity (and after new rules), they all reappeared.
See also:
CFN: Bitcoins: Embrace or Beware? 2014
CFN: Flash Boys: Slowing Down High-frequency Traders, 2014
CFN: MiFid 2: Do We Know the Real Impact? 2017
CFN: Making Sense of Derivatives, 2013
CFN: High-frequency Trading, 2012
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