As cryptocurrency markets continue to expand at unparalleled rates, an important development is unfolding this month – the official launch of bitcoin futures. Various announcements in recent weeks that bitcoin would soon enter the world of sophisticated financial derivatives have helped push the price of the currency to record highs above $11,000.
On December 1st, the US Commodity Futures Trading Commission released a statement declaring that contracts for futures and options have been self-certified by the Chicago Mercantile Exchange (CME), the CBOE Futures Exchange (CFE) and the Cantor Exchange. Nasdaq plans to be next to join the race.
The first launch is projected to take place on December 18th. Given the importance of these institutions, this huge step forward is expected to add a new level of legitimacy to cryptocurrencies and cement their position as an emerging asset class. However, the changes associated with bitcoin futures might not all be as rosy as they seem.
What Is a Futures Contract?
Financial derivatives are contracts that have value based on the performance of an underlying asset. Futures contracts are a type of derivative – agreements to buy or sell an asset at a pre-determined price at some point in the future. It allows investors to lock in a price for the asset, either for security purposes or for speculation.
If an investor expects the spot price of bitcoin to be high in the future, and they have the ability to enter into a futures contract at a price lower than the price they predict bitcoin will have in the future, they could profit from that price difference if they predicted it correctly. This can be used to create both long and short positions.
How Does This Change the Game?
Futures markets create an immense amount of flexibility. They enable investors to readily bet on an asset or bet against it (go long or go short), and they are usually characterised by an immense amount of leverage. In the case of bitcoin, this means one can trade a high volume of coins while only paying for a fraction of them, essentially operating with borrowed money. Leverage is used to amplify profits on a small volume of assets, but it is a double-edged sword in that it also amplifies losses.
Will This Benefit the Bitcoin Market?
Many expect bitcoin futures to stabilise the markets because big institutional investors will be able to trade bitcoin using all the flexibility present in sophisticated trading markets, with effective risk management and hedging strategies. Since the CME plans to set price limits on the trading range of bitcoin futures, the price of the coin is expected to become more stable. That is the optimistic outlook. It is reasonable to assume that if futures markets will indeed take off the way they are expected to, the market will eventually gravitate towards a less volatile state.
However, there could be a transition stage in which volatility could actually become worse. Large financial trading firms could enter the market to an extent that has not been seen yet, and because bitcoin is so difficult to value (as Warren Buffet put it: “You can’t value bitcoin because it’s not a value-producing asset.”), a lot of different forces will act on its price. Shorts will become more popular, and disagreements on pricing could manifest in the cryptocurrency markets in the form of extreme price jumps, more so than is already commonplace.
Ultimately, the big and yet unanswered question will continue to loom: is bitcoin indeed the millennials’ gold, as strategist Tom Lee suggests, and therefore has real and measurable value, or is it simply used for speculation as investors like Jack Bogle and Warren Buffet have implied? The answer that important investors will come up with for that question should have a significant impact on the price movement of bitcoin, and it is completely uncertain what it will look like.
What Does This Mean for Smaller Investors?
Words of caution are appropriate when talking about going short and using leverage. These strategies are incredibly effective because they allow investors to not only profit from a general upward trend in bitcoin but to profit from the fluctuations in the market. At first, it is hard to think of a more perfect asset than bitcoin for such purposes. The upward trends have been fast and extreme, yet fluctuations are very common and tend to be substantial.
If an investor gets the timing of the oscillations right, they can make money at every point along the way, going long when the market goes up and short when it drops. However, it is also difficult to come across any reliable strategy that has thus far been able to predict which events influence the price of bitcoin to which extent. The initial calling off of the Segwit2x fork is a good example of that. Shortly after the news broke, the market appeared to be divided into two camps – those who saw less value because they would not receive the equivalent amount of their holdings in the new currency (“dividends”), and those who saw the news as a consolidation of bitcoin’s strength. The two camps pushed the price in opposite directions in a way that made it hard to predict which side would have the upper hand at which point in time.
A large investor tends to have portfolios that are diversified enough that they can stomach deviations from expected price movements even with leverage. But smaller investors have smaller accounts, and that is where leverage can be fatal. This is because amplified losses can grow larger than the account balance and cause the need for a margin call when facing the prospect of going into severe debt.
For smaller investors, it may be wise to bet simply on long-term developments in the bitcoin markets by buying and holding. Thus far, the returns on this strategy have been large enough to justify at least the consideration of whether they would not outweigh the expected payoff of trading with leverage, taking the associated risk into account.
Bitcoin futures promise more flexibility for investors and potentially a more stable price. Yet, there is a chance that volatility could increase in the interim and while strategies like shorting and using leverage hold a lot of potential when used within the right infrastructure, they can be detrimental to smaller investors and, in the worst case scenario, could derail the market in dangerous ways.
South Korea Bitcoin Regulation on The Horizon
South Korea’s government held an emergency meeting to discuss the impact of cryptocurrency speculation last Wednesday. Banning minors from investing and introducing capital gains tax on cryptocurrency were suggested as means of protecting citizens, reports say.
The meeting was a response to talk of cryptocurrencies being in an asset bubble and the impact investing is having on younger generations. New measures to tackle this problem could be announced by the end of the week, according to Reuters.
Why It’s Important
South Korean exchange Bithumb – the worlds busiest – has hit it off with students. The ease of opening an account and the option to invest small amounts has caught the attention of many young people.
This group’s obsession with the digital assets prompted the emergency meeting. President Moon recently expressed his fear of students joining the trend and becoming obsessed with the rapid price changes of cryptocurrency prices. He labelled this a “serious pathological phenomenon.”
“Some even abandoned their studies and part-time jobs as they believed they could make much more money by investing in bitcoin,” said Reuter Correspondent Dahee Kim. The trend appears to be causing social problems in the country.
The country banned initial coin offerings back in September.
Indian Tax Authorities Swoop in on Bitcoin Exchanges
Indian tax officials are investigating transactions at Bitcoin Exchanges across the country on suspicion of alleged tax evasion, official sources have said.
The Income Tax department is conducting surveys in cities such as Mumbai, Delhi, Bengaluru, Hyderabad and Gurgaon. The aim of the survey is to gather evidence to establish the identity of investors and traders, their transactions and the bank accounts used.
The Indian tax authority is not the only one to be looking into cryptocurrencies. The famous US tax authority, the Internal Revenue Service (IRS), has recently asked Coinbase for information on users who had more than $20,000 in annual transactions between 2013 and 2015. This is because they realised that the number of tax returns claiming gains from virtual currencies didn’t coincide with the increasing popularity of them.
Bitcoin’s value has surged more than 17-fold since January, mostly driven by high demand. However, virtual currencies do not have a legal status in India and are not regulated. The Reserve Bank of India (RBI) has recently cautioned citizens about buying or transacting them.
In a statement on 5 December, it warned people of the “potential economic, financial, operational, legal, customer protection and security related risks associated in dealing with such virtual currencies”. Earlier on this year, the RBI also clarified that it had not given authorisation to any company or entity to deal with virtual currencies.
SALT – A Technology Bringing New Opportunities?
One goes to a bank, asks to take out a loan, but is denied – Bitcoin is not accepted as collateral. Given its price fluctuations, it seems natural that a bank declines such a request. Then comes SALT (Secure Automated Lending Technology) – the “first asset-backed lending platform to give blockchain asset holders access to liquidity without them having to sell their tokens”. Where the banks are not willing to get their hands dirty, cryptocurrencies seek to find an opportunity; lenders and borrowers are brought together with blockchain assets. Yet could this platform shake the foundations of a stable economy?
How SALT Works
A SALT coin is purchased for $25, which grants the user one-year access to a loan of up to $10,000. The more SALT coins one has, the larger the loan capacity. An amount of cryptocurrency is given as collateral, where the user pays periodic instalments for the loan. This framework creates a base demand for the coin, which can be defined as the underlying driver for its price.
This sounds very convenient for the blockchain asset holder, yet there is one catch: if the value of the crypto falls below the margin requirement, the borrower receives a margin call, and if not fulfilled, the asset is liquidated to cover the remaining part of the loan. If a payment is missed, a portion of the collateral is liquidated.
Everything appears to be in order. Yet when one considers that many investing in cryptocurrencies devote their entire savings – where they would also be inclined to leverage their position – SALT paints a scary picture.
No Credit Checks
Another attribute – or perhaps shortcoming – of SALT is that it requires no credit checks. So anyone can take out a loan; SALT has the collateral, where the lender can liquidate to cover its unpaid loan. The problem affecting society does not arise from a structural weakness of such a system, but from the borrower’s final state.
Stories of Past Misery
As it was observed in recent crises such as the housing market bubble, society fails to learn from its mistakes when it comes to leveraging and investing. This risk of a bubble is exacerbated when combined with a boom in credit.
As former Federal Reserve Chairman Alan Greenspan stated:
“All of us knew there was a bubble. But a bubble in and of itself doesn’t give you a crisis… It’s turning out to be bubbles with leverage”.
The Great Recession happened at the hands of the informed investors. Even though the financially innovative products used at the time were vague, they were created and traded by those informed investors, where the credit ratings of those products were given by well-respected organizations.
Today, when we gaze at the cryptocurrency peninsula, they are either lagging behind, declaring their lack of interest or outright calling everyone to avoid them. Wounds still fresh from the crisis, the average citizen is inclined to ignore their statements, if not completely stand against them. All of these factors brew the pot for a bubble enforced with leverage.
A Scary Tale
Although the market capitalization of all cryptocurrencies is a mere drop in the sea of investible assets, as the penetration of cryptocurrencies deepens, so will the risks along with it. As of now, no one knows how far the price of bitcoin or any other cryptocurrency can rise. But as long as they do, people will be attracted to the idea of depositing bitcoins for a loan to enable them to buy more, and to cover the loan along the way. As for when the bubble bursts, this is a tale with a well-known end.
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