Deregulation of US power markets once made electricity the most volatile commodity in history. Could regulation be bitcoin’s yin to electricity’s yang?
From the mid-1930s until the early 1990s, municipal and state-controlled public utilities regulated US electricity prices. These six decades are remembered for inefficiencies and rising costs. Deregulation was supposed to leverage new technologies and financial models. Lower costs and increased reliability would result. Instead, within just a few years of restructuring, power prices arguably became the most volatile commodity in history.
What made power unique was bull markets didn’t grind higher as most financial products do. In electricity markets, where supply must meet demand in real time, bull runs were often highlighted by explosive thrusts that increased prices twenty, fifty, even a hundred-fold. Power for next-day delivery would trade $25 per megawatt hour (MWh) one day then explode to several hundred dollars the next. On a few infamous occasions, trades were recorded as high as $5,000/MWh to $10,000/MWh. Prices would then crumble nearly as fast as they rose. Supply and demand balanced, markets would ebb and flow until the next meteoric rise set the stage for another stunning crash. While each market is unique, with wildly different economic drivers, bitcoin displays many of the same trends the US power markets exhibited twenty years ago. Awe-inspiring rallies are followed by devasting crashes. Like the US power markets at the turn of the millennium, it will be astonishing rallies in cryptocurrencies, not the ensuing crashes that will be remembered.
Power and Bitcoin
When the first breakout in power prices occurred in June 1997, the market topped out at $325.00/MWh. The following year, $1,000 call options for the summer months of June, July and August were offered. Inexperienced and arrogant power traders mocked the outlandish strike price. They boasted the premiums collected selling the call options was free money (before the ensuing spike in prices, most of the option contracts traded between $0.25 and $0.45, approximately $4,000 to $7,200 per month per contract). In the summer of 1998, after a heatwave blasted the eastern half of the US with ninety-five-degree temperatures, power prices screamed through the $1,000-dollar mark. The exponential rise in prices destroyed several electricity short sellers. A bi-lateral market at the time, a daisy-chain of credit failures nearly brought the power trading industry to its knees. Lightning struck again in the summer of 1999. Prices rocketed to even greater heights. Again, the system teetered on collapse. The multi-year transition from a regulated to a deregulated market severely tested the philosophy “free-markets meant lower prices and greater reliability.” Could bitcoin, originally unregulated, and now under intense worldwide regulatory scrutiny, be the yin to electricity’s yang?
Whether considered a currency, a commodity or hybrid security, bitcoin and other cryptocurrencies experience similar price patterns that the electricity markets did two-decades ago. Explosive upside moves give way to merciless bear markets. Over its history, bitcoin has suffered declines of 70%-94% on six different occasions. From peak to trough, the devastating declines have taken place over just a handful of days to more than a year. Six additional declines of 20% or more have rocked bitcoin as well. Most have occurred in less than two weeks. The most volatile one-day moves have also been down, though multiple massive one-day spikes have happened as well. More importantly, day to day price rises measured as LN> +.10 have virtually matched daily price declines of LN> -.10. For most traders, this price action is atypical.
The Powerful Lessons of History
The deregulation of electricity introduced a lot of new professionals to trading. Utilities with generation assets formed trading floors with employees from a variety of departments. They understood power distribution, accounting, and other key business functions, but most, including many division presidents, were never schooled in markets or how complex derivative portfolios behaved under stress. All were seduced by Wall Street’s mentality “Greed is good.” It didn’t take a full decade before the most volatile commodity in world history left numerous power trading firms in ruins. The carnage ran up and down the streets of Houston. The blood even reached the wannabe trading hubs of Cincinnati, Ohio and Louisville, Kentucky. To this day, volume breadth and liquidity have never fully recovered.
What’s unnerving is many of the early investors and traders in cryptocurrencies are like the earliest power traders. Many are considered experts in their field. This time the traders understand the power of blockchain technology, peer to peer networks, and the potential fallacies of fiat currencies and central banks. Few, however, have experience trading other products. Few understand the history of markets. And unlike the power markets earlier, market entry is not limited to several dozen players. Bitcoin traders are not restrained by borders, complex master ISDA agreements or large capital requirements. This time the market is open to the world.
The Two-Headed Monster
Bitcoin’s history has been one of massive rallies and crashes. The cryptocurrency’s volatility skew is a two-headed monster. It makes power trading’s original skews seem like child’s play. Increased regulation will bring some stability—for now. But regulation will also encourage more short sellers. Will the multitude of exchanges worldwide unwittingly create new daisy chains of credit? The 2017 rally caught the world’s attention. The battlefield is still being defined. And considering bitcoin is Godzilla on steroids, the potential for scandalous uncapped losses are real.
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