Bitcoin May Surprise On The Downside Next Week

All that Glitters is Not Gold
All that Glitters is Not Gold

Undeniably, the meteoric rise of Bitcoin has gathered the attention of the main stream media. In a short 11 months, Bitcoin has gone from $1,000 to $11,800. In 2009 it was 25 cents. This has happened, despite the fact, not one of the traditional US exchanges or brokerage houses have offered investors a way of buying Bitcoin. While many of the most prominent names in the financial community have labeled Bitcoin a “fraud” or in a “ bubble”, the desire of investors to have the ability to trade Bitcoin in a regulated, traditional market has resulted in two of the most important exchanges in America to begin trading Bitcoin next week. The Chicago Board of Options Exchange (the largest US Options Exchange) will begin trading futures contracts on Bitcoin on Sunday and the Chicago Mercantile Exchange will begin on December 18th.

These markets will not trade the actual Bitcoin but instead future’s contracts. This is no small distinction. The vast majority of trading of actual Bitcoin occurs in exchanges in Asia. Prior to the Chinese government outlawing the trading of Bitcoin, China was the country with the most trading volume. Japan’s Bitflyer has become the most active exchange. Roughly 60 percent of global Bitcoin trades are Yen based, and of those 80 percent are on Bitflyer. As a result of the announcement of US exchange entering the future’s market Japan’s Tokyo Financial exchange has announced they will also begin trading futures.

The implications of traditionally regulated exchanges beginning to trade futures as opposed to the actual Bitcoin can not be overstated. Futures are derivatives. Futures are very different then the underlying product and consequences to the price movement are different then in markets without derivatives. Derivatives allow investors to hedge by going short as well as long. Futures do not require the investor to ever actually own the underlying Bitcoin.

It has been suggested that these new exchanges will allow more traditional investors in the United States a familiar and convenient way to buy Bitcoin and as a result the price will rise. The rise in the last two weeks from $8300 to $11, 700 has been a result of the belief that new buyers will enter the market and drive the price up. This is far from certain.

In fact, these derivatives could have the opposite effect. Today, it is difficult to go short Bitcoin. It is next to impossible to borrow large dollar amounts of Bitcoin to go short. The bitcoin market has been dominated by buyers. The vast majority of participants in the market have stood to gain by the rise of Bitcoin. Bitcoin is in fact not being used as a currency now. Very few purchases of goods occur in exchange for Bitcoin. What can be bought for Bitcoin? Not much. Hence, most purchases of Bitcoin are for investment not use. Naturally, this may change, but it is clearly not yet the case.

The presence of an easy way to short Bitcoin could transfer a market dominated by the buyers to a market with professional investors selling short. The entry of deep pocket short sellers could result in a shock to the present market. Bitcoin is already extremely volatile having swings in one day of 15 percent. If a downward spike starts and short sellers step in and join the sell off, the long term present holders may experience a sell off unlike any they have yet seen.

Bitcoin’s incredible, shocking price increase in such a short time was unpredictable. The future is unknowable, but future contracts may cause an equally surprising price decline, instead of the increase so many are anticipating.

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