Yesterday, Bitcoin rose above $19,000, only two days after it reached $12,000. Then, it plunged some 20%. As we said before, Bitcoin is in a bubble. And things will get riskier soon.
Next week, on Dec. 10, 2017, Bitcoin futures contracts will begin trading on the Cboe. On Dec. 18, 2017, they will begin trading on the CME. Both the Cboe and CME are longstanding exchanges that trade many well-established financial products. The commencement of Bitcoin futures trading lends Bitcoin a legitimacy it doesn't yet have. Investors who may shy away from the little known, often foreign markets where Bitcoin is currently traded could be drawn to the Cboe and CME because they are well-known, located in America and regulated by the U.S. government. American investors may become far more exposed to Bitcoin than they are today. And that could be bad.
The underlying Bitcoin market is opaque, to say the least. Much of it is overseas, and reliable transactional data is scarce. Ownership information is, by design, unavailable. How does one price a futures contract when one doesn't have a good idea of what's happening in market for the underlying asset?
The Bitcoin futures market will also differ dramatically from Bitcoin in another aspect. There is a limit on the number of Bitcoins that can be created: 21 million. There is no limit on the number of Bitcoin futures contracts that can be created. People who don't want to pay or mine for Bitcoins can trade futures instead. Since futures contracts can be purchased on margin (i.e., with money borrowed from a brokerage firm, after putting some cash down as collateral), it may end up being cheaper and more potentially profitable to trade Bitcoin futures instead of Bitcoins. The volume of Bitcoin futures trading could end up dwarfing the volume of trading in the underlying Bitcoins. And there is no limit on how large the futures market could become.
If Bitcoin futures trading expands the way Bitcoin trading has ballooned, the amount of marketwide exposure to Bitcoin price movements could increase exponentially (or maybe even faster). The volatility of Bitcoin's price could wreak havoc with investors trading futures contracts, who generally buy futures contracts on margin. When the price of a futures contract purchased on margin drops, brokerage firms can ask for additional cash to be deposited as collateral (via a "margin call"). This cash has to be provided quickly or the brokerage firm may sell the futures contract to prevent further losses to itself. Investors sometimes fail to provide the additional cash demanded, either because they don't have it or can't get to it fast enough. Either way, the brokerage firm's sales then add to the downward pressure on the market. That can push the price of the futures contract lower and result in more margin calls. These in turn can produce even more selling, leading to a downward spiral. That's what happened to stocks in the great stock market crash of 1929, and it could happen to Bitcoin futures contracts.
None of this requires that the Bitcoin futures market be cornered or otherwise manipulated. It can happen from the daily craziness we already see in the Bitcoin market. If a lot of investors dive into Bitcoin futures, the aggregate risk created could be immense. Abrupt price drops such as we have recently seen (i.e., 20% a day) could be catastrophic for investors trading on margin. Widespread failures to meet margin calls can endanger the financial stability of brokerage firms and clearing houses. Some may collapse, something that happened after the 1929 stock market crash. That, in turn, could put the financial system at risk.
Of course, everyone thinks the Fed will bail us out. There seems to be an assumption in the market that the Fed has always bailed us out and always will, so risk is irrelevant. But this is no longer true, if it ever was. The Dodd-Frank Act, much detested by conservatives, limits the extent to which the federal government can underwrite financial market bailouts. There is no insurance covering market losses in futures accounts. So investors taking losses in this scenario, and their brokerage firms, are pretty much on their own.
Some might think that the way out of this dilemma is for investors and firms to hedge their exposure. That way, if the market goes bye-bye, the losses are passed to whoever gave them the hedge. But, from a systemic basis, hedges don't solve the problem. Financial risks, once created, don't go away by themselves. When they result in a loss, the loss lands somewhere. If not on the original investor, then on the person who provided the hedge (or if that person hedged the hedge, then on the person providing hedge for the hedge, and so on). No matter how long one extends the chain of hedges, the loss will land somewhere.
If those losses are concentrated into one or a few firms, the result could be seriously bad in a systemic way. That's what happened during the financial crisis of 2008, when very large amounts of derivatives market losses from mortgage-backed or mortgage-related investments were concentrated at a single large insurance company--AIG--which, had it collapsed, would have taken down the world's financial system. As things happened, U.S. taxpayers, in a ceremony M.C.'d by the Fed, bailed out AIG and the world financial system, which although gasping for breath, was able to limp along and muddle through.
Could Bitcoin futures losses end up concentrated in a way that would put the financial system at risk? That will be the challenge for financial regulators, in the U.S. and elsewhere. Since Bitcoin is traded around the world, regulators in the U.S., Europe, China, Japan and elsewhere need to be alert and communicate enthusiastically with each other. Given the astounding celerity at which Bitcoin trading has ballooned, and the jaw-dropping volatility of Bitcoin prices, there is every reason to believe that Bitcoin futures could provide a ride as wild as, or wilder than, the Bitcoin monster roller coaster. And the world may well not be prepared for what could happen.
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