The Best Asset in a Time of Volatility

All markets are volatile these days.  Stocks are gyrating, bonds are falling as interest rates increase, oil is bouncing up and then down, bitcoin has fallen all year, and even the real estate market seems to be going wobbly.  Gold and silver have been slipping away.  And foreign markets look even gloomier.

Investors naturally look for opportunities when prices fluctuate.  Whether you're a buyer or a short seller, price movements create the potential for profit.  Volatility is gut wrenching if you're taking losses, and can stimulate panicky selling when prices are low.  But it can be exhilarating if it looks like a lucky break.

That's why cash is often the best asset to hold in a time of volatility.  It gives you the means to take advantage of fortuitous price movements, while its stability insulates you from the emotional roller coaster that often drives people to sell when prices are dropping.  Don't think that you have to remain fully invested all the time.  What you have to do is remain unemotional, as emotion is the enemy of careful investing.  A nice, comforting cushion of cash can prevent an unwanted flood of adrenaline.

Cash may appear to have a low rate of return, with greedy banks still paying miserly rates of interest on deposits even though interest rates have been rising.  But cash also offers the potential to profit from price volatility.  You can dive into an asset when its price is low and make a bundle when it rebounds.   That potential makes the effective return from cash much higher.  So don't be afraid to hold a lot of cash in a time of volatility.  That's when it's an investor's best friend.

The Cryptocurrency Bust

Cryptocurrencies are down about 75% from the beginning of the year.  See https://www.cnbc.com/2018/08/20/after-the-bitcoin-boom-hard-lessons-for-cryptocurrency-investors.html.  Many investors have taken losses in the range of 70% to 90%.  Those who borrowed to buy cryptocurrencies learned the hard way that investments may or may not work out, but debts have to be repaid either way.  There may be some winners, but clearly there are plenty of losers.

The problem with cryptocurrencies is that they basically have no intrinsic value.  They're only worth what someone else will pay for them.  If buyer interest falls, people holding cryptocurrencies end up holding the bag.  If you want to buy cryptocurrencies, that's your choice.  But understand it's a speculative choice and lots of speculations end badly. 

The reason why stocks, bonds, real estate and a few other things have stood the test of time as good investments is they generally have underlying value.  If you want to build wealth, invest in value.  If you want to speculate, hope to win but don't be surprised if you lose.  If you want a decent retirement, avoid wishful thinking and focus on the higher percentage plays.  See  http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.

Bitcoin Futures and the Growing Systemic Risks of Bitcoin

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.

How Much Damage Will the Bitcoin Bubble Do?

Bitcoin is a bubble.  There's no doubt about that.  Its value has risen 1,000% this year, and indeed by $1,000  (or about 10%) on each of the past two trading days.  This morning, it popped over $11,000 before dropping about 18% (i.e., over $2,000), all in one trading day.  That's volatile.  That's a bubble if ever there was one.  We once again have graphic evidence that there are a lot of stupid idiots in the financial markets.  History teaches that market stupidity can have major, and indeed systemic, consequences.  Those of us careful enough to avoid Bitcoin may nevertheless be adversely affected by the idiots.  The question at this point is how much damage will this bubble do.

The investors who trade Bitcoin can be found all over the world.  Their personal losses, although potentially large in the aggregate, may be spread out and therefore appear to have a  relatively diffuse impact.  A person who risked and lost most of their net worth on Bitcoin can now look forward to uncomfortable (to say the least) discussions with their spouse and children.  But that personal loss won't affect the rest of us.

The potentially widespread and even systemic impact of Bitcoin losses could come from where and how Bitcoin was traded.  Bitcoin is traded on exchanges and through brokerage firms.  If investors were trading on margin (i.e., with borrowed money) and can't repay the loans, the brokerage firms will take the loss.  If the customers were able to transact directly with a Bitcoin exchange, the exchange takes the loss.  Or, if transactions went through a brokerage firm that sent them to an exchange and the firm can't pay the exchange what it owes for trades, the exchange takes the loss.  There is no organized settlement and clearance process for Bitcoin.  Unlike stocks and bonds, there is no clearing firm, with substantial amounts of capital, to protect against large scale defaults in payments.  If a Bitcoin exchange collapses, the firms and individuals to whom it owes money may be S.O.L.

If a brokerage or proprietary trading firm takes Bitcoin losses, it still needs to pay its obligations.  In order to do so, it may begin liquidating other assets it holds--stocks, bonds, commodities and currencies.  If the firm's losses are big enough, its selling may affect the price of those other assets.  If those other assets begin to sag, other investors (who may not be involved with Bitcoin at all) may begin to sell in order to limit their losses.  This increases the downward pressure on those assets, which may lead in turn to yet more selling.  The potential for a more widespread market crash may develop.

In order to reduce the potential for market contagion, financial regulators need to identify the firms and exchanges where the impact of Bitcoin losses may be concentrated and take steps to limit the damage.  That would be pretty hard, since Bitcoin trading is, by and large, unregulated and there is no organized way to find out where the losses and risks may lurk.  In other words, we may not find out how bad things are until the losses have landed in our laps.

When Bitcoin was trading for a few hundred dollars (in those ancient times as far back as a year ago), the potential for major or systemic loss was almost nonexistent.  But when Bitcoin rises by 10% a day and drops 18% in a day, while trading around $10,000 or more, the losses may be much, much larger and the potential for major or systemic losses increases commensurately with the increases in transaction amounts.  Even though they could have shrugged a year ago, regulators and creditors of Bitcoin exchanges and traders need to start paying serious attention.  The volatility in Bitcoin could easily get worse before it gets better.  Bitcoin may soon trade for $25,000, $50,000 or even more.  The losses, when they inevitably come, could involve mucho dinero--and we mean mucho.  Failure to give Bitcoin their full attention could be very costly and painful, not only for players in the Bitcoin markets but also for we innocent bystanders.  The time for vigilance has arrived.

Is Inflation Hitting Bitcoin?

Bitcoin is supposed to be insulated from inflation.  Because there is a predetermined limit to the number of Bitcoins that can be created (21 million), Bitcoin supposedly should not be subject to anything like the monetary actions of governments, which can inflate fiat currencies by printing more money.  There was an operational problem in August 2010, when someone created 184 million Bitcoins in a single transaction.  But this transaction was voided and the operational problem dealt with.  Thus, the 21 million coin limit was preserved.

Nevertheless, Bitcoin is subject to inflation risk.  Inflation results from increasing the amount of a currency.  Although the number of Bitcoins is limited, the number of digital alternatives to Bitcoin is not.  Other cryptocurrencies, such as Ethereum, can be created with relative ease.  There are few barriers to entry.  Some 1100 cryptocurrencies now exist.  Among them is Bitcoin cash, created by the Bitcoin community with features that make it easier than Bitcoin to use for transactions.  The Bitcoin community also created Bitcoin gold, a cryptocurrency created to facilitate decentralized mining (Bitcoin itself is now dominated by a small number of large miners).  As these alternatives proliferate, the value of Bitcoin can fluctuate wildly.

So far, Bitcoin has recovered from its sharp drops, and continued an overall upward trend in value.  But volatility attracts fast money, and cash seems to be flowing into the Bitcoin market for speculative purposes.  This may not end well.  Hot money never stays in one place for long.  With all the alternatives to Bitcoin, and the low barriers to entry for more, numerous other venues for volatility and speculation are or will become available.  Speculators will stampede to whatever market appears to offer larger and quicker profits.  The effect on Bitcoin could be similar to inflation.  As cash flows away from Bitcoin, its value will diminish.  Pause and think before you buy Bitcoins.

Why Regulate Bitcoin?

Okay, so Mt. Gox, once the largest Bitcoin exchange, has belly flopped and lots of people have lost lots of Bitcoins (apparently hundreds of millions of dollars worth).  Mt. Gox is in bankruptcy, but unsecured creditors like its erstwhile customers usually get the back of a hand in bankruptcy proceedings.  Last year, Bitcoin was celebrated for its independence from any national authority and the anonymity it supposedly provides.  This year, the losses from Mt. Gox have many crying for regulation.  Is that a good idea?

First, Bitcoin would have to change fundamentally for regulation to work.  Anonymity would have to go.  Regulators need to safeguard the market from thieves, manipulators, and all variety of fraudsters and other crooks.  That necessarily means they need to know who is behind transactions--potentially any transaction.  It is axiomatic among financial regulators that, in order to uncover shenanigans in the market, one follows the money.  And you have to be able to find out who is behind transactions in order to follow the money.  So, if you really want regulation, say goodbye to the anonymity of Bitcoin.

But an even more important question for the nation(s) that might consider regulating Bitcoin is why would regulation serve the public interest?  Bitcoin is economically trivial.  If all Bitcoins disappeared tomorrow, the world economy and all major national economies wouldn't even hiccup.  Setting up an effective regulatory regime would require not just one nation, but the participation of all economically significant nations because Bitcoin can be bought or sold worldwide.  The costs of establishing regulatory agencies, hiring personnel, buying equipment, leasing office space, and funding investigative and regulatory processes would, by all appearances, greatly outweigh the societal benefit. 

Another risk of regulating Bitcoin is that doing so would legitimize it.  Once a government begins to regulate a financial contract, it makes that contract more attractive to mainstream financial markets players.  That would mean the major banks, hedge funds and other big players would start trading all manner of Bitcoin contracts.  A derivatives market in Bitcoins would pop up, and with it all kinds of headaches about risk management, settlement and clearance, and so on.  All for something the world doesn't need. 

And sooner or later, some form of governmentally sponsored deposit insurance would probably be sought by Bitcoin enthusiasts.  If the big banks and hedge funds add their lobbying power, such insurance might make it through Congress.  But deposit insurance could easily, directly or indirectly, end up putting taxpayers on the line to cover Bitcoin losses like those suffered by Mt. Gox customers.  Which would be just peachy--another taxpayer funded bailout in the making.

The bottom line:  don't regulate Bitcoin.  There's nothing in it for national governments or taxpayers.  We don't need more financial risk for regulators, central banks and taxpayers to worry about.  If Bitcoin is truly worth anything, it will survive in the market.  And if it doesn't, good riddance.

Questions About Bitcoin

The hype about Bitcoins is reminiscent of some of the early hype about the Internet.  Long, long ago, in the Paleolithic times of 20 years ago, the Internet was seen as an idyllic world where all would be equal and a person could accomplish anything with a computer and just a little effort.  The wide open nature of the Net allowed anyone, however anonymous and humble, to speak out and be heard, create and be seen, reach out and touch untold millions, all with just a few keystrokes.  Wondrous things would happen; lead would be turned into gold; a veritable digital Eden would arise and everyone who entered would attain nirvana.

Well, it didn't quite work out that way.  Gigantic corporations now dominate the Internet, and powerful government agencies lurk in the background, spying high and low, leaving no server unmolested.  Bad people from around the world seek to victimize, defraud and destroy; and the wide open nature of the Net allows them to do so with just a few keystrokes.  The free-standing individual who was supposed to have been the pillar of the digital community has shrunk into an online sheep, waiting helplessly to be fleeced of all personal information, browsing habits, bank funds, and credit lines.

The Norman Rockwellian narrative of Bitcoins would have us believe that they are a pure form of value, unmarred by the pock marks of central bank policy.  "Mined" by solving mathematical problems, transacted anonymously on a peer-to-peer basis, Bitcoins would be finite in amount and invulnerable to inflation since no one, supposedly, would control them.  Those who held Bitcoins would be liberated from the oppression of governments and the highway robbery of fee-charging financial institutions that handle transactions in fiat currencies.  A brave new monetary system would supersede the corrupt, degenerative fiat currencies of yore, the clouds would part and the sun would shine forever.

But reality is turning out to be blemished.  It seems that the use of Bitcoins for payment made an online market for illegal drugs called Silk Road attractive to denizens of dark corners of the Net.  The anonymity of Bitcoin transactions is a godsend for scoundrels and knaves of every variety, with government crime fighters largely unable to figure out who to put on the Ten Most Wanted List.  It's now clear that Bitcoins will attract criminals, organized criminals, terrorists, tax evaders, and other miscreants with something to hide.

But, are there bigger monsters lurking in the shadows?  Rogue nations, which may be facing sanctions in financial systems denominated in fiat currencies, might find Bitcoins a convenient way to get back in business.  And business could be nefarious indeed, with weapons, equipment for processing radioactive materials, drugs, and other suspect cargo changing hands.  Intelligence services--foreign and domestic--would have many reasons to use Bitcoins.  Undercover operatives need to be funded.  Bribes need to be paid.  Deniability would be enhanced.  Detectability--and accountability--would be reduced. 

Then, there's the market for Bitcoins.  Unregulated and opaque, it's ideal for manipulators and fraudsters.  The mining process is getting harder and harder, as the mathematical problems that need to be solved become increasingly difficult.  More and more computing power is needed to solve them.  That means bigger, more complex and more expensive computers must be used. The advantage goes to those that are well-capitalized.  Yet the price of Bitcoins is notoriously volatile.  Who can afford to invest in the massive computing power that it now takes to operate a successful mining operation while withstanding the wild price swings in Bitcoin prices?  Wealthy speculators, rogue nations, organized crime, and financiers operating from secrecy jurisdictions might all see an opportunity to make a fast Bitcoin or two--or maybe a lot more--off of the naive true believers who buy and transact at the retail level.  Trading anonymously, these big boys could bid prices up using multiple accounts they control to trade back and forth with themselves.  They could pay for online ads hyping Bitcoins as they walk the price up, provoking an investment frenzy among the sheep.  Then, as the price reaches meteoric levels, they dump the coins that they've mined, and then walk away, leaving the price to move whichever way it will (which is likely to be down). 

The biggest potential problem for Bitcoins may well be that the big players will move in.  And, as with the Internet, the little people will suffer.  Invest at your peril.