Taking a Bite Out of Bitcoin

It has been quite a wild ride these past few months for bitcoin and other nascent cryptocurrencies. As the first decentralized digital currency, bitcoin earned a measure of credibility in December 2017 when it started trading on the CBOE and CME Group’s futures exchanges. By then, bitcoin had quadrupled in price over the previous two months and market regulators were alarmed about retail investors’ exposure to the bitcoin market. There were even calls in many jurisdictions to ban cryptocurrency trading and claims that bitcoin was the “biggest bubble in history.”

Louis Gagnon, Distinguished Faculty Fellow of Finance at Smith School of Business, had learned about the Chicago exchanges’ plan to launch bitcoin futures trading back in September. He had been watching the bitcoin marketplace with renewed interest ever since, anticipating a major price correction soon after the futures introductions. Gagnon’s prediction was based on findings from his recent research, published in The Financial Review, a peer-reviewed finance journal.

His insight about bitcoin wasn’t rooted in a deep-seated belief that bitcoin was inherently overpriced — though he confesses he can’t make sense of the market. Rather, Gagnon observed that, until now, there was no market mechanism to temper the “over optimism” and “over pessimism” that had been driving the currency’s wild price swings.

In the stock or bond market, for instance, those who believe an asset is overpriced can “borrow” the asset and “sell it short,” thereby pushing down its price. “It’s like bringing more supply into the market artificially,” says Gagnon.

A futures market "provides a very efficient mechanism to resolve the supply and demand imbalances that often prevail in the spot market, especially when there’s overpricing”

Futures markets offer a simpler alternative to short selling. Here’s why: when you buy or sell a commodity or stock in the futures market, you’re not acquiring or unloading the actual commodity or stock certificate; you’re simply taking on the obligation to buy or sell the stock on a certain date in the future, at a price fixed today. If you think the stock price will rise a few months from now, you can take a long position. If you think the price will fall, you can go short.

“The futures market enables market participants to sell short the underlying asset without actually having to borrow it from a lender beforehand, and to exert downward pressure on overinflated market prices,” says Gagnon. “This market provides a very efficient mechanism to resolve the supply and demand imbalances that often prevail in the spot market, especially when there’s overpricing.”

Although it makes intuitive sense that futures and other derivatives such as options provide a viable way to conduct a short sale, there was no consensus on whether they actually relax short sale constraints facing market participants, let alone contribute to the elimination of overpricing.

“Up until this point, researchers had relied on crude proxies for short sale constraints,” says Gagnon. “None of them had been able to control for supply and demand in the lending market to clarify this relationship.”

Proving That Futures Operate As Promised

Gagnon figured out a way around this problem. He secured access to a new proprietary dataset capturing around 90 percent of all stock-lending transactions in the U.S. He then crafted an experiment involving the nearly 1,300 single stock futures (SSF) contracts introduced on the OneChicago exchange between 2002 — when the all-electronic futures exchange was first created — and 2009. He then studied the market’s reaction to the SSF introductions.

Gagnon found that futures exchanges do not necessarily list futures contracts on single stocks to address issues related to overpricing. In fact, overpricing is only evident in the bottom third of his sample. When overpricing exists, however, it tapers off soon after the SSF introductions, albeit slowly as trading in the contracts builds up.

Tellingly, after SSFs are introduced, lending fees drop precipitously by three quarters of their pre-SSF levels. Furthermore, the proportion of shares lent relative to the total number of shares in the stocks available in the lending market drops markedly following the SSF introductions. Clearly, futures introductions have a profound impact on market behaviour.

Voting on Bitcoin's Value

As far as Gagnon is concerned, everyone wins when there is a thriving futures market that offers a transparent setting for short sellers to do their work. This is particularly the case for bitcoin and, eventually, other digital currencies. Since there was no way to short bitcoin prior to the introduction of bitcoin futures — large institutions were not prepared to invest in bitcoin let alone lend it — pessimistic investors had no means to contribute their sober views to the marketplace.

“Up until mid-December 2017, all that we had seen in the bitcoin marketplace were bullish people buying bitcoin,” says Gagnon. “When prices are driven by an endless queue of people who are very bullish, prices have nowhere to go but up.”

Now, market participants have an alternative venue in which to purchase and sell bitcoin that circumvents the need to buy and sell the actual asset in the spot market. And existing bitcoin investors have a vehicle that enables them to effectively liquidate their bitcoin without actually doing so.

"The new bitcoin futures marketplace will keep the bulls in check and give the bears a unique trading venue to do their work"

“Bitcoin owners can sell their bitcoin in the futures market,” says Gagnon. “They can use bitcoin futures as a risk management tool. When they think prices are too high, they can — without actually selling their bitcoin in the spot market— actually hold onto it and sell it short in the futures market until the market cools down.”

Of course, the bitcoin story has only just begun. As Gagnon cautions, “no one knows how far the bulls will be able to carry bitcoin.” No matter what happens though, “we can rest assured that the new bitcoin futures marketplace will keep the bulls in check and give the bears a unique trading venue to do their work because, thanks to this new futures market, they can sell bitcoin even if they don’t own it.”

— Alan Morantz