The Bitcoin Bubble

There’s a lot of talk and hand-wringing about Bitcoin in the last few days/week and a half, as the price climbed from around $10k per bitcoin to $17k at its peak. A lot of this climb in price is expected, as trading on Bitcoin futures begins on Monday, December 18th. I’ve been surprised at the increase in Bitcoin’s value, but generally speaking, the price of bitcoin has been closely coupled to the price of electricity and the number of people mining it, and this has held true for quite a while, but no longer seems exactly true. This last statement might be a little bit confusing if you don’t know much about Bitcoin. If you want a quick introduction to it, read my article where I explain the process before moving on.

Since there is a fixed number of bitcoins in the bitcoin economy, there is a deflationary effect on the price of Bitcoin. Like gold, which we don’t have a way to create more of, the more people that want gold, the more expensive it gets. This is very different than, say, Coca-Cola. If more people want Coke, then the price might go up briefly, but the Coca-Cola company just makes more of it to keep it affordable. In the past, the only way to make money on Bitcoin is to buy Bitcoin, and hope that the price goes up (which it usually does, since its deflationary). If, instead of thinking that the price of Bitcoin was going to go up, you thought it was going to go down? Well, there hasn’t really been a way for you to make money with Bitcoin, so you just ignore it.

The end result of this is that the people who are participating in the Bitcoin economy are (generally speaking) people who think the price of Bitcoin is going to go up. Up to this point, it has also generally been people using their own money to speculate on Bitcoin. This results in a strong bias towards people who are not professional investors (since they are using their own money) *and* people who think Bitcoin is going to go up. This, not surprisingly, has born out to be true. You have a number of people who think the price of Bitcoin will go up, a limited supply, and surprise surprise, it’s relatively easy to sell any amount of Bitcoin at a price higher than what you bought it for, because there’s a large group of potential buyers who think it will go up, and are not quants doing the math. As long as most of those people are not selling their bitcoin, and are instead watching the value of their wallets climb, then the price of bitcoin will continue to rise.

So how does the futures market change the price of Bitcoin? Well, you’re now going to have a group of professional investors, who are not using their own money, and will be able to bet on both the price of bitcoin going up, but also on the price of bitcoin going down. Couple that with a large group of people (let’s call them, I don’t know… maybe… suckers? Yeah, that’s the word I’m looking for) who think the price is going to go up endlessly, but are also somewhat risk-averse, emotional, and using their own money. History has shown time and time again how this is going to play out, and who’s going to make money on it. I can guarantee there will be tons of stories about individual investors (or, more accurately, speculators) who made a bunch of money on the increase of Bitcoin, and it will be completely in the interests of professional investors to pump up as many of those stories as possible. A number of those professional investors will simultaneously be making investments betting on the price of bitcoin crashing at some point. Now, you’ll hear a lot of hand-waving about how those investors aren’t really buying Bitcoin, and that they’re only buying Bitcoin futures, which means they’ll be betting on the price of Bitcoin going up and down without owning any Bitcoin itself, so they won’t have an effect on the price. This misses two very important parts of the equation. One, amateur investors are generally pretty skittish, and if you can manipulate the press, you can probably start a run in one direction or the other. Two, professional investors are going to be using a *lot* more money, and they can buy and sell large enough amounts of bitcoin directly that they can probably manipulate the price of it rather easily.

Now, you’ll hear a lot of explanations on why that won’t be true. A common one is that if you look at the total size of the Bitcoin market, it’s large enough (in monetary terms) that individual investors won’t be able to manipulate the price. There are a couple holes in this theory.

The first, is that the total size of the market is not nearly as relevant as the total monetary value of the transactions that can occur, also known as the liquidity. There can be 100 billion dollars of bitcoin, but if the total amount that can be bought and sold at any moment was only $100k, and you saw $200k of bitcoin being sold in a relatively short period of time, then there’s going to be a perception (and risk) that the price is declining, and a bunch of people will move to cash out. Those people moving moving to cash out put downward pressure on the price of Bitcoin, which just feeds the beast, and you end up with plummeting prices rather quickly, with a much smaller outlay in cash than what people suspected based on the price of the market.

The second thing you’ll hear is that because this is on the CBOE and CME, they’ll be regulated. This is true in the sense that Bitcoin futures will be regulated, and if you buy and sell a future of Bitcoin, that there will be rules enforced on that futures contract. What is *not* true is that it would in any way regulate the Bitcoin economy itself. Bitcoin will continue to be unregulated, and lots of people will now be incentivized to manipulate that market. Even if the CBOE or CME says that such market manipulation won’t be tolerated, what is to prevent my rich derivative trader friends from telling me to buy or sell some large amount of bitcoin. Since I don’t trade on the CBOE or CME, there isn’t anything to prevent me from doing that.

So, in conclusion, my speculation is that there is going to a bunch of upward pressure on the price of Bitcoin as every amateur investor thinks the price of Bitcoin is going to keep going up,  are certain in their beliefs, and are willing to put their money where their mouth is. Meanwhile, there will be a bunch of professional investors who are not as easily phased by large amounts of money, who will not be spending their own money, who are looking for a bunch of marks and suckers that they can manipulate so that they can extract as much cash as possible. My guess as to how that’s going to play out is that the price of bitcoin will continue to climb leading up to the trading of Bitcoin futures, and that there will be a correction either immediately or soon after the futures trading begins, and the price will drop dramatically. There’s a chance that it goes the other way I suppose, but the one thing I’m sure of is that the marks and suckers will fare a lot worse than the professional investors. I’m not (and wasn’t) heavily invested in Bitcoin in the past, but I had a small amount of Bitcoin that I had bought a bit more than a year ago that I had virtually forgotten about that was worth considerably more than it was before. I’ve sold it, and cashed out when the going was good. In the worst case, I made 20x my original investment, and missed out on making more. In the best case, I cashed out at the peak, and made 20x my original investment. Don’t say I didn’t warn you….

 

 

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