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What does it mean to “own a Bitcoin?” It means there is a recorded transaction on the Bitcoin blockchain where someone sent one bitcoin to your public key address and that you (and you alone) know the address’s private key. Even if that terse description explains things, it does not help with the logistic details of how you go about doing this. It is complicated. But it is also complicated to physically buy and hold a bar of gold or a barrel of oil. Google it. You could make it happen, but it is work.
Bitcoin, like many commodities, has been “financialized.” There are now financial contracts you can buy and trade that might be just as good as (or better than) literally having an entry on the Bitcoin blockchain. What does financialization and the growing role played by centralized cryptocurrency exchanges mean for everyday investors?
Investing in Bitcoin by directly owning a bitcoin on the blockchain creates a long position that appreciates as the value of Bitcoin (in US dollars, say) increases. If you owned a coin, you could sell it. There is no mechanism inherent to Bitcoin’s blockchain that allows you to create a short position — just like you cannot sell a physical bar of gold you do not have. Financialization facilitates adoption of long positions and makes the adoption of short positions feasible.
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For many, the easiest way to invest in Bitcoin is to use a financial institution like Coinbase. This transaction is easy, in part, because Coinbase does not literally sell you a bitcoin. Instead, Coinbase issues you a liability denominated in bitcoins and backs its liabilities with (bulk) transactions of bitcoins on the blockchain. The tradeoff for the convenience of the transaction (and security) is the risk you bear from the institution. This is analogous to “money” you keep in the bank which in fact is dollar-denominated bank-issued liabilities whose safety depends on the health of the bank and regulation; your money is not literally dollars in a vault somewhere.
Cryptocurrency exchanges like Kraken, Binance, and BitMEX also offer financial contracts that mimic ownership of bitcoins. More importantly, these exchanges allow you to trade “short” so that the value of your position rises when the price of Bitcoin falls. They also allow “leverage” where position values may increase (or decrease) at more than one-to-one with the Bitcoin price.
In new research with collaborators at Carnegie Mellon University, we study cryptocurrency exchanges using data we compiled from BitMEX. Founded in 2014, BitMEX was particularly successful because of its innovation of a “perpetual futures contract” whose price tracks the current Bitcoin price but facilitates both leverage and short trading. BitMEX was less successful in their attempt to avoid US regulator jurisdiction. Here are a few observations about financialization in Bitcoin we draw from our deep dive into this exchange. Most of our data is publicly available on our interactive companion website.
The “how” of financialization matters
Designing a financial instrument involves many choices. Exchange traded financial contracts for typical commodities like oil are standardized. Some of these contracts, such as many oil contracts, are settled physically requiring physical delivery of an exact type of oil to an exact location. Other contracts are settled financially where instead of oil you receive the cash-equivalent of a barrel of oil measured from some index price.
BitMEX tried many different contracts before introducing the perpetual futures contract that now generates a majority of the volume on BitMEX (and many other exchanges). On the surface, the perpetual futures is similar to a forward contract. But a few details jump out as different and important.
First, BitMEX settles in bitcoins (you invest in and get back bitcoins) while long positions held in perpetual futures gain when the (familiar) US dollars per Bitcoin Index price rises. This means that the settlement currency (Bitcoin) appreciates as long positions appreciate; for most forward contracts, the settlement currency (US Dollars) depreciates as long positions appreciate. Using Bitcoin to settle trades makes “long” and “short” positions behave in less familiar ways.
Second, the contracts allow for leverage. With 0.01 Bitcoin you could enter a contract of “size” one Bitcoin. Your profits (and losses) move 100 times more than the change in Bitcoin prices. Frequently, positions end up with a zero balance (called a “liquidation”). These positions are “non-recourse” and so zero is the lower bound on the account. That zero is a likely outcome means the “futures” contract looks more similar to an “option.” Interestingly, to protect the exchange from losses, BitMEX liquidates your position before it hits zero. That small buffer is one source of profit for BitMEX and important when thinking of the market value of these contracts.
Third, the contract features novel interim payments (from long to short or vice versa) called funding that are intended to make the contract price track the Bitcoin Index price. This feature is more common in swap contracts. BitMEX and other exchanges promote these contracts as a simple way to invest in Bitcoin and yet these contracts blend features from forward, option, and swap contracts in complex ways.
The “who” of financialization matters
Trading on BitMEX is round-the-clock and not the standard 9:30 AM and 4 PM. of Wall Street. In cryptocurrency derivatives markets, the trading volume shows little time-of-day pattern. Moreover, round-the-clock trading reflects in part people in the same time-zone trading every minute of the day.
The participants of cryptocurrency exchanges include small and large retail investors, traditional institutional investors, and funds specializing only in cryptocurrency. This is an unusual mix for a derivative market. Our data show occasional large transfers among these traders and specifically from small accounts to large accounts.
Why financialization matters
Financialization changes the way people can invest in Bitcoin. The impact of financialization on the price of Bitcoin is less obvious. Making it easier to buy bitcoins increases demand, but exchanges that facilitate “short’’ contracts let pessimists express their views. More subtly, financialization may change the way people use Bitcoin. For example, Tesla’s ability and desire to accept Bitcoin for payment may be enhanced by the ability to hedge price fluctuations on an exchange. Conversely, the high leverage in some cryptocurrency exchange markets may create instability cycles where volatility in cryptocurrency prices dive which drives further volatility.
So, what does financialization and the growing role played by centralized cryptocurrency exchanges mean for everyday investors? It means it is easier to invest in Bitcoin without owning Bitcoin directly. Exactly what this means for your portfolio is a much harder question.
From time to time, we invite industry thought leaders, academic experts and partners, to share their opinions and insights on current trends in blockchain to the Blockchain Pulse blog. While the opinions in these blog posts are their own, and do not necessarily reflect the views of IBM, this blog strives to welcome all points of view to the conversation.
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