What happens when bitcoin's market cap overtakes world GDP?

Because there’s no reason why it couldn’t. And that’s the problem.

Unlike any other market in the world, there are no natural sellers in bitcoin. Even the miners who mint coin stockpile as much of it as possible and try to obtain as much free energy from alternative non monetary sources.

If and when they are forced to sell to pay for electricity bills they do so through established bilateral OTC channels out of fear that dumping huge amounts of coin on public exchanges could impact upward momentum, eating into their potential gains.

Walter Zimmerman, technical analyst at ICAP Technical Analysis, has been in the commodities and futures market for more than 35 years. In that time, he says, he’s never seen a market quite like it. He’s worried the launch of bitcoin futures next will only exacerbate the one-directional trading. And since bitcoin has no fundamental value that takes the next technical target point to as far as $47,400.

The closest thing he’s seen that’s comparable, he says, is the Synergy and Entergy electricity contract launched by Nymex in 1998.

Due to regulatory reasons it too had no natural sellers in the market on a structural basis, says Zimmerman. This prevented any proper market making in the contract.

The history is telling. Brokers, unable to offset flows naturally in the market, began to step out. They had no incentive to keep supporting the contract. The result: thin trade and little to no liquidity.

Traders complained that it was impossible to liquidate positions and unforeseen spikes became a perpetual problem.

As they walked away, futures volumes died and OTC markets took over. The contracts had to be delisted.

As Zimmerman noted to FT Alphaville:

The Nymex was in such a rush to get the contract listed that they didn’t bother to wait around until utilities could hedge, which they couldn’t for regulatory reasons. They were the natural shorts that had to sell to lock in prices. The spikes were so high and caused so much turmoil because there were no natural sellers.

And remember, this was electricity, which can still be equated with some fundamental value.

Market structure lessons of this kind cannot be ignored. Yet the upcoming launch of bitcoin futures next week is likely to repeat these issues if not magnify them to unprecedented proportions.

Many of the same structural challenges are to be observed.

Over the last year bitcoin positions across many markets have become entirely one-directional. We’re told, for example, that over 90-95 per cent of client flow on some of the most popular CFD and spread betting platforms is on the long side.

Prudent platforms tend not to like this sort of thing. Ideal markets for them are ones that offer a good balance of buyers and sellers so that flows can be offset naturally against each other (known in the industry as being internalised) without the need to hedge the differentials. This way the platforms can charge a spread while bearing little to no cost and risk from dealing with outstanding positions.

When flows don’t match properly, prudent platforms look to hedging. But hedging isn’t free. Associated costs have to be passed on to clients, usually in the form of other charges, whether through wider spreads or overnight funding charges.

When positions get excessively one-sided, these costs spiral.

This is particularly the case in bitcoin, where traditional hedging techniques aren’t easy to deploy. Ordinarily, a platform would wait to see what end of day differential is necessary to hedge, before going out into the market to cover its position. But with bitcoin’s wild volatility, even a small delay in hedging can expose a platform to mismatch risk, since the price of bitcoin can move so quickly you can’t hedge quickly enough to cover your price exposure. This encourages some level of pre-hedging, which carries its own price risks.

The second problem is a lack of liquidity and uniformity in pricing. Big platforms have a lot bitcoin to hedge. That’s often not so easy in a fragmented marketplace where the price can deviate between exchanges by multiple percentage points. This sees a lot of them scoping out the OTC markets, which — ironically for such a digitally-focused frontier — are serviced by old fashioned voice-brokers who introduce expenses of their own.

Third, there’s the issue of counterparty risk. Live balances have to be held on exchanges, and yet many of these venues are unregulated, opaque and have little to no track record coping with crises. This can be managed for to a certain degree by spreading positions around. Some responsible platforms tell us they will work with up to 10 exchanges. But the more exchanges a platform has to deal with the greater the admin costs, the due diligence work and the risk management costs. (It’s hard keeping up with all the risks being faced by all these venues. There’s rarely a day some sort of scandal or hack doesn’t hit somebody in the sector).

Fourth, there’s the issue of security and the cost of managing all your bitcoin hedges from a complexity and security point of view.

Last of all, there’s the issue of overall cost. Margin trading is mostly not a thing, so hedges have to be fully funded.

Due to all these complexities, many less prudent platforms don’t hedge at all. Instead they run business models that more closely resemble those of casinos, making money either on the spreads they charge, the overnight funding rates applied or, more commonly still, from playing the odds that their clients are more often than not going to find themselves on the losing side of the trade.

But bitcoin’s bull run is now testing those models too. Since too many clients are winning while the house is losing — with no effective hedges in place — the costs have to be made up in other ways. Hence on some platforms overnight financing rates are reaching Wonga-style rates of 365 per cent a year or more.

It’s all a bit like this:

Now, the casino-models were probably prepared to suffer a bit of risk and even loss for the sake of the promotional value of offering bitcoin. The hope no doubt was that a slew of new clients would come for the bitcoin but stay for the opportunity to punt in all sorts of other markets, where failure is a much more common thing.

But, informed sources tell us, this isn’t really happening. Punters have come for the bitcoin and stayed for the bitcoin. And they’re now so in the money, the house is beginning to get nervous. In the interim, the only offset are high overnight charges, which — from a customer’s point of view — ensure bitcoin has to rise a good percentage every day just to keep everyone in the money.

Hedging and pre-hedging

Given the above dynamics, for the burgeoning market of intermediaries who bridge the gap between the core unregulated cryptocurrency markets and the mass-market retail punting world, it’s a bit of a god send that respectable venues like the CBOE and CME might soon start offering a regulated market in bitcoin futures. They, after all, are the natural shorts in the market at this point, and they’re dying for a headache-free way to hedge.

Moreover — even with margin demands of 33-35 per cent or more — for these guys, the futures look cheap compared to any of the equivalents they’re currently being forced to use in the non-regulated space. If the futures are liquid to boot, it all becomes a bit of a no-brainer.

But is it really as simple as all that? No!

All the trade opportunities available in cryptoland are the product of a giant credit trade. Established CFD and spread-betting houses — while on the lower end of the financial legitimacy end — are still overseen by some sort of regulatory system which forces risk management and compliance upon them. The key product they bring to the market, as a result, is reduced crypto trading credit risk. In short, they take on the credit risk that comes along with dealing with the cowboy crypto space — by deploying more established risk management techniques than otherwise offered in the market — so clients don’t have to.

The problem is, providing such a service is not easy. Risk management bears cost. And offering clients fiduciary guarantees when you yourself don’t get to benefit from any, eats into business model profitability unless the costs are distributed properly.

Futures might at first sight seem like a panacea to this problem, but chances are they will only push the credit risk onto somebody else.

Which brings us back to the intrinsic market structure problems at hand.

For any futures market to work efficiently, especially if it’s to offer much desired liquidity, it must be attractive to market makers and bi-directional traders. As it stands, however, there’s no capacity for a market maker to be able to offer this sort of service without taking on huge amounts of credit and liquidity risk onto their own books. Small surprise many of the established (well supervised) players — such as the big broker-dealers — are seemingly not prepared to take the risk on.

Since the risk must be transferred to someone if the futures are to offer the service the natural shorts want, we’re left with only three scenarios going forward. One: the futures will flop. Two: the risk will be transferred elsewhere, most likely into the clearing houses that support the futures exchanges (to the risk of the entire trading community). Or three: a less established player with a lot more tolerance for risk — possibly a natural long — steps into the market comes into absorb the risk.

Though, it’s worth noting that option number three doesn’t necessarily stop scenario number two from playing out, given any such entity would still have to be serviced by the CME/CBOE clearing systems.

When excessive digital luxury squeezes the world

Which brings us back to the title of this post. A market with no intrinsic fundamentals has no ceiling on what the price can get to. As Icap’s Walter Zimmerman has pointed out in recent notes, that leaves it partial to over-exuberance until the point that the (impractical) realities of what has been created become impossible to ignore.

At the $47,400, those absurdities of the system will begin to become self evident, not just in relative asset-class value terms but also in total energy-cost terms to support the system. For example, as Zimmerman noted at the end of November,

  • As a thought, experiment 21 million Bitcoins at $50,000 each would mean a total market cap of $1 trillion
  • The total value of all the world’s coins and banknotes is estimated at $7.6 trillion*
  • At $1275 per ounce the total value of all the world’s gold is $7.7 trillion*
  • The total value of the world’s money ( Broad Money ) is est. at $90.4 trillion*

In short, once people start having to go without just for the planet to keep maintaining this most excessive and exuberant of luxury asset classes, the obvious absurdity of the creation will cause the bow to break. How that realisation comes about nobody can be sure of at this point. But the two most worrying paths come via an inflationary surge brought on by the hypothetical purchasing power imparted on the global system by all those freshly minted billionaires, or — more likely — via the liquidity constraints which will be imposed upon the rest of the system through having to accommodate bitcoin risk.

Until then, as Zimmerman notes, there’s nothing to stop asymmetrical interest from pushing the valuations ever higher in the style of a video game that has absolutely no boundaries:

  • Bitcoin can be seen as a currency of video gamers, by video gamers, and for video gamers. What do I mean by this?
  • Users of other currencies find utility in a stable value. But not here in Bitcoin world.
  • The reality of Bitcoin is that users are also players. And the objective of this game is the highest possible score. • The path to wealth for Bitcoin users is to drive the value higher, and higher, and higher.
  • This dynamic and the above cited freedoms make Bitcoin a likely future home of the largest speculative bubble in recorded history.
  • And the lack of law enforcement also make Bitcoin a potential future home of the largest theft ever.

Related links:
Are there systemic risks in clearing bitcoin? – FT Alphaville
Why Bitcoin futures and a shoddy market structure pose problems — FT Alphaville

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