Yahoo Finance contributor Jake Moore is a former hedge fund manager for Caxton, Tudor and Citadel. He now runs a new firm called Kaiseki Systems.
As someone who has spent a huge part of my career thinking about the mystery of currency rates, the rise of cryptocurrencies, and bitcoin in particular, has been a fascinating development.
To start with, there is the problem of whether or not bitcoin is a currency. For now, it is a store of wealth. You could buy a pizza with it, but you might regret it later on. That said, theoretical definitions of currencies seem to be of little significance now, when the value of bitcoin feels more like a force of nature.
The bitcoin market is moving day by day away from quirky crypto believers to serious large investors. Bitcoin’s notional market capitalization is more than $300 billion. Adding in other tokens, the market cap of all cryptocurrencies is more than $500 billion.
While the volume trades in cryptocurrencies are minuscule compared with currency pairs such as EUR/USD, it is worth remembering that there are many legitimate currencies in the world that are extremely illiquid. Try moving a substantial trade in the Icelandic krona, particularly in times of stress. (It’s not fun.)
Of course, bitcoin could prove ephemeral, a bubble of over-exuberance. But as a currency investor, I notice the market is developing more technical similarities than differences to mainstream currency markets.
Bitcoin trading is getting more serious
From a technical perspective, the methods to trade bitcoin are becoming more varied, and safer. The introduction of two futures contracts in the U.S. is a bold move but one that could in itself create tremendous changes to the landscape. It means that much of the credit risk of buying the underlying instrument is removed, meaning institutional investors and other more risk averse investors can put to work a tiny proportion of their assets in a way they understand.
In mainstream currency markets, a huge source of trading revenue — and by extension, market efficiency — comes from the ability to “arbitrage” between various sources of liquidity. In currencies these include Reuters, EBS and CME futures. In bitcoin, all the various exchanges are today arbitrageable and there are opportunities all the time. On the first day that Coinbase added trading of bitcoin cash, for example, a large price discrepancy emerged between bitcoin cash on Coinbase and bitcoin cash on other exchanges.
The ability to borrow bitcoin, and therefore go short, is fledgling and enormously costly. But it is here nonetheless, and this adds another facet that mirrors mainstream currency trading: the interest rate arbitrage opportunities between the FX forward curve and interbank interest rates.
In mainstream currency markets, we often rely heavily on quantitative models. These models can spot pricing anomalies, follow trends and highlight valuation discrepancies. There is now a lot of study going into using these same methods and newer machine learning technologies to produce trading models in bitcoin. Again, this mirrors almost exactly the methods used in mainstream currency markets.
Problems in bitcoin trading still exist
Even as bitcoin volume trading gains legitimacy, obvious problems remain.
From a trading and technical perspective, getting into bitcoin is like entering Jurassic Park. The scale of the moves and the potential for an existential shock are overwhelming for most investors. The volatility is so enormous that sizing positions with any degree of confidence in the statistical properties is nigh on impossible. And there are other factors, such as skew and kurtosis, that really haven’t been tested at all.
As such, it is still a believer’s market when one has to size positions with the real possibility of losing all of one’s capital. In mainstream currency markets, a 5% move would be a big deal.
Technically, it is also still very hard to short bitcoin. This is not a problem in a rising market, but in a falling market, short-sellers tend to be a large proportion of the liquidity. In a falling bitcoin market, it is possible that there will be few buyers.
Existential threats are unique to bitcoin
Existential threats exist for bitcoin that simply do not have any parallel in other currency markets.
The creation of quantum computing, for example, could have an enormous impact if 51% of the block auctions are won by one party. There are security issues, regulatory threats and changes to the internet itself, in particular the possibility of China implementing the ‘great firewall’ that could split the chain in two.
It is possible that the parallel for mainstream currency markets is bitcoin itself. But here we all are, going down a rabbit hole, for another time.
Bitcoin is similar to gold
In many ways, bitcoin is most comparable to gold bullion.
Gold is in very short supply and is very hard to find. All the gold ever mined would fit in a fairly small cube, possibly as small as 20 cubic meters. It is also enormously valuable, but has very few uses. Compared with mainstream currencies, it is a little more volatile and far less liquid.
And many “gold bug” investors sound a lot like bitcoin believers, despite the fact that you can’t spend gold and it costs a fortune to hold it.
Are we missing a larger lesson?
Any investors focusing on bitcoin’s uses (or lack thereof) or its technical properties might be missing a far larger point that goes beyond bitcoin itself.
To me, currency investing is largely about asset allocation and therefore the explosion in price and interest in bitcoin cannot be taken in isolation.
It can be no coincidence that bitcoin’s rise is occurring at a time when all other asset markets are looking extremely highly valued, by historical standards. Government bond yields are negligible and equity indices are, give or take, the most expensive compared with measures of value that they have ever been. Real estate in many countries is similarly highly priced right now.
It will take time to determine, but it is possible that the bitcoin explosion is a sign that investors are getting seriously concerned with valuations across all mainstream markets.
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