Bitcoin’s winter price peak and subsequent decline coincided with the introduction of bitcoin futures trading on the Chicago Mercantile Exchange. A team of researchers doesn’t think it was a coincidence.
Galina Hale, Arvind Krishnamurthy, Marianna Kudlyak and Patrick Shultz — economic researchers writing for the Federal Reserve Bank of San Francisco — claim in a research paper that the rapid rise and subsequent decline in the bitcoin price is consistent with trading behavior that accompanies the introduction of futures markets for an asset.
Futures Contract Boosted Price
Following bitcoin’s launch in January 2009, the price remained below $1,150 until February 22, 2017, when it jumped for about 10 months. This growth ended on Dec. 17, 2017, when bitcoin reached its peak price of $19,511. Such dynamics were not caused by overall market fluctuations, as indicated by comparison with the Standard & Poor’s 500 stock index, the researchers noted.
Instead, the peak coincided with the day bitcoin futures started trading on the Chicago Mercantile Exchange (CME).
These price dynamics are consistent with the rise and collapse of the home financing market in the 2000s. Researchers Fostel and Geanakoplos in 2012 suggested that the mortgage boom was caused by financial innovations in securitization and groupings of bonds that attracted investors. The mortgage bust was caused by the introduction of instruments that enabled pessimistic investors to bet against the housing market.
Similarly, the introduction of blockchain delivered a new financial instrument, bitcoin, which investors bid up the bitcoin price until the introduction of bitcoin futures permitted pessimists to enter the market, bringing a change in bitcoin price dynamics.
Transactional Versus Speculative Demand
The researchers separate transactional demand, which is based on using bitcoins for purchases of goods and services, from speculative demand, which happens when people buy bitcoins hoping their value will increase. Speculative demand is a bet that the price of the asset will increase, as the investor does not need the asset itself.
For most currencies and assets, investors have ways to bet on the change in their value using financial instruments based on the currency or asset, so-called financial derivatives.
Prior to December 2017, no major market for bitcoin derivatives existed, meaning it was extremely difficult to bet on the decline in bitcoin price. Such bets typically take the form of selling an asset before buying it, forward or future contracts, swaps, or a combination.
Speculative demand for bitcoin came from investors willing to bet the price would go up. Until December 17, optimists’ demand pushed the price of up, energizing more investors to join. The pessimists, by comparison, had no way to bet the bitcoin price would fall.
Futures Contract Gave Pessimists a Market Entry Point
This one-sided speculative demand ended when the bitcoin futures started trading on the CME on Dec. 17. While the Chicago Board Options Exchange (CBOE) opened a futures market a week earlier, trading was sparse until the CME joined the market.
Pessimists could bet on a price decline, buying and selling contracts with a lower delivery price in the future than the spot price. They could sell a promise to deliver a bitcoin in a month at a lower price than the existing spot price and expect to buy a bitcoin during the month at an even lower price to realize a profit.
With offers of future bitcoin deliveries at a lower price being made, the order flow also put downward pressure on the spot price. Those in the market to buy bitcoins for transactional or speculative reasons and willing to wait a month had a good deal. The new opportunity led to a drop in demand in the spot bitcoin market, causing the price to drop.
As to why the price of bitcoin fell gradually rather than fast is hard to explain, the researchers noted. It could be that pessimistic investors did not enter the market on the first day or week of trading. The total volume of transactions in the CME futures market began very low, with the average trading volume of contracts committing to deliver about 12,000 bitcoins in the first week of trading, compared to the estimated spot market turnover of 200,000 bitcoins.
The rapid price rise and its decline following the issuance of futures is consistent with pricing dynamics suggested elsewhere in financial theory. While some of the factors that play a role in determining the long-run price of bitcoin are understood, the understanding of the transactional benefits of bitcoin is too imprecise to quantify its long-run price. But as speculative dynamics subside from the market, transactional benefits will likely drive valuation.
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