Bitcoin, Short Sales, and Volatility

I am fascinated by Bitcoin and would love to see it be a success.  But Tyler Cowen has a quote that reflects some of my concerns about it:

…bitcoins are an uncomfortable combination of commodity and currency. The commodity value of bitcoins is rooted in their currency value, but the more of a commodity they become, the less useful they are as a currency.

Bitcoin is in the midst of an enormous price bubble, with increases in value of as much as 50% over just a few days.  This is astounding volatility for even a commodity, much less a currency.

Cowen said something at the end of the post, almost as a throw-away, that got my attention:  "There is, by the way, no current way to short Bitcoin."  The reason this caught my eye is that I have argued a long time that short selling is an important mechanism to reduce market volatility.

Every time we get to a market bubble or problem, insiders always start arguing against short selling saying it makes volatility worse and undermines markets.  But what they are really saying is that they like volatility so long as it is up. They had no problem with the bubble that propelled their securities up, they just don't want them to come back down to Earth.

In certain bubbles, when interest in a certain asset class gets really frothy, anyone who is skeptical of the asset and its new high values will sell and get out.  This means that as the bubble grows, all the skeptics are long gone from the market.  No longer owning the asset, these skeptics have no further "vote" or influence on the price.  Short selling is a way for skeptics to continue to influence the price and asset values.  To this extent, I think it tends to limit the peak of bubbles, just as bottom-fishers limit the debt of troughs.

Bitcoin would likely benefit from skeptics having some sort of influence on bitcoin values.  But without a way to short, Bitcoin values are driven solely by wacky anarcho-capitalists (e.g. people like me) and people fearful of Cyprus style depositor losses.  Essentially all the true believers are bidding against themselves.

  • Johnathan

    There certain *is* a way to short Bitcoin--find a private party to agree to loan you their BTC, then sell it on an exchange. Buy it back when the price goes down and repay them the loan.

    This is exactly the same as shorting a stock.

    What is different, however, is that there is no way to do a *naked* short. You can't sell BTC that doesn't exist, in the hopes that the price will go down and you close out your position for less than you made in the original sale.

  • What the...

    Quasi exchanges exist, but not as easy to do as it should be for proper price discovery to take place - topical story yesterday at: http://www.businessinsider.com/how-to-short-bitcoins-if-you-really-must-2013-4

  • NL7

    But in principle there's no reason you couldn't, only that presumably nobody is openly offering this service now. But anything that can be sold can be shorted. It just requires enough players involved to keep the market liquid, including enough volume that the dealers can hedge both ways.

    Of course, you could also just do a forward contract where somebody agrees today to buy Bitcoins from you in six months for whatever strike price you set. If the market price drops below strike, then you've made a profit. You can even settle the whole thing in cash.

    The problem is not the access to the material. Shorting can happen without the asset itself (because of put-call parity). The problem is the lack of dealers willing to take the bet, and thus the difficulties of finding somebody who wants to go long Bitcoins (but for some reason not actually buy them). And the market doesn't have a long history or a deep trading community, so it would feel like little more than wild speculation to a lot of investors. Whereas coffee futures have long histories giving you an idea of price movement, and the relationship to things like weather is better known. Traders and investors don't really know how to weight various factors that might influence Bitcoin purchases, except that jacking Cypriot bank accounts makes the price go wildly up short-term.

  • ErikTheRed

    While I'm not throwing my hat into this speculative ring, if bitcoin does take off as a currency rather than just a commodity then the price is still incredibly low. The question is whether or not it will become a currency in the present sense of things. Right now, dollars and euros are used as both a means of storing wealth and as a transactional medium. Crypto-currencies are undoubtedly a very powerful transactional medium - they do the things physical gold and silver can't easily do (buy stuff over the Internet), while offering better protection to merchants than credit cards do and virtually no protection to consumers. Bitcoins are easy to store now, but when you consider the fact that over 50% of personal and business computers have some sort of malware on them it is inevitable that raiding bitcoin wallets will become a major cybercrime issue. As an IT security professional I could certainly store them safely, but I'm not sure it'd be worth the hassle. For 99% of the rest of you, good luck with that. Perhaps hardened, dedicated devices will become available to facilitate this but in a PC / tablet / smartphone world security is a complete joke (and don't get me started on "the cloud"). The bitcoin system itself appears to be robust, but is only a few years old and the security of systems like this are best proven over a time span of around a decade. Maybe less for bitcoin - it really is a very simple, elegant design, and simple plus elegant often equals robust.

    I see the long run being comprised of physical value stores (gold, silver, energy shares, etc), with crypto-currencies being used as you would your physical wallet (enough cash to do stuff on a day-to-day basis, not so much cash where you worry about being mugged) and plenty of local vendors providing "metal-for-math" exchanges. There is still plenty of room for credit / charge cards and banks in this world. Bitcoin may rule forever, but I strongly suspect crypto-currencies will come and go over the years - especially in the next decade or two if quantum computers gain the ability to start factoring large primes instantly (and similar attacks on elliptic curve crypto, etc)...

  • morganovich

    you cannot (legally) naked short a stock either. i'm surprised that no one has started a btcn futures market. if intrade were still usable, you could just do it as prop bets. shame they shut that down.

  • BGThree

    Imagine someone invented a machine that allows you to put a pile of cash in a box your living room, and have that pile of cash teleported to a box in the living room of anyone else on earth, nearly instantly and with a negligible transaction fee. What would be the fair market value of such a machine?

    Will the fair market value of this machine be increased by threats of capital controls in Europe? Will the fair market value of this machine be increased if organized crime begins to use it to transport dirty money?

    This is why I don't buy the argument that bitcoin "is not backed by anything." It is backed by its UTILITY. And it has a revolutionary utility - there has never been a technology that provides this utility until now. By far the biggest risk is government regulation/prohibition, but it remains to be seen how feasible prohibition is. Shutting down P2P networks is easier said than done.

  • morganovich

    nl7-

    it's not about liquidity for dealer hedges. it's more of a statistical multiplexing problem. a bitcoin wallet provider like mt. gox will have customer balances. they can lend those out (much like fractional reserve banking) to someone who wants to short (assuming there is such a thing as a bitcoin margin account or if lending like a bank is permitted).

    the dealers do not hedge when you short, they just need to be sure they have stock available to meet the demand in case the original owner turns up to sell. if they start running out, they'll buy in in and force you to cover the short by revoking the borrow.

  • http://www.facebook.com/matthew.slyfield Matthew Slyfield

    "But without a way to short, Bitcoin values are driven solely by wacky
    anarcho-capitalists (e.g. people like me) and people fearful of Cyprus
    style depositor losses."

    Question: What happens if a natural disaster wipes out the server your bitcoins are stored in and the data can't be recovered?

  • http://devilish-details.blogspot.com/ mesaeconoguy

    My thoughts exactly.

    Then we can have the SEC step in and start asking stupid questions, and build a ridiculous Bitcoin Rule 204.

  • Nick P.

    Then you lose your Bitcoins and are out of luck.

    Which is why you don't keep your Bitcoin wallet on an online service exclusively but back it up locally.

    Hell, you can actually print out a paper backup of your Bitcoin wallet and stick it in a safe if that suits you.

  • Old Surfer

    Karl Denninger had an interesting take on bitcoin a couple of days ago. I'm not tech-savvy enough to use bitcoin, frankly I'd rather have junk silver, and it does sound like a bitcoin bubble is emerging.

    http://market-ticker.org/akcs-www?post=219284