Patrick Watson says asset bubbles usually only hurt the buyers who overpay, but that changes when you add leverage to the equation

By Patrick Watson*

Bitcoin mania is starting to look like a religion.

I say that because both bitcoin and religion involve faith in the unknowable. Some bitcoin investors believe the cryptocurrency, along with the underlying blockchain technology, will be a vital part of a new, decentralized, post-government society.

I can’t prove that won’t happen—nor can bitcoin evangelists prove it will. Like life after death, they can only say it’s out there beyond the horizon.

If you believe in bitcoin paradise, fine. It’s your business… until your faith puts everyone else at risk. As of this month, bitcoin is doing it.


Photo: Getty Images

Lenders & leverage

Is bitcoin in a price bubble? I think so, as I said in last week’s Why Bitcoin Can’t Be Money article. 

Asset bubbles usually only hurt the buyers who overpay, but that changes when you add leverage to the equation.

Leverage means “buying with borrowed money.” So when you buy something with borrowed money and can’t repay it, then the lender loses too. The problem spreads further when lenders themselves are leveraged.

For bitcoin mania to infect the entire financial system, like securitized mortgages did in 2008, buyers would have to use leverage.

The bad news is that a growing number do just that.


Photo: Getty Images

“My Hands Are Tied”

In the US, we have a Financial Stability Oversight Council to watch for system-wide vulnerabilities. The FSOC issued its 164-page annual report this month. Here’s its plan on bitcoin and other cryptocurrencies:

“It is desirable for financial regulators to monitor and analyze their effects on financial stability.”

Sounds like FSOC is on the case—or at least will be on it, someday.

Meanwhile, this month commodity regulators allowed two different US exchanges to launch bitcoin futures contracts.

Oddly, instead of griping about slow regulatory approval, futures industry leaders think the government moved too fast. To get why, you need to understand how futures exchanges work.

One key difference between a regulated futures exchange and a private bet between two parties is that the exchange absorbs counterparty risk.

When you buy, say, gold futures, you don’t have to worry that whoever sold you the contract will disappear and not pay up. If you close your trade at a profit, the exchange clearinghouse guarantees payment.

The clearinghouse consists of the exchange’s member brokerage firms. They all pledge their own capital as a backstop to keep the exchange running.


Photo: Getty Images

So, when the Commodity Futures Trading Commission (CFTC) gave exchanges the green light to launch bitcoin futures, member firms collectively said (I’ll paraphrase here): “WTF?”

Thomas Peterffy, chairman of Interactive Brokers, was among the unhappy members, according to Financial Times (subscription required).

When he learnt that the exchanges were pushing ahead with bitcoin futures, Mr Peterffy spoke to Terry Duffy, chief executive of CME, and Christopher Giancarlo, CFTC chairman. Mr Duffy told him “there’s nothing you can do about it”, while Mr Giancarlo said, “Look, my hands are tied”, recalls Mr Peterffy.

CFTC representatives did not respond to requests for confirmation; the CME refused to comment.

Mr Peterffy then wrote a letter to Mr Giancarlo, which he also published in the Wall Street Journal. In it he urged the regulator to require a separate clearing house for bitcoin futures so customer losses do not infect brokers who do not want to be involved.

He was unpersuasive. “I think that people believe that more and more people will be believers in bitcoin. It’s only a matter of belief; it’s practically a religion,” he says.

Peterffy’s separate clearinghouse idea seems sensible. It would fence off bitcoin’s possibly unknown risks from the rest of the financial system.

But no. The CFTC chairman said, “Look, my hands are tied.” (You ask who tied them? Good question.)

In any case, as of now the very same capital that backs up stock index, Treasury bond, and foreign currency futures also stands behind bitcoin futures. To me, that seems extremely unwise.

Bitcoin futures volume has been light so far, so it’s not a big risk yet. But I expect that will change as the whole world (including people who have never before invested in anything) falls prey to the bitcoin cult.


Photo: Bitflyer.jp

15X Crazier

Bitcoin’s biggest fans are in Asia. The Chinese government has cracked down on it, so now the main action is in Japan.

A Tokyo-based exchange called bitFlyer handles 80% of Japan’s bitcoin trading and 20–30% of the global market.

With that in mind, consider this from another recent Financial Times story (subscription required).

Trading on bitFlyer is roughly 25 per cent in actual bitcoin and 75 per cent in derivatives, where customers make leveraged side bets with each other on the bitcoin price. “We don’t take any risk. The trading is between our customers,” Mr Kano said.

Actual bitcoins are only a small part of the activity. The rest is derivatives or “leveraged side bets.” The FT report says bitFlyer traders can buy in with up to 15 times their cash deposits.

I don’t know how many people actually use that much leverage. Hopefully it’s not many because at 15X, a 7% move in the wrong direction will wipe out your capital.

Even if the trade works, somebody is on the other side of that leverage. Whoever it is can lose their money in a flash.

Similarly, the US bitcoin futures are zero-sum. You can’t buy a bitcoin contract unless someone simultaneously sells one, or sell unless someone buys. In either case, one of you will lose.

Remember, too, that bitcoin futures aren’t actually bitcoins. They simply track the currency’s price. The open interest in a futures contract can be many times the actual inventory of the underlying asset. So the fact that bitcoin supplies are limited isn’t necessarily much help.

This leaves US futures brokers in a bind. Their customers want to trade bitcoin futures, but letting them do it creates risk for the firm, its other clients, and even other clearing firms.

Tell the customers, “No, we won’t do this for you,” and they’ll just find another broker. So the brokers—including Peterffy’s firm—hold their noses and process the bitcoin trades.

The good news: futures brokers are requiring higher margin deposits on bitcoin than is normal for other products. That reduces systemic risk but doesn’t eliminate it.


Photo: Getty Images

Dangerous Combo

Leveraging bitcoin won’t necessarily cause a systemic crisis—but it could. At least one transmission channel is open now via the futures exchanges, and more will probably follow.

That makes it your problem, whether you like bitcoin or not, and whether you own bitcoin or not.

Like other historic bubbles—few of which ended well—bitcoin has:

  • Large numbers of people,
  • Trading a speculative, highly volatile asset,
  • With borrowed money and
  • Systemic risk exposure.

A dangerous combination.

We may look back at December 2017 as the month bitcoin broke the firewall. Now it’s loose in the theoretically safer, “regulated” financial markets.

The regulators responsible for financial stability think this is fine. They’d better be right.

------------------------------------

*Patrick Watson is senior economic analyst at Mauldin Economics. This article is from a regular Mauldin Economics series called Connecting the DotsIt first appeared here and is used by interest.co.nz with permission.


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73 Comments

Frankly, this is terrifying. Let bitcoin bubble along for another 6 months and infest the rest of the financial markets.. then pop. This could make Black Monday look like a hiccup.

i sort of agree but really it is one more nail in the coffin. Or maybe straw on the camel's back ie there are lots of other huge risks and impacts out there. I agree on the leverage when the one thing that gives, gives first I think there will be a snowball effect...

regards

Let it pop. It'll teach some people an important lesson.

And if it triggers Stockmarket and housing crashes bringing back 20years of great depression? You want to try that?

It won't.

$300 Billion leveraged to 10x or more suddenly devaluing 80% or more won't spook the markets? Hmmm, I wish I had your confidence. All the same people that are suddenly jumping on the bitcoin bandwagon will flee like rats once the value takes a couple of sequential 10-20% hits.

A short term spooking won't cause a sustained share market crash. It'll just mean cheap shares for a short period of time for the people who weren't foolish to gamble on crypto currencies.

Didn't have to wait very long to get your feared 20% hits... Tulip mania in the tech era.

At some point, the hit will approach 100%.

(Position disclosure: long nocoiner)

Yep, it was surprisingly quick.. seems to be rallying a bit now tho. Read about some poor software developer that maxed his credit cards out for $35k to buy bitcoin the day before the plummet. Whoops.

Interesting, in that some think that 20 - 30% valuation variations in a single day is okay... just crazy stuff. Bitcoin, gambling on steroids!

It will be fun to see what happens now that there are BTC futures being traded. The concept of BTC being a functional currency is comical. Now that the big boys are in the market, the rubes will get fleeced. The vampire squid is far more sophisticated than the millenial coiner, and has far deeper pockets. One can profit in this environment as long as one doesn't get greedy or become a believer in the crypto-currency validity as a currency. One just has to find the greater fool when it is time to sell. What amazes me is that there are no regulations for the exchanges. Financial "wild-west" libertarian paradise!

Pragmatist,

I have no doubt that the hype over Bitcoin is irrational and for many,there will be tears before bedtime. It has just been reported that Emil Oldenberg,a co-founder of Bitcoin.com,has sold his entire holding,describing it as virtually useless,with high transaction costs and times. I quote: "The old bitcoin network is as god as useless".
However,I think that it is quite ridiculous to suggest,as you do,that a bitcoin crash could "bring back 20 years of great depression". You mention a figure of $300bn which in global financial terms,is peanuts. In 1999,when Long Term Capital Management imploded,the potential cost was around $1trillion and that would not have brought down the financial system.

Maybe, but I don't consider the equities markets to be that solid themselves, all developed nations markets overvalued with Schiller CAPE at >22. Some of the fundamentals are different due to QE, but it makes me nervous. I think we are one trigger event away from a major correction, and humans (in large numbers) are dumb animals that are easily scared into stampeding for the exits. Add leverage on that $300bn, have a bit of a scare and a few headlines screaming "$100billion wiped off markets last week" and watch the lemmings run.

Pragmatist,

I too am somewhat nervous. I thought that our stock market would fall this year to around 7000 and here we are over 8000. I believe that there will be a significant correction-20% or more- and I have been adding gradually to my cash holdings in anticipation. I would see that as a buying opportunity,though not immediately.

Same here. Spidey sense tingling that it's getting very, very unstable.

But then there is substantial bitcoin believers who in cases of a large sell off throw more money in to buy to keep the ship steady (which they have done at periods previously). Given the rise in user numbers and the increases in demand they may have the funds to slow down a bubble burst. It depends on the triggers. Minor exchanges, Youbit, NiceHash etc being hacked and declaring bankruptcy may only be a small drop but if a big one was to go, e.g. Coinbase, Bitfinex, Bithumb (the largest wallets) etc and did not have the insurance and funds to cover the loss then that would be far too much to accommodate with a lot of goodwill and faith drying up with it. Much like other online structures they get measured in active users (wallets with funds) and large investors. Check out the wallet user growth rate it is growing incredibly (perhaps owing to more non traditional investors). Piss either the whales or bulk users off significantly and there could be a problem. Fail to continue to strip funds from the users and the value in doing so is lost. Those exchanges are getting enough of the funds to hold much of the same crypto investments and they want to continue the high fees mardi gras. Now if only the technology was capable of amazing scaling rates to match growth everything would look peachy.

blah blah blah revolution, new, exciting,disruptive technology, jazz fingers.. buzzword bingo material. I've never found a bitcoin proponent that can explain in a paragraph or two why an investment in bitcoin will go up in value. Can you?

Supply and demand.

Limited supply with excess demand will drive up the price (not that I believe there is infinite excess demand). But it has no productive value, it is simply a method of exchanging wealth, so it's value is purely based on the supply and demand curve.

Yes, I've heard this several times.. but there is no natural demand for it. I don't _need_ bitcoin to buy anything, there are existing and established mechanisms for buying stuff, and moving money around the planet electronically is easy and cheap. I don't see any base level demand for bitcoin apart from speculation.

I'd disagree, there's an entire black market of money that wants to be laundered.

There's also 1,590,000 millionaires in China who cannot get their money out officially.

**Disclaimer: not saying crypto currencies are the best method of laundering money ***

"it's value is purely based on the supply and demand curve"

It has value has a new form gambling entertainment.

They said the same about houses and cryptokitties, and the houses are the more solid investments, ironically given past history.

Silly Beliefs is enough on its own. Not too different from Religion really.

It's more than "a paragraph or two", but perhaps this article is worth reading and thinking about. As it says, "Bitcoin has a bigger story to tell", and even that doesn't speak to the promise of decentralized applications and organisations. https://bravenewcoin.com/news/5-bitcoin-lessons-for-every-investor/?utm_...

And once again, the answer comes back.. Imagine what it could become if we all believe... No actual real, current argument as to why one bitcoin is now worth ~$15k and will be worth $20k next year.

Maybe you can explain what "value" gold has to be currently priced at $US1263 ?

Nope, shiny metal with some really good mechanical/electrical properties but limited industrial uses.. but I also dont call gold an investment or see any reason it will be worth more next year.

No chance, bitcoin capitalisation is only 300 billion. Global sharemarkets ~68 trillion, so bitcoin is ~0.25%, global sharemarkets fluctuate by that much daily. Also, only gamblers and idiots are trading Bitcoin - it is clearly demarcated as a super risky play that no one is going to lend against without very good cover - so little risk of contagion when it crashes.

except you have leverage on leverage going down we dont know how many levels.

There will also be people borrowing money on their mortgage for example which nobody will not know about. Even immediately after a bitcoin crash. That loss will only show up when that individual either sells the house or has trouble paying the mortgage.
The other thing is that a bitcoin crash could be extreme. So even though the total value of bitcoins is small compared with real currencies, the crash could potentially be the full value of all bitcoins. Which would be significant. And would cause "ripples".

Same as gamblers borrowing against their mortgage to pour it all into the casino's. It's not any different. If it needs to crash, let it crash.

You don't need to deal in any crypto currency to take bets on whether it will go up or down.

Let's be honest, we're all a bit sad we didn't invest in bitcoin a year ago. But you'd have to be nuts to invest now.

Nah, I'm all good. Slow and steady wins the race.

Yeah these media stories of people who sold early or did not invest when they would have....its all pure imbecilic bollox. I could put an article in the media saying: I was going to buy a place in Queenstown in 1988 but didn't. Who cares? Or, I should have put all my kiwisaver into growth funds after they started actually growing a few years after kiwisaver first started. And again, its just like saying, my lotto number was just 3 different to the winning number.... Might as well have been 3000 different.

Hey some of us were early adopters concerned now that the exchange standards and tech scalability is so poor. That doesn't make it more or less special than winning a race only to find out the horse will be shot afterwards. Celebrating now is poor taste. More of a muted review of future risk and finding a new horse. Unlikely to see another bitcoin ATM at another NZ conference for a while. Australia maybe, but NZ no.

Biologist -- I think you will find a few honest common taters here , who were glad not to buy bitcoin a year ago.

BitCoin is very small on the world stage.

But I do wonder if, when it fails, it will make people think about their investments in stock markets and real estate which are all time highs as well.

Stock markets only stay high if the investors in it consider the stocks to be worth the high prices. The moment they start to lose confidence all bets are off. Might be rational or irrational, doesn't matter.

Agreed the price of stocks is also driven by demand, but a least they're productive assets. The underlying company produces a product or supplies a service, and can either payout their earning as dividends or increase the value of the stock through share buy backs (often the most tax efficient method of distributing earnings).

This underlying value creates a floor for stock prices.

No such thing exists for tulips or bitcoin.

"increase the value of the stock through share buy backs (often the most tax efficient method of distributing earnings)" ...what!!!
Buybacks are announced to juice the stock, but never carried out. What's worse, some investors view even debt-financed stock buybacks as a form of returning cash to shareholders—except, it isn't! Just as a company wouldn't borrow to pay a dividend, it also shouldn't borrow to buy back shares

is that right? Never carried out?

ALL investment classes rely on "confidence" and any currency is no different either.

Yes yes ...lets blame the crash on bitcoin..not liar loans, in-sider trading, QE, greed, cronyism...its all BITCOIN faults don't you see!! The central bankers have it all under control, go back to sleep.
Merry Xmas

How much have you got invested in Bitcoin? Your emotional outbursts to any negative Bitcoin comments seems disproportionate to the regular commentators on here.

Emotional Outbursts...??? No just frustration at those who read the headlines and call it research. Lets just say my investment is now comparable with Auckland house price rises...

Ok, no worries. Don't shoot the messenger, but why did he say its going to crash?
https://www.express.co.uk/news/world/894499/Bitcoin-Cash-investors-crypt...

"Lets just say my investment is now comparable with Auckland house price rises.."

Do you mean the government is passing a law to stop you selling it to foreigners?

Is a very interesting technical project non the less, and nicely bypass all manner of government and bank (deep state) control. Until its accepted everywhere including the IRD its just another fad project not unlike barter card dollars. If Bit Coins crashes so be it, the big difference is that global governments wont bail out Bit Coin speculators, unlike the banking sector in 2008.

I know that our government won't be bailing out our Australian Banks if they hit the wall, so for that reason alone, many may wish to take a punt?

The nz subs of the Aussie banks ARE our banking system, so if they and their parents get into trouble we will certainly be bailing the nz subs out. The aussie regulator and govt certainly won’t be.

NZ Term Depositors and the banks shareholders will be bailing them out. Our government won't, because of our Open Bank Resolution Policy, so it will save the NZ Tax Payers but yes, you are correct that individual people will loose their savings and shares. I am a shareholder and I am almost seriously thinking about selling out, but still riding the risk wave for now.

Ie the nz govt is the residual risk holder in the nz subs of the Aussie banks. If they need capital beyond the OBR, and the Aussie parent cos are in schtuck, that will have to come from the nz govt. the shareholders are the Aussie parent cos. It is entirely possible to contemplate a situation where the Aussie parent cos are unwilling or unable to recapitalise the nz subs. There is no way in hell that money would come from Aussie taxpayers or that the Aussie parents would be permitted to prefer the nz operations over the Aussie operations in terms of capital.

And if they think the OBR will mean that depositors will take a haircut I think that’s completely unrealistic. If NZG “did a Lehmans” and ran the OBR process on a bank (say an Aussie one) they would immediately face a run on every other bank not of unimpeachable credit ie just about every other Aussie bank. Totally unrealistic.

There certainly is some truth in what you are saying. It certainly makes me uneasy not knowing the possible worst case scenario, but I agree that NZ will be left in a whole world of pain!

That's the reason in the US for FDIC. To maintain depositor confidence in the banking system, so that there is no systemic bank run by depositors on other banks.

FDIC also serves another purpose - to reduce the cost on the government. A case in point is Ireland. After the Irish government guaranteed the deposits of its banking system, they needed to recapitalise three of the banks (from memory), and this resulted in government debt to GDP increasing from 25% to 75% (which is considered a high level - at it's highest it reached 120%). The Irish government may be able to recoup some of its money when it chooses to privatises the banks and sell down its stakes.

In one of the banks that weren't recapitalised, they did manage to raise money from investors. In this case the amount of money required was a lot less than for AngloIrish (which required recapitalisation due to the number of property related loans that went uncollectible).

From what I have read I cant agree with that position.

From what I have read I cant agree with that position.

How many times has the NZ govt done large scale bailouts, everyone here can name a few. Even to a bank, *cough* BNZ. Yet the Aussie banks whose funds go into large proportions of business and residential debt in NZ would have no bailout option? Oh yea of little faith. NZ govt does not even need a good reason to drop its trousers and bend over.

you dont have to be the best or the brightest but it pays to try and be first....spent 10k of my retirement fund some months back on crypto....my wallet tells me i have 29k there now.....i understand blockchain but am not that tech savvy....im HODL....

Sell.
Now.

Maybe just pull 10k out, or 15k for a guaranteed win while staying in the game. That's what I would do if playing Blackjack. However my gut just says go for it, keep it all in and see what happens.

Hilarious, people here claiming they are glad they didn't get in to crypto. Nocoiners everywhere.

Yep, didnt get into gold either, didnt make 3000 let alone the 5000 "promised"

Price down 15% today, looks like reality might be setting in for it.

nah more likely Coinbase stall and YouBit hack bankruptcy scare, small stuff.

Ummm.... the "small stuff" is getting smaller.

The vast majority of Kiwis that have invested in cryptocurrencies will have taken up some aditional mortgage loans or cashed up on credit cards - many people will be caught with a debt when it collapses and nothing to show for it but I suppose a large number of younger non property owning younger people will use the No Asset Procedure to bail them out

Bigblue

They've borrowed to buy cryptocurrencies? It is highly likely that is not going to end too well. Does anyone have any idea what proportion of households in NZ have done this?

Down 25% now, it might not be looking good for people that invested heavily in it at the peak price of the last few weeks.

Bitcoin Crashed and Took the Whole Market Down With It....At the moment the price of bitcoin is at $11,709. That figure, of course, will be different in a matter of moments. The number one cryptocurrency hit a record high of $19,857 earlier this week.

https://gizmodo.com/bitcoin-crashed-and-took-the-whole-market-down-with-...

Bitcoin

In the past week both CBOE and CME exchanges established Bitcoin Futures contracts with Bitcoin as the underlying "physical" instrument. This has enabled the cowboys and the smart money to "short" the shit out it, a mechanism which wasn't available to them before. They would have been salivating at this opportunity

Interesting Bitcoin lesson about professionals coming to town and feeding on weak longs.

Not what you could call a crash. The warnings were there for all to see.

Starting about 4 months ago much of the news about Bitcoin had a pump-and-dump feel to it. It was euphoric. It was constant. Everyday. When it first began that was my take of it - had all the hallmarks of a pump-and-dump program. Usually they fail because they are pumping some small-time cheap penny-security dressed up with inside intel inside private emails. This was different because it was public, in t6he news and about a well established instrument. And sure enough it slowly responded. In the end 100,000 new accounts were being opened daily. The un-sophisticated little-guy novice was climbing on-board. When saying un-sophisticated novices I'm talking about people who are not tuned in to the daily market hurley-burley of trading and professional traders.

Then

In December 2017 Chicago Board Options Exchange and CME (Chicago Mercantile Exchange) established futures Contracts and trading to allow access to Bitcoin by the Professionals who are doing this everyday with very deep pockets. Professional Trader open the day by placing large Sell Orders into the order-book during the opening phase as a price-discovery mechanism to find out where the buying-strength is and how much depth there is. On discovering there is limited depth they can attack that side of the order-book and if there is no resilience they will keep attacking until buyers appear and they will shake out the weak-longs

That's what happened - the weak longs covered, took their losses, and got out. Price discovery finds support at USD $11000. There will be some medium Longs still to cover and will get out as buying emerges. Will take a while. But they are now at the mercy of the Professionals who are now short and need to get out themselves by buying. Might well be they are now providing the buying themselves.

Appears that Bitcoin is heading lower from the current range of 15k+/-20%!! It is an extremely volatile and almost a cult product with inherently zero value!! The believers are ignoring all signs of stupidity and mania which is very apparent to non-believers. The technology behind BTC is great and has immense potential, have not found a decent way to value it. Based on the rough guess estimate of adoption @ 0.1 to 8% in medium term, and , ignoring the inherently zero value! , BTC value comes to 216 USD to 16220 USD. (I am not in yet! as opening an account is a nightmare). Market talk-professionals are on short side and retail and pigs are on long-you can guess the outcome! 44-48% of BTC is owned by ~ 800 individuals/groups. Do your homework before you consider it as an Asset..looks like this product is more of an Ass that an Asset!! It is galloping though! :)