BitCoin’s meteoric price rise has captured the imagination of the financial and mainstream media with its rally to touch 19,000 over the past couple of days. What has been covered a bit less is the breathtaking amount of inefficiency that has been shown in the market. As shown in the following chart of the CoinRoutes Consolidated Best Bid & Offer, the amount where the best bid has exceeded the best offer has reached over 10% at times and has consistently been in the multiple percentage points for 2 days. (This chart only includes the 5 exchanges that the CME and Cboe plan to use for the BitCoin futures contract. Gemini by the Cboe, and GDAX, Kraken, BitStamp, & ItBit by the CME. A chart using all 22 exchanges currently processed by CoinRoutes shows even more inefficiency.)
I was discussing this with a journalist, who summarized our business as “CoinRoutes basically helps traders find arbitrage opportunities, which ultimately will make uniform pricing.” I was happy enough with the conclusion to not bother correcting him, but the real point is that CoinRoutes can help investors from overpaying or selling too low, by ensuring they know the optimal place to trade at any point in time. The point here, apart from our shameless self-promotion, is not that the current market is irrational, but rather that there are free-market solutions that will ultimately fix things. Sure, there are people paying too much at any point in time for BitCoin or Ethereum, but that does not mean that there is no value in the assets. (It does mean that investors need help in understanding the market, however.)
While the news coverage has been overwhelming, I was struck by a blog post in the entertaining FT Alphaville, that asked the question “What happens when bitcoin’s market cap overtakes world GDP?” It makes the assertion that there are no natural sellers in BitCoin, since the miners and holders are stockpiling it. They describe an endgame where this one-way ride to the moon results in no liquidity, as brokers step aside, and the futures contracts end in failure… There are two problems with this analysis. First, is the obvious, there is always a price for everything, and even though there are many zealots that believe bitcoin should replace all the worlds fiat currencies, there are many that are in it for a trade. (Editors note — There is a lot to be said for the view that democratized, blockchain based currencies are likely to continue to gain adherents, but we at CoinRoutes are not precient enough to know whether BitCoin is “the one”)
Second, the inefficiency in the physical market does not prevent brokers from hedging, and, in some circumstances, it will make it even more profitable to hedge. If a futures market maker wants to sell futures and buy bitcoin in the spot market, all they need do is buy their spot bitcoin on the exchange with the lowest price and they will outperform the index used to calculate the future. The reason is that there is a large spread in available offers, and the “index” used by the CME is based on an AVERAGE of all four exchanges. To illustrate: consider the following 6 charts from the CoinRoutes software for the same time period (9:03 – 10:03 am EST this morning), which show each of the 4 CME “approved” exchanges plus Gemini and a Consolidated view of all 5:
These charts show that a futures market maker would be able to hedge a short futures position at a profit by buying on Kraken or BitStamp or hedge a long futures position at a profit by selling on GDAX. The later could be problematic as it is hard to short BitCoin, but it is not impossible, and it seems likely that it will get easier to do in the future. That said, the difficulty in shorting bitcoin in the physical market could set up an interesting “clash of cultures” in the futures market.
It is simple to short the futures contract, so those interested in shorting BitCoin will have their mechanism to do so, but market makers will have a relatively harder time hedging resulting long positions than hedging short positions. Therefore, to avoid the futures contract from trading at a persistent discount to the value of BitCoin, there will need to be natural buyers of the futures contracts. Of course, if one believes the media, there is latent demand among those that don’t trust the underlying asset, but we shall see… (It is also worth pointing out that there is another reason for the futures to trade at a discount, which is that the CME and Cboe futures do not participate in upcoming “forks” of BitCoin. Those events essentially create crypto-dividends that futures holders are not entitled to. )
No matter what happens, the next few months are going to continue to be interesting..