Bitcoin Futures and Banky Thoughts
Happy Bitcoin Futures Day.
"It is rare that you see something more volatile than bitcoin," said consultant Zennon Kapron to Bloomberg News, "but we found it: bitcoin futures." Congratulations then! Cboe Global Markets Inc.'s bitcoin futures started trading at 6 p.m. Eastern time yesterday, and promptly blew through trading halts at up 10 percent and up 20 percent from their opening price of $15,000. The January contract hit a high of $18,850 overnight, though it is lower this morning. A chart (through 8:15 a.m. Eastern time):
One thing you will notice about that chart is, in addition to being more volatile, the Cboe price is just higher than the "spot" price. (The spot price in this case being Bloomberg's index of bitcoin prices on five exchanges.) Why would you pay $1,000 more for a bitcoin in January than you would for a bitcoin today? One answer is that the Cboe January futures contract doesn't exactly give you a bitcoin in January: It is cash settled, and gives you an amount of dollars equal to the price of a bitcoin on January 17, 2018. If you are the sort of bitcoin dabbler who wants to participate in bitcoin's rally without ever actually touching any bitcoins -- and I suspect a lot of futures investors are -- then this is a very appealing feature. It makes a kind of intuitive sense that more people would want a dollar-settled bitcoin contract than would want actual bitcoins, so the price should be higher. (Though that does rather undermine the notion of bitcoin as a world-dominating currency, doesn't it?)
Still that is a little unsatisfying. Even if the average investor finds the futures more convenient than bitcoins, someone should be willing to do the arbitrage. Sell futures, borrow dollars, buy bitcoins, and wait; then in January sell the bitcoins, get the dollars, and pay off the futures. You clip $1,000 or so -- about 6 percent of the spot price -- for your trouble. What's the problem with doing that?
Well, maybe nothing; it is early days yet:
“We’re in the early stages here, and there’s not enough professional liquidity from the big market makers who can provide depth and hold in the movements,” said Stephen Innes, head of trading for Asia Pacific at Oanda Corp. “It’s going to be a learning curve.”
I mean we are talking about less than a day of trading, and that day was a Sunday. When regular trading hours start today, you might expect more professionals to come in and arbitrage away some of the price differences.
But there are other possible answers. Perhaps the cost of bitcoin storage -- keeping your private key in a vault, worrying about hackers, etc. -- is so high that arbitrageurs need to charge $1,000 for a month of it. Also, the Cboe contract doesn't settle based on "the bitcoin price" in the abstract. It settles based on the price in an auction on the Gemini exchange, and that auction is a bit light:
Cboe’s contract uses a price determined in a daily auction at Gemini. Gemini data show its daily auction volumes this year have averaged $1.3 million—a drop in the bucket of global bitcoin trading, which runs into the billions of dollars daily. Gemini’s auction process also has failed to produce a price several times in recent months, on lightly traded weekends or holidays.
Gemini says its auction will gain in volume as Cboe’s bitcoin futures contract takes off, and even if the auction is small relative to global trading activity, it offers a useful measure of bitcoin’s price at one point in time each day. “Auction mechanisms are tried and true,” said Gemini President Cameron Winklevoss.
Bitcoin futures volume is -- so far -- a tiny fraction of bitcoin volume, but Gemini's auction volume is -- so far -- a tiny fraction of that. If you're long $10 million of futures, you can afford to buy $2 million of bitcoins at stupidly uneconomic prices in the Gemini auction to manipulate your futures prices higher: Every extra dollar you pay in the auction makes you five extra dollars on your futures settlement. And if the auction volume is only $1.3 million, a little manipulation can go a long way. I guess this works almost as well if you're short the futures, though, so Gemini is probably right that its volumes will increase: Anyone who wants to manipulate the futures price in either direction will know where to go. Perhaps they'll balance each other out.
Here is a toy model for a bull case for bitcoin:
- Everyone in the world wants to own some bitcoins.
- It is too hard.
- As it gets easier, more people will own more bitcoins, and the price will go up.
It is not a great model. The evidence for proposition 1 is a bit thin, and proposition 2 is itself bearish: If the actual bitcoin ecosystem -- of complicated access and "cold-storage" wallets and exchanges that keep getting hacked -- is so annoying to use that real-money investors prefer synthetic substitutes (futures, etc.), then that is an argument against bitcoin's usefulness, which in the long run you would expect to drive the price. And yet as a rough cut it seems to be true. The launch of futures -- which will among other things make it much easier to short bitcoin -- nonetheless pushed the price up. But futures have only barely launched: for less than a day, in extended trading, with many banks and brokers not yet offering them. Perhaps as the futures market develops the short sellers will come to dominate it and drive the price down. But so far every expansion of bitcoin access has had the opposite effect.
- "The Japanese exchange at the heart of bitcoin’s recent surge has said its investors are fuelling the cryptocurrency’s feeding frenzy as they buy in with leverage up to 15 times their cash deposit."
- My Bloomberg Gadfly colleague Andy Mukherjee argues that what we really need are more liquid bitcoin options, because futures aren't volatile enough? "Bitcoin options, in their current form, only reward expectations of abnormality: a price gain of 50 percent or more, or an erosion of at least 25 percent, in one month," he notes, versus 2 percent for the British pound. I'd note that bitcoin is actually up 150 percent against the dollar over the last month, versus about 1.3 percent for the pound. Bitcoin options imply absurd moves because bitcoin has absurd moves.
- A bitcoin Q&A with my Bloomberg View colleague Elaine Ou.
- "The Bitcoin Whales: 1,000 People Who Own 40 Percent of the Market."
- "Bitcoin Billionaire Winklevoss Sees Surge of as Much as 20 Fold."
- "How to give the gift of bitcoin this holiday season."
Are bankers boring now?
Here is a fun behavioral economics experiment. Ernst Fehr and Michel Marechal of the University of Zurich and Alain Cohn of the University of Michigan got "128 employees of a large, international bank," gave them some money, and asked them to make a bet with it:
They were given US $200 of which they could invest any amount in a risky asset which (i) paid back 2.5 times the investment with 50% probability or (ii) nothing with 50% probability. Participants knew these probabilities and were allowed to keep all the money they did not invest. We use the dollar amount invested in the risky asset as a proxy for participants’ willingness to take financial risks.
If you bet it all, you like risk; if you kept it all, you don't. The trick is that before having them bet, the experimenters asked them some questions. Some of them were just asked random innocuous questions ("such as what is their favorite leisure activity"), while others were asked "seven questions about their professional background and experience" in order "to increase the saliency of participants' professional identity." And:
We find that bank employees in the professional identity condition took significantly less risk. They invested about 20% less in the risky asset relative to the control group. Thus, the results do not confirm the widespread belief that the professional norms in the financial industry promote risk taking.
That is: If you get some bankers, and remind them that they are bankers, they will take less risk than they will if you don't remind them that they are bankers. Thinking banky thoughts -- about banking, and their bank, and their banking careers -- makes them more conservative than they would otherwise be. The experimenters tried this again with "nonbanking employees recruited from the alumni network of an executive education program" and found no similar effect: "If anything, the professional identity condition tends to increase risk-taking among non-banking employees," and the non-bankers took more risk to begin with. But they did successfully replicate the effect with a sample of "142 employees from many different smaller and larger banks," who also took less risk after thinking banky thoughts.
One way to think about this might be that the risk in banking doesn't come from culture but from structure. The salient fact about banks, as banks, is that they fund themselves with a lot of very short-term debt; that's what being a bank means. If you have $5 of equity and borrow $95 overnight to buy $100 of assets, and those assets go down to $98, then those lenders might not want to roll over their loans, and you'll have to sell the assets to pay off the lenders, and you'll sell them in a fire sale at $94 and eat through your equity and impose losses on the lenders and be a "systemic bank failure." And everyone will talk about how risky your business was, and they'll be right, but on the other hand your subjective experience was that you bought some safe-looking assets that only lost 6 percent of their value even when you sold them in a fire sale, which is like a typical morning for bitcoin. And in fact this description does kind of fit the financial crisis, where a lot of banks blew themselves up on AAA-rated securities. Other businesses -- unicorn startups, neighborhood restaurants, whatever -- tend to take more business risk, but they don't fund themselves with tons of short-term debt, so those risks aren't as scary to the broader economy.
But obviously the control experiment that you'd really want to see is: bankers, but 10 years ago. Is there something about the culture and professional identity of banks as banks that makes their employees particularly risk-averse? Or is it something about their culture as banks in 2017, after a long decade of crisis and scandal and regulation? Is banking culture cyclical, and are we just at a risk-averse time right now?
Active bond management.
Here is Cliff Asness of AQR Capital Management on "Fixed Income Fantasies," specifically the fantasy that passive investing is fine for stocks but you need active management for bonds:
There is a common belief that goes something like this: “Sure active stock picking doesn’t work, but in fixed income, active management really shines.” Various reasons are given for this including the notion that fixed income is, for some reason, a less efficient market or that the benchmarks are worse investments. In other words, fixed income is ripe for the value-add that comes from traditional active management.
The problem is that any perceived alpha has been, at least to a great degree, due to a passive long-term overweight of credit. If we found equity managers out-performed largely because they were strategically, not tactically, higher beta than their benchmarks, would you get excited and pay a lot for that? I hope not. For fixed income managers, the credit exposure doesn’t necessarily eliminate all of their alpha, but once you account for the credit exposure, fees and other simple factor exposures (for example, short volatility exposure) there may not be much left.
There are perhaps two meta-lessons here. One is that stretching into more exotic and less liquid markets may be a way for active managers to get more alpha, but it may instead be a way for them to disguise their beta a bit better.
The other is that you may think that you are an active manager, but there's always the risk that someone will come along, run some regressions, and say "no actually you are just giving people passive exposure to factor XYZ." If you have any sort of systematic way of looking at the world, someone can break it down into factors, and characterize you as giving investors passive exposure to those factors. Asness's AQR colleagues did it for Warren Buffett ("we find that the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors"), and we talked a while back about a paper doing it for the hedge fund industry generally. I suppose it is a little dispiriting to learn that all of the work you are doing to analyze credits and pick bonds could be replicated by a simple algorithm, but at least you are in good company.
Yes right see this is how you do it:
A previously unknown ring of Russian-speaking hackers has stolen as much as $10 million from U.S. and Russian banks in the last 18 months, according to a Moscow-based cyber-security firm that runs the largest computer forensics laboratory in eastern Europe.
The MoneyTaker group broke into 20 systems, which includes 15 U.S. lenders, targeting ATMs with “mules” and Russia’s interbank money-transfer system, Group-IB said in a report provided to Bloomberg.
We have talked before about the weird fact that whenever hackers get into the systems of major banks, they always seem to steal ... email addresses. As the proprietor of an email list myself, I understand that email addresses are valuable; if you're a hacker and you steal email addresses from a bank, you can use them to try to con people into sending you money. (I like to think that, if anyone ever steals the Money Stuff email list, this approach won't work.) But besides email addresses, banks' computer systems tend to have money. Like, that's what money is: It's an entry in the computer system of a bank. (Or in a blockchain, whatever.) If you can change the entries in the computer system, you can give yourself money. And stealing the money just seems more efficient than stealing the email addresses and using them to scam money.
So I appreciate the MoneyTaker approach, in which the hackers gave themselves money and then withdrew it from ATMs. Straightforward! Efficient! Still it is weird that the idea is so novel that they named themselves after it. They are the MoneyTakers, as distinct from everyone else who has ever hacked into a bank, who are just EmailTakers.
A standard story of technology in business is that computers will do menial calculating tasks far more efficiently than humans do, but that this will free up the humans to do higher-level value-added executive functions. But what if ... the opposite?
“What managers do mostly is identify potential, build teams, assign tasks, measure performance and provide feedback. Generally speaking, humans aren’t very good at these tasks,” said Tomas Chamorro-Premuzic, a professor of business psychology at University College London. “Someday, we might not need managers anymore.”
There are counterarguments. ("Machines are no substitute for human judgment and ability to manage interpersonal relations," the article notes, though tell that to Bridgewater Associates.) We talked recently about algorithmic investing in exotic markets, where the algorithms are just fine at finding the investments, but need humans to build relationships with counterparties and execute trades. The computers make the high-level judgments; the humans carry out their instructions. This is the next level of that. It is a little unsettling. "Of course we'll always need humans to fold laundry," people will say, "but robots will take over easier jobs like hedge-fund manager and titan of industry."
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