Thoughts on Bitcoin

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By Kevin Darby

I have a keen interest in industry developments that could give our clients an edge and John Lothian’s “Putting on My Broker Hat About Bitcoin” got me thinking about the imminent listing of Bitcoin futures at the CME and CBOE’s Chicago Futures Exchange. Crypto-mania commentary has focused on the merits of Bitcoin and how the associated technology might revolutionize finance and other aspects of our lives, but I do not see much earnest technical analysis of the system and its flaws.

An Overview

Note first that Bitcoin is neither currency nor commodity, but simply convention. In order for parties to exchange value, a transaction is processed following prescribed rules by a ‘node’ (participating computer) and added to the blockchain, a public ledger of all Bitcoin transactions since its origin. Later, convention dictates that other computers independently confirm that this transaction took place. Roughly 11,000 computers, located across the world (https://coinmap.org/#/world/39.50404071/-0.70312500/2) share this convention.

Participants in the transaction verification process are called ‘miners,’ though a more apt description might be ‘transaction verification agents.’ Miners are compensated both with fees deducted from each transaction and a lump-sum reward when a new block of transactions is added to the ledger, all denominated in Bitcoin. Miners either run a full node using their own specialized computer hardware or lend a piece of their existing computing power to a mining ‘pool’ in exchange for a pro-rata portion of that pool’s revenue.

A Question of Geography

Bitcoin touts itself as a decentralized payment network, but in practice, it’s not entirely egalitarian. A more internationally diversified network of ‘miners’ would add stability and reliability (https://blockchain.info/pools). Chinese mining pools currently dominate transaction verification, controlling more than 70% of the aggregate computing power. It’s important to note that while a pool may comprise thousands of individuals, a single pool administrator controls operating procedure, concentrating network authority in few hands. Also consider that many Chinese pools, for-profit enterprises, operate using government-subsidized electricity, exposing the network to foreign political risk.

A Question of Function

One wonders what might happen to Bitcoin if another of the ever-growing population of cryptocurrencies, possibly by becoming temporarily more profitable, diverted the attention of a large portion of the mining network away from Bitcoin. Just look back to the middle of November (https://blockchain.info/charts/avg-confirmation-time?timespan=30days), when a technical conflict in the mining community regarding how to advance the underlying technology increased average transaction confirmation time to a peak of more than 20 hours. This days-long ordeal degraded network stability and more than tripled average fees from $6 to 20 USD (https://bitinfocharts.com/comparison/bitcoin-transactionfees.html#3m).

The vulnerability of the network to the whims of its mining pools represents an obstacle to widespread acceptance of Bitcoin as a trusted mechanism of exchange. Additionally, the current average fee of roughly $6 to send Bitcoin renders it unviable for small retail transactions.

A Question of Value

Bitcoin’s meteoric price rally has been accompanied by extreme volatility, with annualized averages between 70 and 80 percent, and frequent spikes over 100%, placing it more in the realm of risky assets than investment grade value stores. While our options trading clients would love more market volatility, assets whose prices evolve with 80 or 100 Vol are dicey. Bitcoin must stabilize before it will be considered by institutional investors. Proponents argue that listing futures on DCMs such as the CME and CFE will dampen price gyrations, but the loose federation of 20+ ‘cash markets’ underlying these derivatives is far from stable, producing a considerable replication challenge for would-be market makers.

Conclusion

Until some of the issues discussed above are resolved, it is difficult to classify Bitcoin as an asset. It is rather more of a convention or protocol that will probably yield interesting projects in the future, but it is a work in progress. I fully expect substantial revisions will be adopted to address Bitcoin’s serious problems: it is enforced by a relatively small, unaccountable, group of foreign operators, making network stability an issue; it’s too slow and expensive to compete with other domestic methods of money transfer; and its price is extremely volatile. It seems as if no one would opt to send money this way, yet hundreds of thousands of transactions, totalling billions of USD, take place every day.

All are curious to see how this month’s new futures contracts trade. Margining is tricky, and Mr. Peterffy’s well-articulated concerns about clearing segregation are sobering. It will be interesting to see the implied carry cost in how rolls are priced, and whether significant CBOE vs CME arbitrage opportunities arise.

Bitcoin is confusing because it differs so strikingly from more familiar asset classes. Of course, in our industry, this creates opportunity for those who see first how to resolve and exploit the confusion. In a couple years, we might well be unravelling how they figured it out, marveling at the fortunes they made, and wishing we too had been so smart.

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