The Federal Reserve of San Francisco in its report published on Tuesday argues bitcoin's price peak and crash coinciding with the introduction of bitcoin futures is no coincidence, and parallels it with the rise and collapse of the home financing market in the 2000s.
Crypto enthusiasts see Goldman Sachs’ plan to trade bitcoin futures on behalf of clients as a big-time institutional endorsement likely to lend more credibility to the bitcoin market. The price of BTC even hit a monthly high, flirting with $10,000, just days after the news broke confirming the entry of one of Wall Street’s most storied and scrutinized investment banks.
Goldmans will also create its own more flexible version of a future, a non-deliverable forward. Mainly used in forex and commodities, an NDF is a dollar cash-settled contract for a security that is never intended to be delivered and primarily used for speculating on its price.
Goldman Sachs is renowned for its engineering of complex financial products for its clients to make exotic trades and for proprietary trading. It was one of the few who predicted the subprime mortgage crisis (2007-2008) and took bearish positions on the housing market before it imploded. It created and sold real estate-related collateralized debt obligations (CDOs) and in 2010 the Securities and Exchange Commission charged Goldman with fraud in the structuring and marketing of synthetic CDOs tied to subprime mortgages.
Futures, forwards and financial wizardry
Currently, there are two different contracts offered in the bitcoin futures market, the first to launch was the Chicago Board Options Exchange (CBOE) futures contract (XBT) on December 10. There was very light trading volume in the market until the Chicago Mercantile Exchange (CME) entered a week later with its own BTC futures. The average daily trading volume the month after CME joined was six times larger than when only the CBOE offered the derivatives.
There are subtle differences between futures and forwards. Forward contracts are settled on one date at the end of the contract and not before or after that date. Futures are marked to market daily and so prices fluctuate but they can be settled on any date and rarely ever held out to delivery of the underlying.
The CBOE cites bitcoin futures offering more investor protections: the dangers of counterparty risk are mitigated through use of a clearinghouse – as opposed to a crypto exchange that is susceptible to hacks. Although a clearinghouse doesn’t guarantee customer deposits it does act as guarantor between clearing parties, so if a trader who sold short was unable to repay the borrowed amount of securities to the party on the other side of the trade then the trader who bought and went long is fully compensated for their position.
How futures affected the BTC price
Although much speculation and explanation has been offered on the bitcoin price crash, not much thought has been given to the launch of its futures market.
On December 17, the day that bitcoin hit its zenith at $19,511, the Chicago Mercantile Exchange launched its bitcoin futures trading. The Federal Reserve of San Francisco in its report published on Tuesday – *How Futures Trading Changed Bitcoin Prices -*argues that this is no coincidence and the price action parallels that of the rise and collapse of the home financing market in the 2000s. That has been attributed to the financial innovations in securitization and groupings of bonds that attracted investors when property prices were booming, but when instruments like synthetic collateralized debt obligations (CDOs) allowed pessimistic investors to make a bearish bet against the market the price of mortgage-backed securities and property prices imploded.
The Fed said: "Before December 2017, there was no market for bitcoin derivatives. This meant that it was extremely difficult, if not impossible, to bet on the decline in bitcoin price… Betting on the increase in bitcoin price was easy—one just had to buy it. Speculative demand for bitcoin came only from optimists, investors who were willing to bet money that the price was going to go up.”
Similarly, in the housing euphoria of the 2000s there was no way of shorting the market so the trend was all one way – bullish – until CDOs and credit default swaps (CDS) were created to bet against it.
“The peak bitcoin price coincided with with the day bitcoin futures started trading on the CME… we argue these price dynamics are consistent with the rise and collapse of the home financing market in the 2000s”, the Fed report said.
The Fed believes bearish positions on the future price of bitcoin affected its spot price as investors who were in the spot market for transactional or speculative reasons and could wait a month would have been able to buy the spot at a much lower price. So demand fell in the spot market which fueled further short selling and downward pressure.
From the Fed’s hypothesis one could argue that we’ve already had the "subprime crash" and are over the worst of the bearish bets. Goldman’s entry is evidence of the growing interest of sophisticated investors in crypto but it would be foolish to think that their clients and traders are all bullish on its future price.
As Rana Yared, one of the Goldman executives overseeing the creation of the trading operation, said: “I would not describe myself as a true believer who wakes up thinking Bitcoin will take over the world. For almost every person involved, there has been personal skepticism brought to the table.”
The Federal Reserve of San Francisco has published a report on how the introduction of bitcoin futures precipitated a crash in the spot price and with the impending entry of Goldman Sachs to the crypto markets we’ll look at how this could play out.