Streetwise Professor

December 4, 2017

Bitcoin Futures: What? Me Worry?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:53 pm

The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.

Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.

So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.

If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.

Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg today:

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.

Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.

Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:

“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”

Petterfy has expressed worries about weaker FCMs in particular:

“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”

He has recommended clearing crypto separately from other instruments.

These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.

Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.

As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).

Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.

Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.)  The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.

This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?

(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)

What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.

Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.

All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.

December 3, 2017

Please Reconcile This: The Kremlin Is Hermetically Sealed to Outsiders, But They Told All to Christopher Steele

Filed under: Politics,Russia,Uncategorized — The Professor @ 7:45 pm

This article caught my eye last week: “At the epicenter of the Russian election manipulation story, reporters can’t report.”

As tensions rise, Ferris-Rotman finds reaching sources inside the government all but impossible. She says foreign correspondents based in Moscow can’t just pick up their phone and text or call an official.

“Russia is a very closed place,” she says. “It’s not like the U.S. where, you know, over years or over some time you can develop a source in the White House — someone who you can trust and that you trade information with. Basically (the Kremlin) is a sealed up institution and there’s no way for us to get into it. “

The Kremlin is a “sealed up institution,” but we are supposed to believe that Christopher Steele was able to get multiple sources within the Kremlin to repeat highly sensitive conversations involving the highest personages in the Kremlin, including Putin himself.

The dossier itself is bad enough, but its handling in the US–specifically by the FBI and the intelligence community–is downright sinister. This is even more evident after it was revealed that the FBI agent who was responsible for handling the dossier was a pro-Hillary/anti-Trump partisan who was fired by Mueller for exchanging anti-Trump texts with his lover, also an FBI agent. (Not that Mueller told us that this was why he was fired when it happened months ago. I guess he didn’t have time because he was so busy leaking.) Moreover, this same individual allegedly has been interfering with the House Intelligence Committee’s attempts to get to the bottom of the story of the dossier.

But there’s more: the same FBI official led the investigation of Hillary’s emails.

As the expression goes: the fix is in! Although here, it is necessary to use the plural: the fixes are in!

Boy, if only there was a Republican attorney general who could get control of a rogue FBI and get some answers about the dossier–how it was obtained, and how it was used by the FBI.




Filed under: Politics,Russia — The Professor @ 7:29 pm

Friday was a bonanza for dry cleaners, as the media and the political class collectively wet themselves in glee at the news that ex-National Security Advisor Michael Flynn plead guilty to lying to the FBI.

Alas, their fondest desires ran well ahead of the reality–which is the norm for this lot.

As was the case with Manafort, Flynn plead guilty to lying but not to any underlying crime, least of all a conspiracy with the Russians. The most reasonable inference for this is that there WAS no underlying crime and no conspiracy.

Indeed, Flynn will testify that he lied about two conversations with the Russian ambassador, Kirlyak, neither of which was illegal or even unethical.

In the first conversation, he spoke not just to Kirlyak, but to the ambassadors of every nation on the United Nations Security Council, including Senegal, Egypt–and wait for it–Ukraine. The subject was not Russia, but the stink bomb of an anti-Israel resolution that the outgoing Obama administration supported  but the incoming Trump administration opposed.

And it was the incoming Trump administration, because this conversation took place in December, 2016.

Flynn allegedly contacted the ambassadors at the direction of Jared Kushner.

So this contact is about Israel, not Russia. Flynn talked to Russia only because Russia was on the UNSC. As it (or the USSR) has been since its creation in 1945.

But the breathless media coverage was almost all headlined “Flynn spoke to Russia,” insinuating that his plea showed that Trump was canoodling with Putin.

In econometrics, omitting variables leads to biased inferences. Here, omitting that Flynn also spoke to every other nation on the UNSC about an issue that had noting to do directly with Russia definitely led to biased inferences. And that was exactly the intention, which demonstrates the bad faith of virtually the entire journalistic establishment.

The other conversation was about Russia directly. Specifically, Flynn asked Kislyak that Russia not overreact to Obama’s out-the-door sanctions on Russia. Trump wanted to avoid an escalatory dynamic, which is perfectly reasonable, especially given the fact that Obama almost certainly levied these sanctions with the intent of making life difficult for Trump.

Since these events happened after the election, they did not advance the collusion narrative. The media and the political class dealt with this in two ways.

First, they just lied. Brian Ross of ABC News reported–and the rest of the media repeated–that Flynn was going to testify that he had spoken to Russians during the campaign. WRONG. He will merely say that the Trump team had discussed plans to improve relations with Russia post-election. Big difference.

But this is a classic case of Twain’s dictum about a lie getting around the world before the truth got its boots on. And isn’t it funny how all the lies are in the same direction?

This is in fact a huge benefit to Trump, because what better illustrates his assertions that the mainstream media is a firehose of fake news?

Second, they harrumphed about the Logan Act, a likely un-Constitutional historical curiosity dating from January 30 . . . 1799–and which despite its longevity has never resulted in an indictment, let alone a conviction. The law forbids private individuals from negotiating with foreign states in a dispute with the US. About its only relevance to today is that it was adopted in fevered political times (the wars of the French Revolution, which also spawned the infamous Alien and Sedition Acts) which bear some similarity to today’s febrile political climate.

Further, it is common–and indeed imperative–for incoming administrations to establish contact with foreign governments, including–and perhaps especially–those with whom the US is experiencing tense relations. Indeed, the Trump team received permission from the Obama administration to make such contacts, and an administration spokesman said publicly that Obama had no objection to such contacts, including specifically with Russia.

So if anything, the Flynn plea actually substantiates what Trump et al have been saying all along, and provides no evidence of pre-election collusion, let alone an illegal pre-election conspiracy.

The main conclusions here are: (1) Flynn was an idiot for lying about something that was perfectly legal and ethical, and (2) to avoid outbursts of idiocy, when the FBI comes knocking, don’t talk–there’s no upside, and a big potential downside.

As for the conspiracy theory that excites the imaginations of today’s McCarthyites and Birchers, it is a big fat nada. Zip. Zero.

But that will not deter them. They are so invested in this theory that nothing will disprove it in their eyes. They will react exactly the same to the next hyped non-event, and dry cleaners everywhere will cheer.

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