Bitcoin Futures are coming to the CBOE on December 10 and the CME later in the month. Assuming a sufficiently liquid market develops, large-scale institutional investors will have a platform and infrastructure to buy — and short — Bitcoin.
There is widespread speculation that a wall of institutional money is waiting on the sidelines to enter the bitcoin market. With the advent of derivatives, the wall of institutional money will be unleashed, so the bullish thinking goes, blasting the price of bitcoin to even greater heights on top of the 1400% gains experienced year-to-date.
However, it’s possible that, rather than igniting the next wave of appreciation, the addition of bitcoin futures could herald something else: The end of a market structure that has enabled bitcoin’s historic price rise. Assuming investors can sell short bitcoin with relative ease in the weeks ahead, the digital currency’s parabolic ascent could be over.
As we see daily in the press, opinions about the future price of bitcoin are sharply divided between optimists and pessimists. Optimists believe the digital currency to be the future of money, and predict substantially higher prices on top of the recent astounding gains. Meanwhile, pessimists believe bitcoin is overpriced at best, a fraud at worst, and anticipate much lower prices. However, only one of these points-of-view has been represented in the bitcoin market.
The fact is that, since its inception, the price of bitcoin has reflected only the participation of the optimists. While the optimists can buy bitcoin to express their beliefs, pessimists cannot act on their pessimism — they cannot short bitcoin. Until now.
In an oft-cited study from 1977, Edward M. Miller asserted that restricting short sales can lead to the overvaluation of securities. Specifically, Miller showed that if short selling is restricted, and participants have differing opinions about the underlying value of a security, it’s price will reflect only the opinion of the most optimistic investors. With only bulls investing, the price of the security will be biased upward. Bearish investors who value the stock less are limited in their ability to act on their beliefs when short selling is not possible.
In another study, Michael Harrison and David Kreps (1978) argued that the overvaluation may be even greater than Miller suggests. They show that restricting short sales will cause the price of the security to exceed the valuation that even the most optimistic investor attaches to it today. The reason is that investors anticipate that, in the future, someone else may be even more optimistic about the stock than they are. This is even true for the investor who is most optimistic about the stock’s fundamental value today. He knows that he may be able to sell the stock for more than its fundamental value at some point in the future, and thus he will be willing to pay a little bit more than this value today.
Followers of behavioral finance will recognize that Harrison and Kreps are describing “The Greater Fool Theory” — whereby the price of an asset is determined not by its intrinsic value, but rather by expectations of buyers that that other parties will pay even higher prices in the future. The greater fool theory is a hallmark of financial bubbles where prices rise above real world values to unsustainable levels, then come crashing down. In a market with short sale constraints, where only optimists are participating and setting prices, and few short sellers exist to mitigate overvaluation, the greater fool phenomena is free to run rampant.
Also, in a market with short sell constraints, dominated by optimists, a positive feedback loop may progress unimpeded.
In his book Irrational Exuberance, Robert Shiller defined a bubble as a period of feedback, where price increases generate enthusiasm among investors, who then bid up prices more, and then it feeds back again and again until prices get too high. During that period, people are motivated by envy of others who made trading the market, regret in not having participated and the gambler’s excitement. Stories develop that justify the bubble, and then people think they’re right because everyone’s confirming the stories. Eventually prices get too high and the bubble bursts.
However, the active participation in the market by short sellers can serve to inhibit the feedback, by impeding the easy rise of prices. If optimists buy a security but the price doesn’t rise because pessimistic investors are able to short sell, the feedback loop may not be set in motion. Also, it should be noted, that negative feedback loops can develop, whereby falling prices generate fear among investors, who sell more, and the process builds on itself. Short selling can certainly exacerbate such negative feedback loops.
Bitcoin bulls have long wished for the arrival of derivatives and institutional investors that will take bitcoin to a new level of market acceptance. Be careful what you wish for.