Last spring, as cryptocurrencies seemed on the brink of a linkage with the traditional financial system, there were predictions of a price explosion along with institutional, regulatory and mainstream acceptance of the currencies. Others predicted disaster or a collapse to zero value. In the end, despite some dramatic price moves, not much happened.
Still, liquid crypto derivative trading gives us a lot more insight into what might happen in the remainder of 2018. Derivatives give us greater visibility into bitcoin price moves. Instead of relying on an opaque, fragmented market for price data, we have clean institutional-quality data on both prices and implied volatility.
There were no disasters when cleared bitcoin derivatives began trading. There were no technical failures or regulatory surprises. After some initial confusion, bitcoin futures and options prices settled at rational levels relative to cash prices and volatility. There was no massive selling by large holders cashing out of a Ponzi scheme, and no massive buying fuelling a bubble.
On the other hand, there was little interest in the derivative contracts, which account for only a few thousand bitcoin, out of a circulating supply of 17m. Institutions mostly stayed on the sidelines. No new vehicles for retail investment emerged. Bitcoin prices did not stabilise: they continued to move at around 100% annualised volatility, as they have for most of the currency’s history.
Bitcoin prices did rise, however. Prior to 1 October 2017, bitcoin had never traded above US$5 000. Since LedgerX opened the first cryptocurrency clearinghouse approved by US regulators later that month, bitcoin has never traded below $5 000. The price rose to $20 000 in mid-December, crashed to $6 000 in early February, and currently stands around $11 000.
The term structure of bitcoin option implied volatility is downward-sloping. That is, long-term options are cheaper than you would expect given the price of short-term options. This contrasts with the history of bitcoin prices, in which volatility is higher over longer horizons. The market suggests some volatility in daily bitcoin price moves is noise that averages out over three months to a year. Historically, the opposite has been true: bitcoin prices trended up or down over extended periods.
The term structure of volatility describes how implied volatility changes with the term of the option. For nearly all assets, implied volatility also changes with exercise price. At-the-money options trade at the lowest implied volatility, while options with exercise prices far from the current price trade at higher implied volatility.
However, for bitcoin this does not appear to be the case. Both using historical actual price movements or option implied volatility, volatility seems to be about equal across exercise prices. This suggests bitcoin price movements are smooth, like a normal distribution, rather than characterised by fat tails, jumps and changes in volatility like most assets. Bitcoin volatility is very high, but the volatility captures all of the risk.
Generally, you pay more for options that pay off when for investments are bad in general than for options that pay off in good states. Bitcoin options do not show a pattern. That suggests the market thinks bitcoin’s performance is unrelated to the broader economy.
This is good news for people who want to treat bitcoin as a traditional financial investment. The market seems to think that its long-term volatility is significantly less than we have seen historically; that price movements will follow a thin-tailed, normal distribution; and that bitcoin will provide diversification for major asset classes. However, we’ve seen no sign that large holders of bitcoin are willing to sell large quantities, even when prices went above $20 000.
Unless traditional passive long-term investors pay real cash for a few million bitcoin, the links between the cryptocurrency and the traditional financial system will remain thin and seldom-used, and perhaps will go away altogether. The last few months have demonstrated that the links are possible, and that bitcoin has the characteristics that make it attractive to traditional institutions. But there does not seem to be a price that works for both existing holders and major traditional institutions. The floor is available and the band is playing, but no one is asking anyone else to dance. — (c) 2018 Bloomberg LP
- Written by Aaron Brown, a former MD and head of financial market research at AQR Capital Management. He is the author of The Poker Face of Wall Street