Bitcoin Billionaires May Have Found a Way to Cash Out

(Bloomberg View) -- Bitcoin did a lot of growing up in 2017, but there was one trade this week that could go a long way toward stabilizing the market for the cryptocurrency and further establish its credibility in mainstream finance.

Sure, the meteoric rise in bitcoin prices has everyone debating whether it's one of history biggest bubbles, but just look at all the accomplishments that have put it on the cusp of joining the global financial system. LedgerX opened the first U.S. Commodity Futures Trading Commission-approved clearinghouse for cryptocurrencies in October, and began trading in swaps and options. Cboe Global Markets and CME Group have started trading in bitcoin futures. The New York Stock Exchange, Intercontinental Exchange -- and no doubt others -- plan to offer exchange-traded funds based on bitcoin futures.

But for all those achievements, there are some big issues that have yet to be resolved. The U.S. Securities and Exchange Commission rejected the use of the Gemini exchange to determine bitcoin prices -- which Cboe is using for the daily settlement of bitcoin futures -- and has expressed doubts about using an index of exchanges -- which CME is using. This creates the possibility that a few million dollars of actual bitcoin transactions, assembled in untested ways, will drive hundreds of millions of dollars of derivative settlement payments, which in turn could set the price for potentially tens of billions of dollars of ETFs.

Even in normal markets this can cause instabilities and mispricings, as we have already seen between bitcoin futures and physical prices. It can also play havoc with calendar spreads (the difference between, say, a futures contract with delivery next month and one whose delivery is in six months) as well as the premium at which the Bitcoin Investment Trust open-ended fund trades. And don't forget the spread among exchanges. In a crisis market, these issues could cause a break down. They are likely driving some volatility in bitcoin prices, and also probably keeping many institutional investors on the sidelines. (Full disclosure: I own bitcoins and other cryptocurrencies.)

But this week, one or more people delivered 275 bitcoin (valued at $4.5 million at the time) to the LedgerX clearinghouse, and wrote one-year calls at a strike of $50,000 ($13.75 million in total) against them for a premium of $3,600 per coin ($990,000 total). These are real bitcoin, and there is no need for any sort of settlement auction, the call option buyer can exercise and receive the physical bitcoin.

I spoke to some large bitcoin holders, most of whom have held for years and never sold, and all expressed at least some interest in doing similar trades. It is a natural one, the "bitcoin billionaires" -- the approximately 1,000 people who hold an estimated 40 percent of all bitcoin, or an average of around $350 million each -- reducing their exposure in return for some cash today. In turn, financial investors get a secure, levered exposure to bitcoin that is not hostage to an unproven price-setting and without the expense of setting up a system to hold physical bitcoin.  Bitcoin miners need cash for equipment and electricity bills (China this year cut off lending on bitcoin collateral) and early bitcoin adopters could stand to diversify their portfolios.

One trade doesn't make a market, but if, say, 1 percent of all bitcoin were taken off the market and held as option collateral, and financial investors put up cash in one-year derivatives, that could do a lot to stabilize the market. That means both reducing price volatility and giving confidence that market prices represent true trading prices for institutional quantities of bitcoin. This, in turn, could make Cboe and CME cash-settled futures more attractive, and thereby represent a solid base for bitcoin ETFs.

And once that happens, institutions are likely to accept custodianed ownership of physical bitcoin, broadening and deepening the ownership base. There are few entities with institutional access to bitcoin derivatives trading and expertise with trading and holding physical bitcoin. That has to change for bitcoin to join the global financial system.

On the other hand, if bitcoin billionaires stay out of the market, institutional investment in bitcoin will remain problematic. Individuals will be able to trade small amounts in a fragmented market of loosely regulated exchanges, but futures and ETFs will not be securely backed by physical bitcoin -- their prices will be pushed around by betting sentiment of people who own no bitcoin.

That's not necessarily a bad thing. After all, bitcoin was invented as an alternative to financial markets, and it functioned quite nicely for years with no connection to Wall Street. That's one possible path for cryptocurrencies, a parallel financial system. But many people have set their hearts on linking the two systems, and we may have just seen the first trade to validate their dreams.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street."

1. That is, the buyer paid the seller $990,000 today, and has the right but not the obligation to buy 275 bitcoin for $13.75 million any time before December 28, 2018. These 275 bitcoin are held by the LedgerX clearinghouse and will be released on Dec. 28, 2018 to either the buyer (if the buyer exercises the option by paying $13.75 million) or the seller (if the buyer does not exercise).

2. The implied volatility of this trade is 128 percent, which seems quite high for a one-year option, and perhaps speaks to investor enthusiasm for secure, levered bitcoin bets without the need to handle physical bitcoin, or perhaps to the reluctance of large bitcoin holders to sell even a little bit of their upside.

3. Another natural trade is for large bitcoin holders to buy out-of-the-money puts on some of their holdings in order to borrow money against them. Selling these puts also gives investors levered exposure to bitcoin, while providing bitcoin holders with cash.

4. This is a key difference between cash-settled futures (as Cboe and CME offer) and physical-settled derivatives (as LedgerX offers). Physical settlement enforces a link between the derivative price and the physical price. In the case of LedgerX, which requires 100 percent collateral, the physical bitcoin are actually taken off the market. This reduces price volatility and guarantees that at least one side of any LedgerX trade actually owns physical bitcoin.

To contact the author of this story: Aaron Brown at aaron.brown@privateeram.com.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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