Bitcoin Has Entered The Awkward Adolescence Stage

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Last fall, 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 volatilities.

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 volatilities. 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 17 million. 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 per cent annualised volatility, as they have for most of the currency’s history.

Bitcoin prices did rise, however. Before October 1, 2017, Bitcoin had never traded above $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 volatilities.

However, for Bitcoin this does not appear to be the case. Both using historical actual price movements or option implied volatilities, volatility seems to be about 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 in bad states for investments 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.

When the LedgerX platform for trading Bitcoin swaps and options opened in October I wrote, “The next few months could be a crucial test for virtual money.” A few weeks later, when CME Group announced plans to offer Bitcoin futures, I suggested three possible outcomes: failure to link Bitcoin to the traditional financial system, a successful link but little interest, and Bitcoin joining the traditional financial system.

Arguably there was a bubble/crash up to down to there was certainly a lot of hype and a lot of overexposed unsophisticated retail investors. But the up and down was entirely typical of historical Bitcoin price moves; there’s no reason to assume it was caused by recent publicity or innovations.

The one existing vehicle, GBTC, sells at a per cent premium to the underlying Bitcoin it holds, a level inconsistent with Bitcoin being a normal financial asset.

The crossover point is six-month options, which are priced around the level consistent with history. Options with less than a month until expiry are priced around per cent of historical volatility, while one-year options are priced at only about per cent of historical volatility. So, while the market prices imply Bitcoin will have its historical level of volatility over the next year, they imply much more of that volatility will be in short-term ups and downs that average out, and much less of it will be in long-term trends. Bitcoin day traders will get more action, but Bitcoin long-term investors will have more stability.

Options whose exercise price is near the current price.

That is, are cheapest.

That is, are more expensive.

For example, stock options with low exercise prices have higher implied volatilities than options with high exercise prices.

If realised volatility shows the patterns the market predicts, it would likely increase both institutional demand for Bitcoin and trading interest from dealers and hedge funds.

But institutions take longer to make and implement decisions, and probably have been looking seriously at Bitcoin for a year or less. So the lack of institutional buying in quantity to date doesn’t mean that there is no interest. From personal conversations, there is a lot of cautious institutional interest, while the large Bitcoin holders I know are split between the “never-sell” and ambivalent camps.

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