LONDON (Reuters) - Bitcoin is taking its first steps toward becoming a legitimate investment vehicle with the creation of futures contracts in the crypto-currency this month, moves which may also allow it to infect wider financial market stability for the first time.
Although the financial world simply does not have enough exposure to the sector to cause concern right now, growing participation of hedge funds and their banks via the new futures creates a link and risk that a bursting of what many see a gigantic bubble could leak into other markets.
In some ‘worst case’ scenarios, it could be the trigger for a correction across global equity markets that have seemed impervious to pretty much all other risks for the past two years.
Let’s be clear - we’re not talking systemic risk here. We saw that with Lehman Brothers in 2008 when the financial and economic world as we know it came within hours of a wipe-out.
This is about the market-to-market contagion that could spread if large banks or leveraged speculators like hedge funds, having taken on big positions in bitcoin futures, find themselves on the wrong side of a sudden and dramatic price swing.
In this scenario, they would be forced to liquidate holdings of other assets like stocks or bonds to cover their position in Bitcoin, or meet the hefty margin requirements stipulated by the market-making exchanges and brokers.
Doug Kass, president of Seabreeze Partners Management, thinks one of next year’s big market surprises could be bitcoin soaring above $20,000 before plunging below $2,000, a crash that could take hedge funds down with it.
“Several large, well-known hedge funds desperate for alpha are caught with their pants and portfolios down and with a large weighting in bitcoins and other cryptocurrencies; they lose more than 30 percent of their funds’ assets and value, and are forced to liquidate their cryptocurrency holdings and close their funds,” he ventures.
Clearing houses, the institutions charged with ensuring exchanges aren’t left exposed if a bank or fund is unable to meet a cash call, may also forced to sell assets to raise the required cash.
Selling begets further selling, especially in the opaque hedge fund world and market participants aren’t sure who’s bailing or why. If there’s the whiff of smoldering panic, a lack of visibility will fan the flames.
The collapse of a hedge fund, exchange or brokerage often has no impact on markets at all. But sometimes it does. The most famous was hedge fund LTCM in 1998, and in 2011 the demise of broker MF Global triggerd a 10 percent correction on Wall Street over a 4-week period.
To say there’s been no shortage of volatility in bitcoin is an understatement. It has soared to over $17,000 from under $1,000 in January and intraday swings of $1,000 or more are now routine.
There are good reasons to believe bitcoin’s extreme volatility will hit only those exposed to the cryptocurrency, and that ripples across financial markets will barely be felt.
For all the hype, press coverage and wild price moves lately, bitcoin remains only a very small part of the financial universe.
Its entire market capitalization is around $280 billion, roughly the same as Walmart. If Walmart shares crash, say 50 percent, will world markets crumble with it?
Volatility would certainly spike higher, but it’s unclear how widespread or lasting the contagion would be. To put that market cap into context, Wall Street’s total equity market cap is over $20 trillion.
Even if hedge funds do wade into bitcoin, how deep can they go? Hedge fund assets under management are nudging $4 trillion and the bitcoin universe is $280 billion.
If bitcoin crashed as much as 90 percent today it would still be higher than it was at the start of the year. So those who have been holding it for a while - i.e, most Bitcoin investors - would still be sitting on paper gains.
Yet the combination of extreme price volatility, the introduction of futures and the opportunity for speculators to take risky bets with borrowed capital creates a new and riskier dynamic.
In the cash market, most bitcoin trading has been from retail investors and unleveraged. That means losses are limited to the individuals and nominal positions in question. The scope for wider contagion is minimal.
But that won’t necessarily be the case when bigger players and more aggressive speculators get involved with borrowed capital in the desperate pursuit of higher returns.
Andy Brenner, Head of International Fixed Income at National Alliance Securities in New York, says the growth of trading volume and open interest in bitcoin futures bears monitoring.
“What you need for any contagion risk to emerge is a lot of trading, a lot of positions. It doesn’t matter if people are long or short the futures - but futures is the only way contagion risk appears,” he said.
Cboe Global Markets Inc launched a bitcoin futures contract on Dec. 10. Trading volume and open interest so far is minimal - barely 400 contracts - but that will surely rise in the coming months. The CME Group launched its bitcoin future on Sunday Dec. 17.
Both exchanges are taking extraordinary steps to protect themselves against excessive volatility, with intraday price limits and initial margin rates of 30 and 35 percent respectively.
These are far tighter controls than other asset classes. And if a fund has deep enough pockets to put up a 35 percent margin then you could argue it can take the hits when they come.
But 2017 has been a bad year for hedge funds. Many will be tempted to borrow and gamble heavily next year.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever; Editing by Angus MacSwan