Between January 1 and December 17, 2017, the value of a single Bitcoin skyrocketed from under $1,000 to nearly $20,000. To match Bitcoin’s 1183 percent return during this period, an investor would have needed the equivalent of 38 years’ average equity market returns. Investors and news outlets alike were entranced by Bitcoin’s stratospheric rise, and direct investment in the crypto-asset surged. But Bitcoin’s climb was followed by an equally stomach-turning fall, as its price declined 70 percent in less than two months between December 17 and February 6.
Discussion of Bitcoin’s swing occurred primarily in one of two registers: the language of economic bubbles or of disruptive technologies. Skeptics placed Bitcoin’s dramatic rise and fall in a long line of cases of irrational exuberance followed by cold realization: a new dot com crash. Optimists argued that Bitcoin is the currency of the future, that it will undercut traditional financial services soon enough, and that it merely became a bit too frothy with the influx of so much speculative retail capital.
While these perspectives have dominated the post-mortem discussion, we believe a critical explanatory angle has been seriously under-analyzed: the financial economics of the Bitcoin marketplace. The structure of the Bitcoin market, and the sophistication of financial products available for Bitcoin position-taking, have substantial weight in explaining the events of the last year and a half.
The critical factor in Bitcoin’s fall was probably not sudden shifts in market sentiment, but rather the market’s improved ability to accurately reflect sentiment. Bitcoin skyrocketed when it was only possible for serious investors to be long and fell as viable options for shorting allowed skeptics to express their views. The key event in this drama was the introduction of futures contracts by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME).
For a commodity-like asset to trade efficiently, investors must have the opportunity to either be long (betting the price will rise) or short (betting the price will fall). In traditional commodities markets, variations of these options allow investors to project their outlook on a commodity’s future demand. Consider a hypothetical investor who suspects that this year’s serious grain shortage will be followed by a grain glut next year. This investor, betting that the price of grain next year will be much lower, can take a large short position by engaging in various contracting maneuvers, regardless of the number of bushels actually in his account. If the investor makes these bets on the future value of grain, his negative sentiments will be communicated to the marketplace and affect the represented value of a bushel today. On the other hand, if this investor were unable to sell short, the most he could do to profit from his insight would be to sell any grain he currently holds. If he only owns a few bushels, it would be very difficult for him to convey to the market the strength of his belief in the coming grain super-abundance. In other words, in a marketplace without short-position mechanisms, only investors who are very positive about future prices can have their voices fully represented. Investors who are very negative have a much more limited ability to express that sentiment financially.
Bitcoin in 2017 was analogous to grain in our example. In the pre-futures-contract era (prior to December), investors could not effectively short Bitcoin. The only investors who could easily make large bets on the underlying value of Bitcoin were long players, who bought coins themselves and watched as the price increased throughout the year. Meanwhile, those who felt Bitcoin was overvalued had strong justifications for their views, ranging from suspected fraud in coin exchanges to impending regulatory change and the rise of competitors.  What they lacked, however, was a means to convey those views in the market.
The introduction of futures contracts changed everything. Suddenly, short-sellers were enabled––and they got into the game. In particular, large institutional investors, hedge funds, and other private capital vehicles disproportionately sold short. An article in the January 8, 2018 edition of The Wall Street Journal explored this trend. Among small investors (those with fewer than 25 of CBOE’s futures contracts), long cryptocurrency bets outnumbered short ones 3.6 to 1. Among the large trading entities identified as “other reportables,” short bets outnumbered long bets 2.6 to 1. Specifically, hedge funds and other money managers were more likely to have placed short bets on Bitcoin, with short bets outnumbering long ones by 40 percent.
It took time for these positions to accumulate, and for a critical mass of short investors to have a real impact on the price of Bitcoin. But this is not unexpected in a maturing market introducing new financial instruments. Importantly, within a few weeks the price declined, demonstrating increasing market ability to represent the intensity of belief among skeptics as well as optimists.
It is probably impossible to predict the final equilibrium point for Bitcoin. It is an experimental product at the vanguard of a brand-new asset class. We may see new appreciation in the next few years, as financial services evolve and investors assess crypto-assets’ role in the next era of money-movement. However, since the end of the Bitcoin price crash in early February, price movement has seemingly stabilized. Compared with the 1100 percent growth of 2017, or the 70 percent drop in early 2018, Bitcoin’s recent fluctuations suggest a progression towards a more mature asset in a better-functioning market. Between February 1 and May 31, 2018, Bitcoin’s volatility was a mere quarter of what it was between June 1 and January 31, 2018.  While such volatility is still considerably higher than that of commodities like gold, it is progressing slowly towards levels more normal for assets of its liquidity and size.
These developments bolster the thesis that the introduction of futures contracts has improved market function by allowing true sentiment on Bitcoin to be expressed in its price. There are many lessons to be learned from the emergence of crypto-assets. However, we believe that one of the most important is how the adoption of well-designed financial instruments can serve to pull markets away from confusion towards increased efficiency, and how their absence invites distortions and bubbles.
 Average historical U.S. stock market returns are approximately 7%. Aswath Damodaran, NYU Stern Business School, Annual Returns on Stock, T.Bonds, and T Bills: 1928-Current, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html (using Saint Louis Federal Reserve data from 1945 to 2017).
 Prices are calculated from the CoinMarket Cap, using the highest price reached on December 17 ($20,089) and lowest price reached on February 6 ($6,048), https://coinmarketcap.com/currencies/bitcoin/historical-data.
 John Quiggin, What Bitcoin Reveals About Financial Markets, N.Y. Times, Feb. 8, 2018, https://www.nytimes.com/2018/02/08/opinion/bitcoin-financial-markets.html.
 Sameepa Shetty, James Altucher’s 10 Predictions About Where Bitcoin and Cryptocurrencies Are Headed, CNBC, Dec. 1, 2017, https://www.cnbc.com/2017/12/01/james-altuchers-bitcoin-predictions.html.
 Reuters, U.S. Regulator Subpoenas Cryptocurrency Platforms Bitfinex and Tether: Source, N.Y Times, Jan. 30, 2018, https://www.nytimes.com/reuters/2018/01/30/business/30reuters-usa-cftc-subpoena.html.
 Taylor Hatmaker, Senate Cryptocurrency Hearing Strikes a Cautiously Optimistic Tone, TechCrunch, Feb. 3, 2018, https://techcrunch.com/2018/02/06/virtual-currencies-oversight-hearing-sec-cftc-bitcoin/.
 Paul Vigna, Which Digital Currency Will Be the Next Bitcoin?, Wall St. J., Dec. 19, 2017, https://www.wsj.com/articles/which-digital-currency-will-be-the-next-bitcoin-1513679400.
 Alexander Osipovich, Bitcoin Futures Split Big, Little Traders, Wall St. J., Jan. 8, 2018, https://www.wsj.com/articles/little-guys-and-big-trading-firms-square-off-in-bitcoin-futures-arena-1515326400.
 See id.
 Quiggin, supra note 3.
 See supra note 2.
 Data Derived from Saint Louis Federal Reserve (FRED) daily London gold bullion prices. Federal Reserve Bank of St. Louis, Gold Fixing Price 10:30 A.M. (London time) in London Bullion Market (U.S. $), https://fred.stlouisfed.org/series/GOLDAMGBD228NLBM.
This post comes to us from Peter Charles Bassine, a student at Yale Law School and a former research associate with the Committee on Capital Markets Regulation, and from Harrison Fregeau, a research associate with the Committee on Capital Markets Regulation. The views expressed in it are the authors’ alone.
This is a corrected version of a draft posted earlier today in error. We apologize for the mistake.