The San Fran Fed Blames Crypto Crash on Bitcoin Futures

News and Opinions: San Fran Points to Futures Products as Catalyst for Crypto Crash, I Fill in the Blanks

Federal Reserve Bank of San Francisco published an analysis of Bitcoin prices and the crash of 2017 – 2018, pointing to Bitcoin futures as the main catalyst for the crash.^[1]

This line of thinking confirms that which many suspected to be the case, that the futures markets opening in late 2017 led to the parabolic uptrend (in anticipation of futures trading, and without pessimists able to easily bet against Bitcoin) and deep crash of late 2017 – early 2018 (in response to the start of futures trading, and with pessimists able to easily bet against Bitcoin)

The Fed’s logic is simple, Bitcoin optimists bid up the price in 2017, but Bitcoin pessimists had no way to bet against it in that time, so the price just kept going up with little resistance.

That changed with futures trading. Once both major futures exchanges (CBOE and CME) opened for business, the price of Bitcoin crashed.

The paper points out that this chain of events isn’t unique to Bitcoin, but rather it is the same thing that happened in the US housing market bubble leading up to 2007 and is consistent with economic theory (in terms of what would be expected when products are created that allow pessimists to short a market with rampant speculative optimism).

Or at least, that is how I would summarize this key concept contained within the official and well written San Fran Fed paper on Bitcoin (make sure to check it out for yourself): How Futures Trading Changed Bitcoin Prices.

NOTE: Retail investors have been able to short crypto via sites like Bitmex for a while. However, large institutional investors didn’t have a way to easily short crypto without entering the space from more retail focused portals (like Bitmex). Futures contracts on the CBOE and CME allowed this for the first time.

Opinions on the Implications of the Fed’s Conclusion on Bitcoins Futures

The above said, I would add also to this that the San Fran Fed is “missing,” or professionally not commenting on, the part where smart people with big money fully realized that things would likely play out like this (if you have 2014 and the housing bubble in your rearview, you likely saw this coming), and thus bid up the price of Bitcoin to create or help ensure a speculative mania based on the idea that big institutional investors were finally validating crypto via futures trading (“the rumor”).

Then, upon “the news” of futures trading, the same (or likely many of the same) people who bid up the price, or let the price get bid up, let the price of Bitcoin drop like a rock (in some cases likely flooding the market with crypto, likely at a loss), thus setting up for a “big short” as futures trading went live (blaming it on Chinese New Year or something silly like that, I “forget” the exact “why” of the time; I wrote about it here).

This then predictably crashed the rest of the crypto market (after it itself pumped), which then allowed key players to buy cheap crypto on the exchanges and OTC, which then allowed them to become a force / even bigger force in the spot buying market (the exchanges we all trade on where we buy and sell crypto).

NOTE: If you short Bitcoin at the top with a big enough position, you can buy crypto rather high and then sell at a loss to force the market down, making up for the losses with your short contracts, then buy low, making up for the rest of your losses, and then go long while at the same time taking sell pressure off the market… in other words, you can take heavy losses and still end up with massive amounts of control and profits with the advent of futures contracts. To avoid affecting exchanges, these players can buy over the counter (OTC). OTC buying has ramped up in recent months. I assume these points aren’t unconnected.

The above thought and opinion part is all clearly speculation (when in Rome, right), however it is also such a clear logical and profitable move, and one that fits with what we know occurs in crypto trading and in futures trading, it is hard to imagine that it doesn’t mostly explain what happened.

Here I’m not saying that bubbles aren’t natural, or that the effect of being able to short a speculative bubble isn’t natural, I’m only saying that because it is natural, it could be expected, ushered in, and then capitalized on.

An overlay that shows Bitcoin bubbles. Not only do we see bubbles in other assets, we see them all the time in crypto. Thus assuming we are in a bubble when this pattern takes shape is a rather solid bet.

Anyway, although the above is great news if you went long in early 2017, sold at the top, shorted at the top of the bubble, and then went long at the bottom again or if you simply traded the volatility (which I think IRS data will show is a minority of retail investors), a bit of good news for any crypto fan is this: from a glass half full perspective the idea that bigger players are entering the space is real [clearly], also the idea that crypto is becoming more legitimate is real.

Also, sort of good news is that whatever players were just pumping the market without any sort of check for 2017 now have a check, and that means the market is likely to be a little more stable overall (maybe)…. and a stable market is good, because it’ll invite in normal people who aren’t speculators and could potentially lead to a crypto space where crypto was actually useful for dapp economies and transactions and such. That is a confusing path to an endgame, but the bottom line here this: None of that would have happened like it did if crypto was dead. It isn’t. Clearly there will be more excitement ahead.

NOTE: The San Fran Fed paper isn’t just about validating my theory [one that I share with others] of why Bitcoin saw a speculative bubble and bust (AKA pump and dump) in late 2017 – 2018, it also discusses how Bitcoin can be priced and how the price might evolve over time. The paper is academic and nature is worth a read.

TIP: Crypto bubbles and busts all the time, and people constantly buy the rumor and sell the news. The last bubble may be partly explained by new players, but the existing players who have been in the game are at least equally as guilty if not actually the main players here (or, I might argue the real main player is human behavior in speculative markets, which smart big players and their algos exploit; anyway). It is likely that the new players worked within the exiting system (and still are), as this would be smarter and take less effort than trying to do all the work themselves. My point being, it is not like crypto was on a nice stable upward trajectory and then some hedge fund broke everything. Crypto has been full of bubble and busts for a long time, each step of the way filled with buying rumors and selling news, each step of the way full of eager speculators, and thus anyone entering the space (but with knowledge of speculative markets) would simply capitalize on that the same way those of this type already in the space already do. It is only that [human nature aside] MtGox explains the 2013 – 2014 bubble, and “futures” explains this one. Things have changed, but they have truly stayed somewhat the same in many ways.

1. How Futures Trading Changed Bitcoin Prices. Frbsf.org.