Saturday, 17 March 2018

What Bitcoin Reveals About Financial Markets

As for the derivative assets that gave us the global financial crisis, they were viewed favorably in light of a widely held theory, known as the “great moderation,” that suggested that major economic crises were a thing of the past, thanks to certain systemic changes in the way developed nations ran their economies. The theory was backed by leading economists and central bankers. Asset-backed derivatives were, ultimately, a bet on the great moderation.

The contrast with Bitcoin is stark. The Bitcoin bubble rests on no plausible premise. When Bitcoin was created about a decade ago, the underlying idea was that it would displace existing currencies for transactions of all kinds. But by the time the Bitcoin bubble took off last year, it was obvious that this would not happen. Only a handful of legitimate merchants ever accepted Bitcoin. And as the Bitcoin bubble drove up transactions charges and waiting times, even this handful walked away.

For a while, Bitcoin was used for transactions that people wanted to keep secret from government authorities, like drug deals. It soon became apparent, however, that if authorities wanted to track these transactions, they could. For instance, Silk Road, the first major online drug market, which made use of Bitcoin, was shut down by the F.B.I. in 2013.

Hardly anyone now suggests that Bitcoin has value as a currency. Rather, the new claim is that Bitcoin is a “store of value” and that its price reflects its inherent scarcity. (By design, no more than 21 million Bitcoins can be created.)

Most economists, including me, dismiss this claim. And if the claim is false, Bitcoin’s value is obviously another deadly strike against the efficient market hypothesis.

But even if the claim is true, the idea that Bitcoin is valuable simply because people value it and because it is scarce should shake any remaining faith in the efficient market hypothesis.

Consider: If Bitcoin is a “store of value,” then asset prices are entirely arbitrary. As the proliferation of cryptocurrencies has shown, nothing is easier than creating a scarce asset. The same argument would apply to any existing financial assets. Any stock in the S & P 500 could be priced not in terms of future earnings prospects but on the basis that people choose to value it highly.

Suppose, more plausibly, that Bitcoin has no underlying value and will eventually become worthless. According to the efficient market hypothesis, financial markets will correctly estimate the true value of Bitcoin and will drive the price to zero immediately.

But that hasn’t happened either. Until recently, it wasn’t even possible because the Bitcoin markets were themselves as opaque as the currency.

Now it is possible: Futures trading for Bitcoin on the Chicago Mercantile Exchange has been going on since December. But Bitcoin prices rose after the creation of futures trading and began their sharp decline only when governments took measures to limit speculation.

Current futures contracts in Bitcoin extend as far as June of this year. According to those contract prices, the market expects Bitcoin to retain its value well into the future.

Whatever happens to Bitcoin, we must not lose sight of a more fundamental — and more worrisome — development: A financial product with a purely arbitrary value has been successfully introduced in the world’s most sophisticated financial markets.

Bitcoin probably won’t bring financial markets crashing down. But it shows that regulators need to cut those markets down to size.

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