In the Mt. Gox aftermath, it’s worth examining the Bitcoin market. I disagree with those that think the Mt. Gox meltdown is “good” because it is cleansing. Failure isn’t ever good-it’s tolerated because without it progress isn’t made. But shrugging shoulders and adopting an Alfred E. Neumann attitude is not correct.
One of the things to look at is if Bitcoin can even develop a market. In order for a market to develop, and the subsequent ancillary markets of options, futures and swaps, there need to be natural shorts and natural longs. There need to be enough of them so the market is highly fragmented. Vertical integration kills markets. Look at the difference between the market for poultry and beef for example. Impossible to have a big market in poultry because of the vertical integration. Two or three players dominate poultry.
One of the things to look for are natural longs and natural shorts. They automatically gravitate to a market place because it’s beneficial for them. For example, in wheat, food processors are natural longs and farmers are natural shorts. Who are the natural players in the Bitcoin market?
Who are the natural longs?
There are a lot of natural longs in the Bitcoin market right now. That explains a lot of the resilience. It’s new, and there is enough money that desires Bitcoin so they buy on dips. Fred Wilson said, “I like to buy when there is blood in the water.”. Warren Buffett followed the same strategy in 2008 to great success. Sometimes buying when there is blood in the water works well. Sometimes it’s catching a falling knife.
As Bitcoin gets more exposure, and more people find out about it, the natural longs increase. This explains the statement, “tulip bulb mania”. It’s not tulip bulb mania, but it is just the market adopting Bitcoin. Every new product goes through cycles, and we are going into the early adopter phase of Bitcoin.
Speculators are also currently natural longs. Buysellbuysellbuysellbuysellbuysell. Speculators are good for markets. They are grease that help it move. Momentum is in favor of the upside, and shorting Bitcoin is suicidal. Kind of like being short the stock market ahead of a Federal Reserve chairperson speech. But remember, speculators can change on a dime. They are not beholden to anything.
Those are the only true longs I can think of. Perhaps people could add more in the comments.
Who are the natural shorts?
Miners are natural shorts. How many of them are there? Mining is highly competitive. But, do they collude, can they collude and are there enough of them to break any incentive to collude? They have a clear economic incentive to keep the market higher in order to sell into it.
Merchants could be natural shorts. In order to accept and hold Bitcoin, they need to be able to sell it to transfer it to goods, services or another currency.
Speculators could become natural shorts. Especially as the market developed. Once there were contracts on the typical calendar of March, June, September, and December, speculators could spread and add shorts in order to roll positions.
Governments, Banks and other institutions that were similar could be natural shorts. They have risk in holding Bitcoin in their account, and need to hedge their risk.
I don’t see a lot of other natural shorts out there. Perhaps people could add some in the comments.
As I look at the natural short base, the one that could become really strong is the merchant/business class. There just aren’t enough of them in the market to counteract demand, which explains the strength of the Bitcoin market. If situations like Mt. Gox continue to occur, it will shake out a lot of the demand, breaking the resiliency. More Mt. Gox experiences will also delay the adoption, or even kill the adoption of technology like Bitcoin.
The volatility in the Bitcoin market is purely the result of low liquidity and lack of vehicles to lay off risk. There just isn’t enough volume to absorb shocks when they happen. The market is pretty puny compared to other markets out there. Participants assume 100% of the price risk when holding Bitcoin. It’s like standing on a cliff with one foot over the ledge and the earth vibrating. One false move and you better hope you can land on another cliff.
Second Market announced they were launching a Bitcoin exchange. They have experience trading illiquid stock. Hopefully those lessons will guide them in Bitcoin. But, Bitcoin is a different animal than Groupon ($GRPN) or Facebook ($FB) shares prior to IPO. Shares in a pre-IPO company have a limited life, and limited market size. That is not true with Bitcoin.