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Watch out bitcoin — the ‘bad’ guys are rolling into town…

With the advent of a ‘futures’ market for bitcoin, the institutions that are about to join the bitcoin community are not evangelists for the technology. If anything, they’ll see their first clear opportunity to benefit from its downfall.

You might think of investing as a process of accumulating assets that you hope will go up in value and that a fall in the price of an asset is always and everywhere a bad outcome. Not so. Many investors specialise in and make billions every year from the value of assets falling — one way they do this is by using futures and they are about to get busy with bitcoin.

What is a “future”contract?

A future contract is a betting mechanism. It allows people to bet on the future price of an asset without owning it. For example, I think the value of your $500,000 house is going to fall in the coming year whereas you think its going to rise in value. We agree a bet between us to represent our differing views: wherever the value settles in a years time, whomever is on the wrong side of their view will pay the other an amount equal to the change in value from today’s $500,000. We agree to meet in a year’s time and close the bet based on its actual value. As it turns out, I was right — the house has fallen in value. We get the value independently assessed and the survey comes back with a value of $450,000 — you owe me $50,000.

I have made money by the fall in the price of an asset — in the business this is known as ‘shorting’ an asset. When you benefit from a rise in the price of an asset you are described as being ‘long’ that asset and the flip side of benefitting from a fall in its price is described as being ‘short’. You’re about to witness a lot of shorting behaviour in the bitcoin market.

There are futures markets for nearly every financial and commodity product you can think of — bonds, oil, wheat, gold — you name it. The kind of investors that are about to join the bitcoin market are not the ones that manage your pension. Your pension fund has rules that prevent it from engaging in purely ‘speculative’ investing, particularly by shorting assets. Hedge funds have no such boundaries.

We’re all bitcoin bulls, right?

The advent of the CME introducing a bitcoin future contract allows large financial institutions to participate in the market for bitcoin on a scale that the ‘physical’ bitcoin market does not allow. Having more players in the market is indeed a good thing but don’t assume they are all entering the bitcoin market to go ‘long’- the future contract will also allow them to go ‘short’.

They could be wrong of course and lose money as the price of bitcoin keeps rising. But if enough shorters start to push the ‘future’ price of bitcoin lower and the price of bitcoin itself begins to follow, it could trigger a vicious feedback loop where more shorting begets more selling of bitcoin. So far, the market has been dominated by players with a positive outlook on the bitcoin price — those with negative price views have not been able to participate.

Longer term this is a very healthy development for the asset class — having more players with a variety of views on its value is a good thing. But don’t assume that all the players are looking for the price to go up ….

[Disclaimer: this article does not constitute investment advice, a price forecast or a recommendation to invest. Investment decisions by readers have no recourse to the author.]