The Bithumb Blog
Published in

The Bithumb Blog

Wag-the-dog in the Bitcoin market

In the stock market, the expression “Tail is wagging the dog” refers to when derivative products such as futures and options become so influential as to drive the price of the underlying stock up and down.

In today’s stock market, futures and options are so highly developed, and wag-the-dog phenomenon occurs quite often in fact. A futures transaction is the trading of a stock at a predetermined future date and price (generally 1 month after) instead of at the current stock price. For such transactions, stock price speculations by investors are bound to be different, and such differences give rise to arbitrage.

For example, let’s say that the current price of a stock is 10,000 won, and the futures market forecasts the price to rise to 12,000 won in a month. Under such a circumstance, if the price of a futures product jumps to 15,000 won, some investors will think that the price became too high, so they will sell this product and buy a relatively cheaper one. Such arbitrage trading will bring the stock price up and the futures price down, maintaining a certain level of price difference. In other words, undervaluation and overvaluation in the futures market can move the underlying stock price.

In contrast to this, the Bitcoin market has rarely experienced the wag-the-dog phenomenon. This is because the Bitcoin price has been mainly affected by big players called “whales” and Bitcoin miners and also because the Bitcoin futures market has been relatively too small to move the spot market.

However, since the giant Chicago Mercantile Exchange (CME)’s entering into the Bitcoin futures market, which had only included a few global cryptocurrency exchanges, the market has been growing exponentially. The Bitcoin futures market grew from about 6 billion dollars in 2017 to as much as about 1.8 trillion dollars now. Currently, Bitcoin futures products are being traded four to five times more expensively than spot trading.

After a period of steep price fall, Bitcoin is struggling to rebound and seems unable to break the line of resistance formed between 38,000 and 40,000 dollars. Behind this are “outflow of institutional investors from the Bitcoin market” and “concerns over additional regulatory restrictions” as well as the increased selling of Bitcoin futures.

While the Bitcoin price continued to fall starting in May, Chinese authorities imposed a clampdown on domestic Bitcoin mining. This brought down the difficulty of Bitcoin mining considerably. Bitcoin mining difficulty is represented by the concept called hashrate. Hashrate is the total combined computational power used to mine Bitcoin in a network. The higher the hashrate, the more difficult Bitcoin mining is. And a lower hashrate means that Bitcoin mining is that much easier.

Because of this, it has been generally agreed that once hashrate hits the bottom, the Bitcoin price will bottom out as well and then rebound. Nevertheless, while hashrate continues to fall recently, the Bitcoin price is still struggling to bounce back. The Bitcoin analyst Timothy Peterson recently declared on his Twitter that the existing model that says lowering of mining difficulty will bring up the Bitcoin price is flawed.

Bitcoin futures played a determining role in breaking the correlation between hashrate and the Bitcoin price. To see how much more expensively Bitcoin futures are traded than spot Bitcoins, you can see the funding rate. Funding rate is calculated based on the rate of funding interest paid to exchanges to buy futures and the premium attached to the futures price. Generally, a higher funding rate means that the futures price is overvalued with a high purchase demand, and a lower funding rate means the opposite.

Recently, the funding rate is going down because an increasing number of investors are becoming pessimistic about Bitcoin. This increase in selling of Bitcoin futures is causing the investors’ confidence to shrink in the Bitcoin market. Also, as Bitcoin futures are being relatively undervalued, more investors are selling spot Bitcoins for arbitrage profit. In fact, an increasing number of investors are selling Bitcoins for profit whenever the spot price rises. To put it another way, the tail is wagging the dog.

However, such a phenomenon is apt to occur anytime in a market with growing derivatives and does not last forever. If the price gap between Bitcoin futures and spot products narrow and some favorable factors calm the speculative selling of futures, the situation can change. Bitcoin has been going sideways for long, but this may not be due to a structural problem but only a temporary result of the growth of the derivatives market. Right now, it is important to prepare for future changes in the market.

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
bithumb_official

bithumb_official

Official Medium account of Bithumb, No.1 Digital Asset Platform based in Korea. https://en.bithumb.com/