Monday, December 9, 2013

Derivative Securities--The Surprising Case of Bitcoin

 I have to confess that I don't quite understand the animosity that many of my chums on the left bear towards exotic financial instruments and the people who trade them. So in lieu of second-guessing their motives, I'll stick to sharing my own distaste as the very first Bitcoin options become available.

The good: derivative instruments are, once you strip away the fancy flavors they come in, a way of pricing today an exchange that will happen tomorrow. All the short sales, the margin calls, the uncovered puts, the mortgage-backed securities, all the American-style options, all the butterfly spreads, all these things are just traders making substantive (read, they put their own assets at risk) predictions about a future state of the world. And the folks trading with them, i.e. producers of real stuff like iron ore or Coca Cola get the benefit of predictable prices and operating capital. I'm not sure that even in my particular bombastic style that I could overstate the value of knowing ahead of time what the price of the asparagus you're growing is. Could you imagine applying for a fertilizer loan and when the loan officer asks you what the price of your crop will be come harvest time in August, the best you can do is a non-committal shrug? Prices are information. They tell consumers what to buy, but most importantly here, they tell producers what to make, and derivative markets tell them what to make months, even years in advance. I don't want to oversell the idea, but without a thick, active market in futures, it's pretty hard to imagine modern industrial production being as nimble and responsive as it is.

The bad: options pricing is broken. Badly. As in, it's based on ludicrous assumptions about the underlying distributions, and even if there were an easy way to correct for the excess kurtosis, there is no way in bloody hell to correct for non-ergodic events. I won't wax eloquent on this. Read here for more. Update, via AG, here. There's a fun question in there about the role of heuristics in different time windows and across changing states of the world, but it's a discussion better suited to its own topic. Maybe on my other blog.

The ugly: witness reader, Deirdre McCloskey spends plenty of ink and sweat explaining the complementary nature of faith and hope in her Bourgeois Virtues series. Faith looks back, counting on promises made to be honored, compacts to be respected, stable Markov chains to remain stable. Hope looks to the future, it is buoyed by faith, but not defined by it. And importantly, it is tempered by prudence. The ugly happens when hope catches a nasty case of distemper, when traders obtain the perverse faith that should they fail, taxpayers will foot the bill for their imprudence. And they have that faith now thanks to 2B2F. As much as this is an embarrassment to the principles of democracy, it undermines good sense and breaches the trust constituents ought retain for their servants in Congress. Bailouts in an ergodic world are bad enough, but in a non-ergodic world, they are horribly pernicious.

Of Bitcoin options, then. Is it euvoluntary to buy a butterfly spread in BTC? Consider the moral intuition.

Conventional ownership? Well, this is the sticky wicket right off the bat. Bitcoin is novel, which makes it weird. It's volatile, which makes it untrustworthy (though being skeptical about options sales which serve to smooth price noise is kind of strange). It's also tarnished by its association with smugglers (and don't let my fondness for the smuggling profession fool you, most folks aren't fond of traders in contraband), which makes it sketchy.

Conventional exchange? The way the underlying asset is traded is "unconventional" in the way your typical citizen might think of money exchanges (and I'm putting one toe in the pot already by calling BTC money), but I think the average person imagines what happens on a trading floor is pretty close to sorcery anyway, so the peculiar protocols that govern BTC exchanges are just another one of the fancy-schmancy ways value changes hands. I don't think the moral intuition is offended by the exchange mechanism per se, though don't ignore the smuggling connection. Folks who traffic in drug sales and prostitution using BTC as a medium can't help but taint the currency in the process.

Coercion by force? No

Coercion by circumstance? BTC doesn't change hands out of desperation, and I think the stereotypical trader is portrayed as a technobrat. Single moms and dudes in the desert aren't part of the equation.

Regret? See "the ugly" above.

Uncompensated Externalities? ibid. The only externalities here are the ones hewn by damnably irresponsible legislators and regulators. But the worm that won't turn in my head is whether or not to apply the bailout heuristics to BTC derivatives. Yeah, we've got the embarrassing precedent of LTCM and Citigroup and all that, but are the "whales" that Andrew references in the tweet above powerful enough to capsize whatever prudence the FTC has managed to cobble together since 2008? I'm not in the game close enough to be able to answer that. I'd default to saying "no", but my prior here isn't particularly strong.

So are BTC options euvoluntary? Maybe not, but it seems to me that the correct response to the uncertainty is to just stay the hell away unless you're betting with money you can afford to lose or you have a really really good grip on the contours of the market. My unsolicited, worthless advice? You can't lose a game you're not playing.


  1. Hi Samuel,

    My concern with the introduction of such derivatives at this point is based on the considerable size of bitcoin holdings by a very small handful of the earliest adopter/users since it's inception. Although the bitcoin protocol has been around since 09 it only quite recently that it has been receiving mainstream attention. Even with this attention the number of users/holder of bitcoins is low by my estimation and lower yet for those that are playing with them in the markets. Given the astronomical size of holdings that some characters undoubtedly have (and this could pose as a problem for bitcoin for the rest of its foreseeable future ) manipulation of the price is a reality, with or without/alongside the presence of a derivatives market.

    What is your take on this? Would the introduction of derivatives lessen any potential influence by those that may essentially have the markets naturally cornered? Is it too early for such derivatives to be beneficial for price finding?


    1. Well, there's really two questions there, one a priori, the other empirical. The a priori question relates to justice: should big players be restrained from harming others. In this case, it's difficult to see in what sense harm is externalized here. My heuristic is a big-stakes poker game in Vegas; no one has to play, but those that do should know what they're getting into. And most importantly, the house is remiss if it ends up compensating losers.

      The empirical case is whether or not whales would be able to successfully bilk the little fish. There's some experimental literature on this, but it's hard to say ex ante how well this literature applies. These aren't randomly assigned university students.

      And as a final note, the cautious small investor has options positions to write that explicitly remove volatility risks and nothing else. Attempts by bigger investors to move the market can end up in their favor. That's the nature of a butterfly spread.

  2. It is well known in the stock market circles that “Derivatives” is a high risk investment option which thrives on the expectations of investors on how the share prices move in the coming days.


Do you have suggestions on where we could find more examples of this phenomenon?