By Padraic McAtee (ME ‘19)
If you’ve ever had a casual conversation on the topic of cryptocurrency, statistics show it included: (1) a computer science major boasting three LinkedIn endorsements on their “blockchain” skills, (2) a person trapped in hindsight, who endlessly regrets not buying Bitcoin when it was still worth a cent, or (3) someone wishing they knew what was going on.
Despite our society’s collective “understanding” of Bitcoin, Ethereum and the like, there is still a contentious debate on a critical fact: whether or not cryptocurrencies hold any intrinsic value. On the topic of Bitcoin, Chairman and CEO of JPMorgan Chase, Jamie Dimon, recently stated “If you’re stupid enough to buy it, you’ll pay the price for it one day.” Dimon is among the many critics of non-fiat cryptocurrencies (fiat referring to currency with value backed by governments), who believe such currencies are only worth “what the other guy’ll pay for it.” Those who find value in cryptocurrency will often cite the underlying blockchain technology, with its benefits of anonymity and regulatory liberation as the source of its value.
No matter which side is right, there is still a lot of money to be made in crypto. Testament to this notion is Goldman Sach’s recent announcement intends to start a digital currency division in response to client demand, making it the first of the big banks to show considerable interest in crypto exchanges. Given that these currencies are traded nonstop with the daily global volume exceeding $11 billion last month, there are bound to be exploitable inefficiencies in the market that only large financial institutions can take advantage of. In this article, we discuss a few of these opportunities and how they may be acted on by big firms.
Many of the investment opportunities found in these markets are direct consequences of the activities of the majority of the user base. For instance, a sizeable amount of people simply buy Bitcoin under the assumption that the price will go up so that they may sell and take profit. This is an example of directional investing, where payoff relies on the price of the asset moving in a single direction.
Another significant group of users are those who use the currencies for purchases on darknet markets. These users find value in the anonymity of transactions using cryptocurrencies. Since the prices of the products/services they purchase on the darknet are often pegged to the US dollar, these market participants have little interest in the exchange rates of the currencies they use and will buy and sell in a manner suited for their darknet transactions.
Both of these groups tend to not care about the execution of their buy or sell orders; they are interested only in entering or exiting their position at roughly the quoted price. In this situation, bigger players can provide liquidity to the market, readily buying and selling inventory at the market demand to profit on the small spread between the bid and ask price at that moment. This sort of activity is known as market making, and it can only be done by large firms such as Goldman Sachs because they have the capital and expertise to turn a respectable profit on these small spreads.
Another opportunity comes about as the result of a widespread ignorance of how to short cryptocurrencies. The overwhelming consensus on the increase in price of cryptocurrencies means the potential profitability of short trades increases with every upward tick. However, the complex structure of cryptocurrencies as foreign exchange instruments makes the short trade more complex for the average investor. Only experienced market participants can take advantage of both sides of the trade, making money in any market condition.
It’ll be a while before we decide if cryptocurrencies hold any intrinsic value, but until then, there is no denying the profitability of the opportunities we have described. As the media-fueled hype train keeps on rollin’, other banks will certainly jump onboard as well. It’s difficult for these firms to ignore potential trading opportunities with news of one Bitcoin going for 10,500 USD on a Zimbabwean exchange (twice the world average price of around 5000 USD). Now before you try to open an account with the First Bank of Zimbabwe, there are many obstacles in the way (i.e. a flight to Zimbabwe) that only a Wall Street giant can overcome—and walk away in the black.