The financialization of cryptocurrencies

What does it mean to “own a Bitcoin?” It means there is a recorded transaction on the Bitcoin blockchain where someone sent one Bitcoin to your public key address and that you (and you alone) know the address’s private key. Even if that terse description explains things, it does not help with the logistic details of how you go about doing this. It is complicated. But it is also complicated to physically buy and hold a bar of gold or a barrel of oil. You could make it happen, but it is work.

Bitcoin, like many commodities, has been “Financialzed.” There are now financial contracts you can buy and trade that might be just as good as (or better than) having an entry on the Bitcoin blockchain. What do financialization and the growing role played by centralized cryptocurrency exchanges mean for everyday investors?

Investing in Bitcoin by directly owning a Bitcoin on the blockchain creates a long position that appreciates as the value of Bitcoin (in US dollars, say) increases. If you owned a coin, you could sell it. There is no mechanism inherent to Bitcoin’s blockchain that allows you to create a short position — just like you cannot sell a physical bar of gold you do not have. Financialization facilitates the adoption of long positions and makes the adoption of short positions feasible.

The “how” of financialization matters?

Designing a financial instrument involves many choices. Exchange-traded financial contracts for typical commodities like oil are standardized. Some of these contracts, such as many oil contracts, are settled physically requiring physical delivery of an exact type of oil to an exact location. Other contracts are settled financially where instead of oil you receive the cash equivalent of a barrel of oil measured from some index price.

The participants of cryptocurrency exchanges include small and large retail investors, traditional institutional investors, and funds specializing only in cryptocurrency. This is an unusual mix for a derivative market. Our data show occasional large transfers among these traders and specifically from small accounts to large accounts.

Financialization changes the way people can invest in Bitcoin. The impact of financialization on the price of Bitcoin is less obvious. Making it easier to buy bitcoins increases demand, but exchanges that facilitate “short’’ contracts let pessimists express their views. More subtly, financialization may change the way people use Bitcoin. For example, Tesla’s ability and desire to accept Bitcoin for payment may be enhanced by the ability to hedge price fluctuations on an exchange. Conversely, the high leverage in some cryptocurrency exchange markets may create instability cycles where volatility in cryptocurrency prices dive which drives further volatility.

We hope you have found this article informative and interesting. For more information or queries contact us to know more about this technology.

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