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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.

Bitcoin, like many commodities, has been “financialized.” 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.

For many, the easiest way to invest in Bitcoin is to use a financial institution like Coinbase. This transaction is easy, in part, because Coinbase does not sell you a Bitcoin. Instead, Coinbase issues you a liability denominated in bitcoins and backs its liabilities with (bulk) transactions of bitcoins on the blockchain. The tradeoff for the convenience of the transaction (and security) is the risk you bear from the institution. This is analogous to “money” you keep in the bank which is dollar-denominated bank-issued liabilities whose safety depends on the health of the bank and regulation; your money is not dollars in a vault somewhere.



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.

Why financialization matters

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.

So, what do financialization and the growing role played by centralized cryptocurrency exchanges mean for everyday investors? It means it is easier to invest in Bitcoin without owning Bitcoin directly. Exactly what this means for your portfolio is a much harder question.

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