Every time Bitcoin (BTC-USD) price volatility spikes up, the defeatists appear predicting the demise of the cryptocurrency.
The most recent bout of volatility was caused by rumors Goldman Sachs was abandoning plans to develop a Bitcoin trading desk.
The cryptocurrency plummeted 6.8% from a high of 7388 on Wednesday, September 5th, only for Goldman Sachs to claim the report was fake news the next day. So why did BTC slide another 7 percent before the weekend?
The Goldman Sachs rumor triggered another canard. The media began speculating that the whales – the big money – are withdrawing from Bitcoin. If that was the case, with a Bitcoin market cap of only $100.5 billion, one would expect the waters to be much choppier. Yet even with the recent swoon, volatility is declining. 30-day historical Bitcoin volatility is 3.25 percent, down from 3.33 percent for the 120-day average, according to bitvol.info.
A number of market developments indicate that large investors are increasing rather than downsizing their exposure to cryptocurrencies.
The increase in Bitcoin futures activity is an indication that large traders are more active in the market. Hedge funds represent about 50 percent of activity and asset managers 5 percent, according to the CFTC Commitment of Traders Report.
Before the Goldman Sachs news Bitcoin futures traders were generally long Bitcoin. Although hedge funds, likely one fund, closed out contracts equal to 37 percent of the long open interest the day before the false news broke.
Average daily volume of 3,577 in CME Bitcoin futures in the second quarter of 2018, a 93 percent increase from the previous quarter, increased to 5,300 the last week of August. 5-day average volume in the tumultuous week of September was 4,559.
Zooming in on CBOE Bitcoin futures during the selloff, only a slight liquidation took place on September 5th, with a decline of about 1 percent in the 3902 in open interest. By Friday, open interest increased 5 percent on 4089 contracts. In other words, the whales were not swimming away but rather ended the week-long on Bitcoin.
Let’s Get Physical
Institutional investors are, in fact, only nibbling at the Bitcoin market. They are holding back while they await a physical market in Bitcoin. In August, Bitcoin futures volume rallied on the news that Bakkt, part of the Intercontinental Exchange (ICE), will launch a one-day physically delivered Bitcoin contract in November. Both Bitcoin CME and CBOE futures are cash settled. No doubt ICE, the operator of the world’s largest regulated exchanges from Singapore to New York, has the pulse of institutional investors’ cryptocurrency trading needs.
Off-exchange forward contracts—favored risk management tools of big investors—are also under development. Goldman says it is working on a Bitcoin derivatives forward product. This summer, broker E D & F Man Capital Markets and crypto exchange itBit arranged the first exchange-for-physical (EFP) transaction, exchanging a CME futures contract for underlying Bitcoin.
But where will traders store physical Bitcoin? Digital money does not require a vault like gold or warehouse like soybeans, but an offline cryptographically secure cold storage wallet is required. ICE is one of the existing providers of regulated custody, clearance and settlement services extending its services to Bitcoin. Coinbase Custody, Goldman Sachs, Bank of America, and itBit also have plans to provide crypto asset custody services for the Bitcoin retail and institutional markets.
As these custody and trading solutions are rolled out, the share of physical versus speculative trading in Bitcoin will increase. More trades backed by physical Bitcoin assets will significantly reduce volatility. Though like the fiat forex market about 90 percent of the turnover will likely remain speculative trading while the other 10 percent will involve hedging physical assets.
But dismissing Bitcoin as an object of speculative excess is short-sighted. As Bitcoin transaction processing increases, so too will the amount of trading related to productive economic activity. As a Blockchain platform for processing transaction, Bitcoin is being left in the dust. Numerous new Blockchains boasting speeds as high as one million a second are speeding past Bitcoin on speed and scalability performance.
With the development of sidechain technology, the Bitcoin blockchain does not itself have to upgrade to benefit from performance improvement. Transactions are processed at high volumes and speeds via a channel that opens on the sidechain. The transaction is then recorded on the main chain, maintaining the immutability, audibility and security advantages of the blockchain.
As payment gateways that accept Bitcoin upgrade, Bitcoin will benefit from the faster transaction velocity. CoinGate, for example, now has 4,000 merchants using the most popular sidechain the Lightning Network, and accepting Bitcoin. Bitcoin capacity on the Lightning Network has grown to 104.16 BTC ($660,421). Not only will the volume and price of Bitcoin increase with improved blockchain performance, but payment processing rather than speculative trading will represent more of the transactions.
Tether’s Part In The Virtual Gold Rush
All these developments will lead to lower Bitcoin volatility. High volatility is causing a rush into the least volatile coins. Indeed, Bitcoin is now competing directly with stable coins. Notably, as Bitcoin’s price declined on lower volume on September 5th and 6th, Tether’s volume and price spiked.
When a demand for Tether (USDT) is placed, Tether mints a coin and backs it with USD at a ratio of 1:1. Tether’s market cap has increased from $1.3 billion USD to 2.8 billion USD in 2018. Accordingly, Tether’s balance sheet currently shows it holds 2.8 billion in USD.
On September 7, daily trading volume in USDT was 2.9 billion USD.
After flirting with a trading volume of $2.8 billion USD on September 5, on September 6, daily trading volume in USDT spiked to 4.8 billion USD. All other coins were experiencing declines in volume and price.
The price spiked to 1.03 closing the week with higher average volatility but closer to its 1.00 trading range. Only in the euphoria of December and January has Tether’s price reached (and climbed past) 1.03. Meanwhile, the USDT/BTC pair climbed almost 16 percent Wednesday morning to 0.00015667 and remained in the 0.00015500 range for the rest of the week.
Closing out the dizzying week, Tether had a daily trading volume of $3.5 billion, second only to that of Bitcoin at $4.4 billion.
As the physical custody infrastructure develops and volatility declines, Bitcoin will play a more central role in risk management and diversification strategies. Bitcoin has a low correlation with major securities including stocks, bonds, and commodities (e.g., oil, gold). Crucially, Bitcoin has the liquidity while other coins are trying to build trading volume.
Elon is an investment writer whose articles on the foreign exchange and cryptocurrency markets have been widely published.