A key idea in derivatives is no-arbitrage pricing. Let’s say that the price of some metal is $100 today, and you think it will be $300 in three months. What should be the price of a futures contract on that metal with delivery in three months? The wrong answer is $300. Let’s say you bid $300 for that contract. I will sell you that contract. I will buy the metal for $100 today. I will put it in my garage. In three months, I will deliver the metal to you, and you will pay me $300. I have made $200 of free money.
I mean, not free, I had to use some space in my garage. In practice the futures price will differ from the spot price for various reasons (interest rates, storage costs, etc.). But none of those reasons, generally, are “I think the price will be higher in the future.” If you think the price will be higher in the future, you can buy it now, and wait.
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What if you are extremely confident that the price of Bitcoin will be $1 million in three months? Here are some trades you should not do:
- Pay $1 million to buy a Bitcoin today, since it’ll be worth $1 million in three months.
- Pay $1 million for a futures contract to buy a Bitcoin in three months, since that’s where the price will be when the contract settles.
- Absolutely any variant on this trade that involves you paying $1 million for a Bitcoin.
Here are some trades you could rationally do:
- Pay $1 million to buy 35 Bitcoins today.
- Enter into futures contracts to buy 35 Bitcoins for $1 million in three months.
I just cannot emphasize enough how much better it is to buy 35 Bitcoins for $1 million than to buy one Bitcoin for $1 million. It is 35 times better. There is absolutely no state of the world where paying $1 million for a Bitcoin today is better for you than paying $1 million for 35 Bitcoins today. “I am confident that Bitcoin will go to $1 million”: Fine, great, buy 35 of them. “I am confident it will go to $10 million”: Still, buy 35. “I am confident that the US dollar will be worthless in 90 days and the only value left will be in Bitcoin”: Okay but then you’ll be much happier with 35 Bitcoin.
On Friday, tech Twitter guy Balaji Srinivasan entered into a Twitter bet in which he bet $1 million against 1 Bitcoin that Bitcoin would be worth more than $1 million in 90 days. Noah Smith explains the bet here. If a Bitcoin is worth more than $1 million, Srinivasan wins one Bitcoin, which in this scenario is worth $1 million. If a Bitcoin is worth less than $1 million, Srinivasan loses $1 million, which in this scenario is worth, you know, (1) $1 million and (2) more than a Bitcoin. In every scenario, Srinivasan is strictly much worse off than if he had just bought 35 Bitcoins today.
What? There are three possible explanations here:
- He is kidding and not actually going to do this.
- He is deeply confused about how money works.
- He does know that this trade is economically irrational, but he is doing it to draw attention to himself and to Bitcoin, and to get other people to buy Bitcoin as a hedge to the societal collapse that he is promising, because he already owns a lot of Bitcoin and would like the price of Bitcoin to go up.
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Explanation 3 seems like the most plausible? Srinivasan himself went on a Twitter Spaces on Saturday and said well, look, everyone is pointing out that this trade makes no sense and I should just buy Bitcoin, but “I’m doing it to ring the fire alarm” and to “put out the bit signal.” He’s doing it to draw attention to Bitcoin and get people to buy it. “Hyperbitcoinization may come at you fast, so don’t wait on us to get Bitcoin,” he tweeted, in a thread about the bet.
Is … that … uh … weird? The US Commodity Futures Trading Commission regulates trading in Bitcoin derivatives, and this bet is, among other things, a Bitcoin derivative. And my impression is that US regulators do not like it when people knowingly enter into uneconomic derivative contracts with the goal of drawing attention and driving up the price of the underlying commodity. We have talked, for instance, about the case against Bill Hwang, who is accused of market manipulation because he kept buying swaps on stocks at prices higher than the market price, or about the CFTC’s case against Don Wilson (which the CFTC lost), accusing him of bidding for futures contracts at the prices he thought they were worth rather than at the market price. If you think that Bitcoin should be worth $1 million and you buy it for $26,000, that’s an economic trade. If you think that Bitcoin should be worth $1 million and you noisily buy it for $1 million, that’s arguably something else.
