Bitcoin reached an important milestone last December. That’s when the digital currency made its debut on the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) after months of furious debate over its intrinsic worth.
Louis Gagnon, a professor and distinguished faculty fellow of finance at Queen’s University’s Smith School of Business in Kingston, was among those watching the marketplace closely as a flood of early optimism among bitcoin investors led to soaring prices but also concerns of a bubble.
Dr. Gagnon’s interest was driven by an expectation of academic rather than financial returns. He saw bitcoin’s emergence on the futures exchanges as a real-life test of his most recent research work, published in The Financial Review.
Drawing on data from 1,300 single stock futures on the OneChicago futures exchange between 2003 and 2009, Dr. Gagnon tested the theory that single stock futures introductions put downward pressure on the price of their underlying stocks, reducing their degree of “overpricing” in the process, and they relax short-sale constraints facing these stocks.
In the stock or bond market, those who believe an asset is overpriced can “borrow” the asset and “sell it short,” thereby pushing down its price — as if bringing more supply into the market artificially, says Dr. Gagnon.
But when you buy or sell a commodity or stock in the futures market, you’re not actually acquiring or unloading the commodity or stock certificate; you’re simply agreeing to buy or sell the stock on a certain date in the future, at a price fixed today.
If you think the stock price will rise a few months from now, you can take a long position. If you think the price will fall, you can go short.
“Futures markets give market participants the ability to manage unwanted risk,” he says. “You can actually take positions in the futures market that will eliminate the exposures that you may sustain in your portfolios, and you can also use it to express your views about the price of the market.”
So, what does all that mean for bitcoin?
Dr. Gagnon’s research predicted that bitcoin would drop in price as soon the futures contracts began to trade — and that is exactly what happened. Here’s why:
Before bitcoin made its debut on CBOE and CME last December, the price was driven by bullish investors buying the digital currency. When that happens, says Dr. Gagnon, “prices have nowhere to go but up.”
The futures markets opened the door to more suppliers, increasing supply beyond what already exists in the bitcoin marketplace, and allowing people who don’t already own bitcoin to place their own bets against the digital currency.
The result is a cooling of prices in a heated environment.
“This seems like a healthy thing to do with any kind of asset, particularly a currency. It seems like you want to encourage that,” says Dr. Gagnon, who believes futures markets should be encouraged.
There are plenty of people who don’t agree. Still stinging from the 2008 global economic crisis, many people believe the exchanges “create an opening for speculators to come in and drive prices too high or too low, and disrupt markets,” says Dr. Gagnon.
“This paper actually exposes the positive side of these markets.”
Story ideas related to business school research in Canada can be sent to firstname.lastname@example.org.