Rule Change Bad News for Bitcoin Prices
In a significant development for Bitcoin prices, exchange giants BTCChina Limited (BTCC), OKCoin, and Huobi quietly revised their margin lending practices late last week. Although BTCC was the only one to issue a formal comment, traders reported that margin lending was no longer available at Huobi, the world’s third-largest Bitcoin exchange.
According to CoinDesk, the CEO of BTCChina, Bobby Lee, acknowledged that changes to the exchange’s service were being made in response to interactions with the People’s Bank of China (PBoC) and that the move came after BTCC received “Informal guidance” from the PBoC, which has been more actively engaged in Bitcoin exchange affairs since the beginning of the year. (Source: “China’s Bitcoin Exchanges Quietly Made Policy Updates Overnight,” CoinDesk, January 13, 2017.)
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While limiting margin lending (thus boosting collateral requirements) will likely dampen market demand and exacerbate existing margin selling in the short run, some analysts view this restriction as a long-term positive.
Historically, restrictions on margin lending in equity markets can be traced back to the U.S. Federal Reserve in 1934. Regulators were eager to curtail the unbridled speculation fueling the 1920s stock market bubble and subsequent crash, which brought about the Great Depression. By January 1934, The Dow Jones Industrial Average (DJIA) had almost tripled off its crash bottom, prompting the Federal Reserve to act.
The Fed subsequently introduced “Regulation T” requirements to the Securities Exchange Act of 1934, with the goal of curbing excessive leverage and stock market volatility. Coincidentally or not, this is exactly what happened over the course of the next decade, down to historic lows by the end of World War II.
Subsequent research by John Kenneth Galbraith in 1955 linking the 1929 Great Crash with unlimited leverage, and Jules T. Bogen and Herman E. Krooss’s 1960 theory on pyramiding and de-pyramiding provided early evidence that leverage and volatility correlation really existed. (Source: “The Impact of Margin Trading on Volatility of Stock Market: Evidence from SSE 50 Index,” Scientific Research, September 29, 2016.)
While ensuing research hasn’t been as clear-cut, adjusting margin levels continues to be a favorite tactic by large exchanges—like the Chicago Mercantile Exchange (CME)—to curb excess speculation.
One such example occurred in the Silver Future Contract in 2011. In an attempt to cool the market, which had almost doubled in price in the prior three months alone, the CME increased its margin requirements by a whopping 84% in a two-week period in April. To put that into perspective, the margin on one silver futures contract (the amount of cash that traders were required to hold in their accounts on overnight positions) rose from $8,700 to $16,000 during that time.
Suffice it to say, this left traders scrambling to cover the margin shortfalls, leading them to dump positions they couldn’t collateralize in short order. The market proceeded to sell off 28% in about a week.
Although we cannot say that Silver 2011 volatility decreased in the short term, the price surely did. This same dynamic is likely occurring at the present moment with Bitcoin: continued higher prices lead to more investor interest and margin buying, pushing prices ever higher. Now that Bitcoin exchanges have largely withdrawn margin lending, people have dumped positions that they can no longer afford to carry. The virtuous cycle is complete.
Looking ahead, the margin lending crackdown should be a boon for Bitcoin prices over the long haul, curbing excess speculation from occurring in the first place. This, in turn, should inhibit the massive momentum shifts of volatility which sent Bitcoin soaring, as well as its inevitable bubble sell-offs. Greater price stability should enhance Bitcoin’s profile as a legitimate holding currency, much to the delight of investors. This is a key hurdle to overcome for such legitimacy to be achieved.
