Hedge funds and the Bitcoin bubble

The first surprising hedge fund play of 2014 has emerged not in an established stock or commodity, but in the emerging digital payment platform known as Bitcoin.  While purists insist it is neither a currency nor a commodity, there’s no denying the growing popularity of Bitcoin.  The digital unit of stored value is attracting more and more interest from a wide array of individuals seeking an alternative to fiat currencies.  Now it seems that even major financial institutions are set to enter the fray.

As with any speculative medium, it was only a matter of time before hedge funds jumped on board the Bitcoin phenomenon.  According to a Bloomberg report, a San Francisco-based hedge fund is looking for a junior Bitcoin trader.  As one reporter put it, “Where big money is, hedge funds go as well.”

The Bitcoin protocol will undoubtedly attract more interest from hedge funds, which in turn will push its value higher.  As an analyst interviewed by Bloomberg pointed out, “Huge price fluctuations is exactly what [hedge funds] are looking for.  [They] love nothing more than mad volatility, and that’s exactly what you’ve seen in Bitcoin.”  And as we’ve seen in all too many cases, when hedge funds commit their capital to anything that’s already in an established uptrend, it can only succeed in generating additional upside momentum. 

Analysts have noted the lack of liquidity in the Bitcoin market and have suggested this as a reason why a bubble may not grow to gargantuan proportions.  Conventional trades in Bitcoin aren’t possible at this time due to the extremely slow transactions times, but that will likely soon change with Wall Street’s increasing presence in the market.  Hedge fund managers are momentum specialists who not only thrive on upward trending markets, but who can collectively create a manifold increase in momentum in the markets they focus on. 

Consider for instance the presence of hedge funds in certain individual China stocks.  You’ll recall the bubble in U.S.-listed China stocks from a few years ago.  While many of these stocks have since deflated, there are still to be found a few conspicuous examples of the active influence of hedge fund managers.  At the time the hedge funds took speculative positions in certain low-priced China shares, these stocks were highly illiquid.  Sometimes two or three days would go by without a single transaction being made in them.  Yet this didn’t deter the “hedgies” from taking a large stake in them. 

Two examples that come to mind are Ping An Insurance Group Co. (PNGAY) and the U.S. listed version of Agricultural Bank of China (ACGBY), both of which are known to be heavily owned by hedge funds.  To this day, despite China stocks being in a bear market, PNGAY has not only seen increased liquidity due to hedge fund presence, but the stock recently experienced a run-up that can only be attributed to hedge fund-created momentum.  Note the follow chart which shows PNGAY’s price trend in relation to the sagging Shanghai Composite Index, the main benchmark for Chinese stocks.  After experiencing a “blow off” top in November-December, PNGAY has since sagged.  Yet the heavy trading volume and upside momentum of recent months is testament to the power of hedge fund speculative activity in a historically illiquid market.

From the above example we can learn an unmistakable lesson, namely that hedge fund presence in Bitcoin is a double-edge sword.  While it will only serve to attract more attention toward the emerging virtual currency and eventually increase its liquidity, it will also create ever-increasing price gyrations.  This will defeat the goal of Bitcoin’s stability vis-à-vis the dollar that many of its exponents had hoped for.  In short, the early appearance of hedge funds in the Bitcoin market virtually assures the expansion of a massive bubble – and its eventual implosion.