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Bears target ways to bet on cryptocurrency mania imploding

At the peak of the South Sea Bubble three centuries ago, a wag famously poked fun at the craze by issuing a prospectus for “a company for carrying out an undertaking of great advantage, but nobody to know what it is”. Cryptocurrency mania has now arguably reached the same stage.

This summer an unknown software developer launched what he termed the “Useless Ethereum Token”, an “initial coin offering” of a variant of a cryptocurrency whose popularity rivals that of the more famous bitcoin.

But this was the “world’s first 100 per cent honest” ICO, he promised, and was admirably transparent about its purpose.

“You’re literally giving your money to someone on the internet and getting completely useless tokens in return,” he wrote on the UET website. “There are no ‘whitepapers’, no ‘products’, and no ‘experts’. It’s just you, me, your hard-earned Ether, and my shopping list.” The ICO raised more than $200,000, according to the backer.

Underscoring the sense that the cryptocurrency mania is reaching frenzied proportions, Paris Hilton, a celebrity heiress known for trademarking her catchphrase “that’s hot”, jumped on the bandwagon and told her followers to check out the latest cryptocurrency offering, LydianCoin. Many investors are unimpressed.

“In my view, the mania for raising funding via the blockchain has all the aspects of a classic bubble, including a lot of schemes that would make the original South Sea Bubble operators blush,” Mark Tinker, a fund manager at Axa Investment Managers, said in an email to his clients.

But the question for investors who fancy betting on the mania imploding is how exactly to “short” the various digital currencies?

Bitcoin and other cryptocurrencies have recovered some of the losses that came after a Chinese ban on ICOs, which are roughly equivalent to an unregulated corporate share offering, but some investors want to profit from what many think is an inevitable crash.

Typically, when fund managers go short, they borrow a stock or a bond from another investor, sell it to someone else at the prevailing price, and hope that the price of buying it back at a later date to return to the original lender is lower. If it has fallen then they can pocket the difference.

But with bitcoin, ethereum, ripple and more esoteric cryptocurrencies like “titcoin” and “potcoin”, designed for purchases in the porn and cannabis industries, respectively, or outright jokes like dogecoin, which was based on an internet meme of an adorable Japanese dog, it is more complicated.

Bitcoin, the biggest and most easily traded of the cryptocurrencies — its two versions account for $86bn of the $163bn total value of cryptocurrencies, according to Coinmarketcap.com — can be borrowed and sold on platforms like Kraken or Bitfinex.

But it is extremely expensive to do so and plenty of collateral is required. At times of high demand and bitcoin shortages, the cost can rise to as much as 1 per cent a day, according to Alistair Milne, a portfolio manager at the Altana Digital Currency Fund, a cryptocurrency-focused hedge fund. For much of the rest of the cryptocurrency universe, it is nearly impossible.

Derivatives are another popular way of betting on securities declining in value, but in the case of cryptocurrencies, there are currently no futures or options to do so on a regulated exchange.

A San Francisco-based bitcoin options trading platform called Coinflip was shut down by the Commodity Futures Trading Commission in 2015, after failing to register with the US regulator.

But trading derivatives through unregulated platforms is something that few serious investors would contemplate. “It’s the wild west,” points out Francisco Blanch, an analyst at Bank of America Merrill Lynch.

So for investors looking to bet against bitcoin, alternatives like the bitcoin Investment Trust, a US-listed fund that owns over 170,000 bitcoins, or Nvidia, a chipmaker whose products are immensely popular with bitcoin miners, might make the most attractive alternative.

Nvidia made about $130m just from ethereum-mining chip sales in the second quarter, Morgan Stanley notes, and the company already trades at about 40 times its forward-looking earnings.

But changes are afoot that could make shorting the crypto craze much easier. The Chicago Board Options Exchange, the biggest US options exchange, said earlier this summer that it planned to offer bitcoin futures later this year or early 2018, while LedgerX received CFTC approval to clear derivatives. This paves the way for the platform to offer options on bitcoin and other cryptocurrencies.

When these bitcoin derivatives start trading, it will finally offer investors a clean and efficient way to both bet on the leading cryptocurrency climbing higher or sagging lower.

This will help two-way price discovery and improve the market, according to Mr Milne. “Ultimately the more liquidity there is, the more volatility will fall, reducing costs all round,” he says.

However, given that trading has thus far been overwhelmingly one-way traffic, Mr Blanch expects the emergence of a clean shorting avenue to weigh on the cryptocurrency market’s ebullience.

“Is it truly digital gold, or a highly inflated asset? We don’t know now, but we will soon,” he says. “When people realise the potential scale of the shorts that will build up, they will probably get nervous.”