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During December Bitcoin prices shot up to $20,000, increasing twenty-fold this past year. This triggered rumors of the Bitcoin Mania possibly surpassing the Tulip Mania-- which spread across the world-wide-web with a mixture of fear and excitement.
Bitcoin’s 100 percent price surge during the first three weeks of December agitated regulators in Asia Pacific, since Japan, South Korea and Vietnam together accounted for 80 percent of Bitcoin trading activity. Japan's central bank chief described it as "abnormal." Denmark’s central bank chief took it up a notch, by calling it “deadly.”
The central bank chiefs of US, Australia and the Turkish deputy prime minister were a bit more diplomatic, characterizing it as "highly speculative.” The central bank chiefs of the United Arab Emirates and Saudi Arabia ignored it, instead kept their focus on testing a new digital currency built on Blockchain technology, for use in cross-border payments. Regulators in Venezuela, Zimbabwe and Nigeria welcomed it as a savior to their highly dysfunctional economies.
The diverse reactions of investors and regulators to Bitcoin’s price spike were irreconcilable.
Behavioral economics
This phenomenon was best explained by 2017 Nobel Prize winner economist Richard H. Thaler, who by integrating economics with psychology, explored the impact of limited rationality, social preferences, and lack of self-control on individual economic decision making. During his cameo appearance in the Oscar-winning credit crisis movie, “The Big Short (2015)”— sitting at a blackjack table in Las Vegas next to beautiful pop star Selena Gomez, Thaler – encouraged by the stacks of casino tokens at his disposal-- explained that a “classic error” investors make, is the hot-hand fallacy “thinking whatever is happening now is going to continue to happen in the future.”
Therefore when Bitcoin’s price flash crashed on Dec. 22, all the way down to $11,970, losing more than 30 percent of its value in a day, those investors who had developed a hot-hand fallacy regarding Bitcoin’s upward price surge, began selling them in a panic, all over the world-wide-web. The flash crash wiped out $210 bln from the virtual currency markets. It bankrupted a South Korean virtual currency exchange after it was hacked for the second time. It halted trading at several virtual currency and futures exchanges including the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) due to frantic trading activity. And it brought down the prices of all other virtual currencies along the way. But panic selling was not the only investor reaction to Bitcoin’s flash crash.
Limited rationality
Thaler developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual economic decision on themselves rather than its overall effect.
Days before Bitcoin’s price plunge, some long holders and founders of virtual currencies who had an aversion to losses - a phenomenon Thaler called the endowment effect - began taking their virtual currency profits by selling them.
For example, the Co-founder of Bitcoin.com, one of the world’s largest Bitcoin websites, Emil Oldenburg, divested from all of his Bitcoins with the belief that others would do the same when they realized how illiquid and high in transaction costs the Bitcoin market was. And Litecoin’s Founder Charlie Lee sold all of his Litecoins to resolve the "conflict of interest" within himself.
Social preferences
Thaler's theoretical and experimental research on fairness was very influential and well regarded. He showed how consumers' fairness concerns may stop firms from raising prices in periods of high demand, but not in times of rising costs.
Days before Bitcoin’s price free fall, North American Derivatives Exchange (Nadex) CEO, Timothy McDermott in anticipation of the bearish market move in Bitcoin, launched a new trading instrument, Bitcoin Spreads.
Bitcoin Spreads allowed an individual trader who was bearish on Bitcoin’s price to bet against it in the short-term, with guaranteed limited risk and with affordable capital requirements. With these guaranteed limits, a retail trader was protected from losses outside of his or her risk comfort level in the volatile Bitcoin market, while still enjoying potential profit opportunities from price movements within the floor-to-ceiling range.
To trade Bitcoin Spreads at Nadex, a trader was required to make an initial deposit of at least $250, with no minimum balance required thereafter. Since Bitcoin Spreads were geared towards the retail trader, it was smaller in size with a value of $0.10 per point, as opposed to the $1 or $5 per point with recently listed Bitcoin futures contracts at the CME or CBOE.
Lack of self-control
Thaler showed how to analyze self-control problems using a planner-doer model, to describe the internal tension between an investor’s long-term economic planning and short-term doing. According to Thaler, an investor could avoid succumbing to short-term temptation by nudging – a term he coined – to exercise better self-control when making economic decisions.
Too often, individual traders impulsively began trading Bitcoin binary options or Spreads with little or no understanding of these products, its costs or its risks as a knee-jerk response to Bitcoin market price movements on unregulated web-based exchanges. This resulted in material damages to the financial profiles of these traders.
In response, the US Federal Bureau Investigation (FBI) published a warning cautioning the public against unregistered binary options websites as tools to commit fraud and stated that it has these exchanges in its crosshairs. The European Securities and Markets Authority (ESMA), with the backing of the UK’s Financial Conduct Authority, went a step further by stating that it is considering measures to “prohibit the marketing, distribution or sale of Bitcoin binary options to retail clients.” While Australia, Belgium, Canada and Israel banned binary options marketing, distribution or sale to retail customers.
Bitcoin binary options and Spreads are legal for trading by retail investors in the US so long as they are traded on one of two Commodities Futures Trading Commission (CFTC) authorized exchanges: NADEX and Cantor Exchange.
Is it only about taxes?
This story doesn’t end with retail investors making a killing by trading Bitcoin Bear Spreads at Nadex in reaction to Bitcoin’s flash crash, I am afraid.
Successful retail Bitcoin Bear Spread traders should keep in mind that the Internal Revenue Service (IRS) will likely characterize their Bitcoin flash crash winnings as gambling income, and tax it under IRC 61. Because a gambler who actively trades on an exchange, basing his or her gambling strategy on limited rationality, social preferences, lack of self-control or Feng Shui will be deemed engaged in a trade or business.
If the successful retail trader is a nonresident alien, then his or her U.S source gambling winnings from Bitcoin Bear Spreads-- subject to certain exceptions --will be subject to 30 percent withholding tax.
If the successful flash crash retail trader fails to timely file or correctly report Bitcoin Bear Spread winnings, he or she will be subject to information reporting and accuracy-related penalties.
Selva Ozelli, Esq., CPA is an international tax attorney and CPA who frequently writes about tax, legal, accounting issues for TaxNotes, Bloomberg BNA, other publications and the OECD.