Coinbase Analysis on Short Selling: David Duong's Expert Take

Introduction

In a recently published research paper, David Duong, CFA, Head of Institutional Research at Coinbase, explains that short selling is a mechanism to profit from declining prices. In the crypto space, this involves borrowing tokens, selling them, and later repurchasing them at a decreased price to return to the lender, capturing the price difference. Duong notes that beyond mere price speculation, entities like Bitcoin miners might employ short selling for purposes like hedging or securing upfront liquidity. Despite its detractors, Duong emphasizes that short selling can offer benefits such as reduced volatility, enhanced liquidity, and improved price discovery. However, he also points out that the active market for shorting digital assets is still in its infancy.

Opportunity or Exploitation?

Duong highlights that short selling challenges the conventional “buy low, sell high” strategy, allowing market participants to identify overvalued assets. Without this mechanism, markets might predominantly reflect positive sentiments, potentially pushing prices beyond their intrinsic value and leading to abrupt corrections. Duong suggests that the lack of a mature short-sale market in digital assets might contribute to its historical volatility. He believes two-way markets can lead to efficient price discovery, potentially tempering volatility across the crypto asset class. Beyond mere price speculation, Duong discusses the utility of short selling for hedging, especially for stakeholders like cryptocurrency miners who face market fluctuations and operational costs.

Disadvantages of Short Selling

Duong acknowledges the inherent risks of short selling. The potential losses can be boundless, especially in crypto markets where some tokens can experience exponential growth. There’s also a concern, as Duong points out, that short sellers might disseminate misleading information about their target companies. However, he also references studies indicating that most false claims often originate from the targeted companies, not the short sellers. Duong believes that short selling can lead to better scrutiny of projects, uncovering potential risks and discouraging mismanagement.

Extraordinary Times and Measures

Duong discusses the criticism that short selling can amplify downward price movements during periods of significant market distress. He references instances like the 2008 financial crisis and the COVID-19 pandemic when concerns about short selling led to bans on short-selling certain stocks in multiple countries. However, Duong cites studies suggesting that the correlation between short selling and price movements is tenuous. He mentions that short-sale bans might even escalate liquidity costs and volatility.

Proving the Counterfactual

Duong emphasizes that data on short selling in crypto markets is sparse. He mentions the absence of a centralized database for short sales of major cryptocurrencies like Bitcoin. Duong references the BTCUSD Shorts index, which monitors the number of bitcoins sold short on the Bitfinex exchange. Analysis from January 2020 to July 2023 indicates minimal sensitivity of bitcoin prices to open short positions. However, during a specific period from November 6, 2022, to January 10, 2023, Duong notes a slightly higher sensitivity of Bitcoin prices to short interest, potentially due to the collapse of the FTX crypto exchange. Yet, Duong concludes that there’s no compelling evidence to suggest that short selling significantly impacted Bitcoin prices during this timeframe.

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