The Threat of Bitcoin Futures

Bitcoin futures and threat LearnCrypto Powered By Wyckoff SMI 2024

The financial press has been in aflutter over the launch of bitcoin futures trading on not one but two reputable, regulated and liquid exchanges: CME and CBOE.

CME Group, the largest derivatives exchange in the world, as well as one of the oldest, will launch bitcoin futures trading on Dec. 18th, while CBOE Global Markets, which owns the Chicago Board Options Exchange (the largest U.S. options exchange) and BATS Global Markets, plans to beat CME to the punch by opening its own trading on Dec. 10th.

In theory, this opens the doors to institutional and retail investors who want exposure to bitcoin but for some reason (internal rules, or an aversion to risky and complex exchanges and wallets) can’t trade actual bitcoin.

And that expected flood of interest is, from what I hear, part of the reason that bitcoin’s price recently shot past $11,000 (which, considering it started the year at $1,000, is phenomenal).

But if that’s true, I’m missing something: I don’t understand why the market thinks there will be a huge demand for bitcoin itself as a result.

A primer

First, a brief overview on how futures work: Let’s say that I think that the price of XYZ which is currently trading at $50, will go up to $100 in two months.

Someone offers me the chance to commit to paying $80 for XYZ in two months’ time. I accept, which means that I’ve just “bought” a futures contract. If I’m right, I’ll be paying $80 for something that’s worth $100. If I’m wrong, and the price is lower, then I’ll be paying more than it’s worth in the market, and I will not be happy.

Alternatively, if I think that XYZ is going to go down in price, I can “sell” a futures contract: I commit to delivering an XYZ in two months’ time for a set price, say $80. When the contract is up, I buy an XYZ at the market price, and deliver it to the contract holder in return for the promised amount.

If I’m right and the market price is lower than $80, I’ve made a profit.

Beyond this basic premise, there are all sorts of hybrid strategies that involve holding the underlying asset and hedging: for instance, I hold XYZ and sell a futures contract (I commit to selling) at a higher price.

If the price goes up, I make money on the underlying asset but lose on the futures contract, and if it goes down the situation is reversed. Another common strategy involves simultaneously buying and selling futures contracts to “lock in” a price.

Futures contracts currently exist for a vast range of commodities and financial instruments, with different terms and conditions.

It’s a complex field that moves a lot of money. The futures market for gold is almost 10x the size (measuring the underlying asset of the contracts) of the physical gold market.

How can this be? How can you have more futures contracts for gold than actual gold? Because you don’t have to deliver a bar of gold when the contract matures. Many futures contracts settle on a “cash” basis – instead of physical delivery for the sale, the buyer receives the difference between the futures price (= the agreed-upon price) and the spot (= market) price.

If the aforementioned XYZ contract were on a cash settlement basis and the market price was $100 at the end of two months (as I had predicted), instead of an XYZ, I would receive $20 (the difference between the $100 market price and the $80 that I committed to pay).

Both the CME and the CBOE futures settle in cash, not in actual bitcoin. Just imagine the legal and logistical hassle if two reputable and regulated exchanges had to set up custodial wallets, with all the security that would entail.

So, it’s likely that the bitcoin futures market will end up being even larger than the actual bitcoin market.

Side effects

That’s important. Why? Because institutional investors will like that. Size and liquidity make fund managers feel less stressed than usual.

The bitcoin market seems to be excited at all the institutional money that will come pouring into bitcoin as a result of futures trading. That’s the part I don’t understand.

It’s true that the possibility of getting exposure to this mysterious asset that is producing outstanding returns on a regulated and liquid exchange will no doubt entice serious money to take a bitcoin punt. Many funds that are by charter prohibited from dealing in “alternative assets” on unregulated exchanges will now be able to participate.

And the opportunity to leverage positions (get even more exposure than the money you’re putting in would normally warrant) to magnify the already outrageous returns will almost certainly attract funds that need the extra edge.

But here’s the thing: the money will not be pouring into the bitcoin market. It will be buying synthetic derivatives that don’t directly impact bitcoin at all.

For every $100 million (or whatever) that supermegahedgefundX puts into bitcoin futures, no extra money goes into bitcoin itself. These futures do not require ownership of actual bitcoins, not even on contract maturity.

Sure, many will argue that more funds will be interested in holding actual bitcoins now that they can hedge those positions.

If SupermegahedgefundX can offset any potential losses with futures trading, then maybe it will be more willing to buy bitcoin – although why it would allow its potential gains to be reduced with the same futures trade is beyond me. And, why hold the bitcoin when you can get similar profits with less initial outlay just by trading the synthetic derivatives?

That’s the part that most worries me. Why buy bitcoin when you can go long a futures contract? Or a combination of futures contracts that either exaggerates your potential gains or limits your potential loss?

In other words, I’m concerned that institutional investors that would have purchased bitcoin for its potential gains will now just head to the futures market. Cleaner, cheaper, safer and more regulated.

Look out

What worries me even more is the possibility that the institutional funds that have already bought bitcoin (and pushed the price up to current levels) will decide that the official futures market is safer. And they will sell.

Now, it’s possible that the demand for bitcoin futures and the general optimism that seems prevalent in the sector will push up futures prices (in other words, there will be more demand for contracts that commit to buying bitcoin at $20,000 in a year’s time than those that commit to buying at $12,000 – I know, but the market is strange).

This will most likely influence the actual market price (“Hey, the futures market knows something we don’t, right?”).

And the launch of liquid futures exchanges increases the likelihood of a bitcoin ETF being approved by the SEC in the near future. That would bring a lot of money into an already crowded space.

But… it’s also possible that the institutional investors that are negative on bitcoin’s prospects (and there’s no shortage of those) may use the futures markets to put money behind their conviction. It’s much easier to sell a futures contract with a lower-than-market price than it is to actually short bitcoin. These investors may well send signals to the actual bitcoin market that sends prices tumbling.

And the leverage inherent in futures contracts, especially those that settle for cash, could increase the volatility in a downturn.

That’s pretty scary.

Let’s not even go into the paradigm shift that this development implies. The growth of a bitcoin futures market positions it even more as a commodity than a currency (in the US, the Commodity Futures Trading Commission regulates futures markets). And even more as an investment asset than a technology that has the potential to change the plumbing of finance.

So, while the market appears to be greeting the launch of not one but two bitcoin futures exchanges in the next two weeks (with two more potentially important ones on the near horizon) with ebullience, we really should be regarding this development as the end of the beginning.

And the beginning of a new path.

Tree of shadows image via Shutterstock

Related Articles

Responses