Bitcoin futures are set to go live Sunday evening at 6:00 p.m. EST on the Cboe Futures Exchange (CFE) despite the protests of JPMorgan, Citigroup and other Wall Street brokers. The CME Group (CME) is expected to launch its own bitcoin futures on December 17 and NASDAQ is preparing for a launch for the second-half of 2018.
Bitcoins are currently mainly traded on one of the many “cash” exchanges that exist around the world. It’s important to note that bitcoin derivatives already exist (LedgerX just launched in October). However, bitcoin futures are expected to eventually bring the liquidity and stability demanded by small retail traders and large institutional traders alike.
The new product by Cboe will allow investors to bet on the future price of Bitcoin. According to data from Markets Insider, the price of Bitcoin skyrocketed to an all-time high above $17,000 on Thursday. This price is 145% higher than when CME Group announced on October 31 that it would launch bitcoin futures trading by the end of the year, and 53% higher than when news broke of the CFTC’s regulatory approval of these markets on December 1.
But how will futures trading affect the price of Bitcoin, especially if institutional capital enters the space? To find out we’ll examine how a futures contract works, as well as the behaviors and motivations of the various players who may use futures to speculate on the price of Bitcoin.
What you'll learn 👉
The Basics of Futures Trading
First I will say something about futures contracts and how they trade. A future contract is a type of financial product, which allows two parties to trade a certain good or financial instrument at a future date and at a set price.
For instance, purchasing a 24-month oil futures contract for $80 means you agree to purchase oil at $80 a barrel 24 months from now, regardless of what the price of oil is at that time. By agreeing to purchase the oil you (the contract holder) are “long” the contract. On the other hand, the person who agrees to deliver the oil then is “short” the contract. It’s important to note that futures contracts can be sold at any time on an exchange that trades that particular contract. The buyer of the contract would then inherit the obligation of the futures contract.
Some contracts can be settled by physically delivering the oil. On the other hand, there are some contracts that allow to settle with cash for the difference between the futures price and the spot price at that time. And finally, there are some contracts that allow both options.
Bitcoin futures to be traded on the CME are structured for cash settlement, meaning that no Bitcoins will actually change hands when the futures contract expires. There’s only a cash payment between the agreed upon price and the actual market price at this future point of time.
For example, I purchase a BTC futures 6-month contract with a $15,000 settlement price. Let’s assume that the actual price of BTC on that day 6 months from now is $18,000.
Instead of the seller of the contract fulfilling the contract by selling me Bitcoin for $15,000 and me taking it to an exchange to sell it for $18,000, the contract seller will simply give me the $3,000 difference. This is known as a cash settlement. Usually, the financial result is effectively the same as physical delivery.
The Risk: Could Large Investors Short Futures and Tank the Price of Bitcoin?
Even if the average crypto investor understands futures trading, they won’t be entering this arena anytime soon. Each contract is for 5 Bitcoins, and the minimum block of contracts in a trade is 5 contracts, and at a $15,000 BTC price, that means you won’t be making any trades for less than $375,000.
A key feature of a futures market is that it’s bidirectional. This means that you can be short the market without the hassle of engaging in a traditional short position (i.e. finding someone to borrow the asset from).
The bitcoin futures contracts will be cash settled. This means that betting against Bitcoin is now much simpler (though there are a few existing ways to short Bitcoin).
Judging by the statements of Warren Buffett, Jamie Dimon, or Mohamed El-Erian, institutional capital tends to be sceptical of Bitcoin at best. This shouldn’t be surprising since in many ways digital currencies are a competitor to the long-term business plans of these investors and bankers, and these people are highly incentivized for Bitcoin to fall in price, or fail entirely.
Add it all up, and Bitcoin bulls might start becoming a bit nervous. Institutional capital is the only group with enough cash to trade these new futures markets. They by and large have a very negative view of Bitcoin, and they are about to start trading on the first reliable exchange that will let them short Bitcoin at scale!
One could argue there is an enthusiasm gap in play here. If you are a crypto believer and you have capital, you already went off to start one of the dozens of crypto hedge funds in operation today. On the other hand, if you are a bitcoin sceptic, your options to express that view just expanded greatly.
Counterpoints: The Bull Case for Bitcoin Futures Contract
So why is the price of Bitcoin still rising so fast if bitcoin futures are such a threat to Bitcoin? Here are some counterpoints to the bearish thesis to bitcoin futures.
First, institutional capital can think Bitcoin is the largest scam since the Dot Com Bubble. However, much of it can’t touch these markets to begin with. The Volcker Rule of the Dodd-Frank Act, which was released jointly by the Federal Reserve and a number of federal regulatory agencies, prohibits banks like Jamie Dimon’s JP Morgan from engaging in speculative trading of almost every kind, of which the shorting of digital currencies definitely counts! The move for these bitcoin bears isn’t to short Bitcoin, or driving the price down. It is merely to steer clear of it and other digital currencies altogether.
Second, for every traditional hedge fund that can’t wait to short Bitcoin, there are others who would love an opportunity to gain long Bitcoin exposure but simply can’t handle constant downtime or the lack of technical support, or they simply don’t trust the custody of crypto exchanges. (If you’ve ever tried to use a cryptocurrency exchange during a major crypto news event or a hard fork, it’s difficult to blame them).
Up until now, their options were limited to the Grayscale Bitcoin Investment Trust (GBTC), which frequently trades at a 30% to 80% premium to actual Bitcoin. This shows that there is significant demand from investors who, for whatever reason, are restricted from buying the actual Bitcoins themselves.
Lastly, only few investors can look at Bitcoin’s price rise in the last year and have no fear of shorting the asset. When an asset can double in value in a week, your risk exposure with a short position is huge. In fact, it is theoretically unlimited.
Some people believe that Bitcoin is in a bubble because it can’t be valued using fundamental analysis. However, that was true a year ago as well, and you would have lost about 17 times your initial investment if you put on a short Bitcoin position in December 2016. In terms of futures trading this means that you would have been margin called and/or had your position forcibly closed long ago by your exchange.
And those losses will add up pretty quickly with a minimum trade exposure of $375,000.
Conclusion: Volatility Ahead, But Ultimately Good for Bitcoin
That doesn’t leave you with a clear decision on whether to go long or short Bitcoin in anticipation of futures trading, and institutional investors and professional traders will likely exercise some caution and enter the Bitcoin futures market slowly. CME Group’s will launch their bitcoin futures product on December 18. However, their smaller rival CBOE recently announced they will beat CME to the punch and begin bitcoin futures trading on December 10th. Various factors could cause the influx of capital to take either long or short position. However, either way, it will likely mean significant price swings in the short term.
However, in the long term, this is a significant step toward legitimizing Bitcoin and other cryptos. This should also eventually lower the daily volatility of Bitcoin as it trades alongside more traditional asset classes.
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