Tomorrow, the first futures derivative contract will be launched on the Chicago Board of Options Exchange (CBOE). This marks the beginning of bitcoin futures trading on a major exchange. One week after this, another competing exchange, the Chicago Mercantile Exchange(CME), will launch it’s own tradeable future. These two exchanges are very large, and will attract the attention of many professional and institutional traders who want to gain exposure to bitcoin, but have so far been nervous to do so. In this article, I’m going to put forth five reasons why I think futures derivatives will be harmful for the price of bitcoin, and could spell an end to the so far meteoric rise in price over the last few months.
Primer - What are futures and why are they important?
A futures contract is a derivative of something. It bases or derives its price from the real asset that it is based upon. Think of a future as a promise or a guarantee to get something at a certain date in the future. For instance, I’ll give the example of an oil futures contract traded on the CME. Each oil future contract is a promise to give the holder of the contract 1000 barrels of oil at a date in the future. If you are trading a January futures contract, it means when you buy the futures contract, you’re getting a promise from another market participant. This promise is that they will deliver you 1000 barrels of oil at a standardized settlement date in January. At any one time there are multiple futures contracts with different delivery dates, usually one for each month of the year, but they are all standardized to be 1000 barrels of oil. Aside from the date of settlement, the futures contracts are all otherwise identical.
Because a futures contract is only a promise/guarantee, It’s very easy to buy and sell to speculate on the price, because you are only buying the promise — As a comparison, think of how much harder it would be to physically deliver 1000 barrels of oil every time a trade is completed! Because selling and buying the promise is much easier, it is much more attractive for speculators who don’t own any oil, but still want to speculate on the price of oil. With bitcoin, it means you don’t have to worry for each trade to be recorded in the block, because instead of having a decentralised model, you have one central exchange which quickly and instantaneously records each trade.
Ironically, the benefits of centralization (on a futures exchange) will give market participants exposure to decentralized forms of money
Another point is that if you ‘go short’ a futures contract, you don’t need to actually own any oil, because the oil is ‘cash settled’. This means that if you short a futures contract at 50$ a barrel and the price goes up to 60$ a barrel by the delivery date in January, you can say “oops, I don’t have the oil, but I’ll pay you the difference in price” meaning you’ll pay a (60–50 =10) 10$ difference for each barrel of oil that you owe to the holder of the futures contract. They get the profits instead of the oil, and you take the loss, and the promise has been settled. This only works when futures are ‘cash settled’. Some futures are ‘physically settled’ meaning, if you are short the contract, the onus is on you to deliver the oil to the holder of the contract. Bitcoin futures are cash settled, and therefore, you don’t need to actually hold any bitcoin to short the market. for a more in-depth guide to how futures work, have a look at this excellent guide on the CME website
With futures contracts, selling and buying become very easy and very quick, there are no worries that you won’t get your price, and there aren’t any fears that exchanges will steal your money. Also the trading is instantaneous and confirmed in microseconds. These are two reasons why speculators who haven’t been involved in bitcoin trading will be attracted to trading bitcoins through futures. Ironically, the benefits of centralization (on an exchange) will give market participants exposure to decentralized forms of moneyThey will be able to trade the bitcoin futures contract quickly and reliably. It will attract more speculators to the bitcoin price.
The futures market as a whole is huge, much much bigger than the current bitcoin market. The futures market is part of the derivatives market, and some have estimated the size of the entire derivatives market to be over 1.2 quadrillion dollars. One reason for the size of the futures market is, like I’ve said, because it’s very easy to speculate using futures. This plays into my first reason why bitcoin futures could be bad for the price of BTC.
Reason #1 — ‘Shorting’ Bitcoins will become easy.
Until now, it has been quite hard to go ‘short’ the bitcoin market. There have been ways to do it, but they have been relatively obscure and haven’t affected the actual bitcoin market. With the inclusion of futures, shorting bitcoins will be done reliably and at the click of a mouse. This can and will affect the price of bitcoins, and I will explore why in my next few points.
Reason #2 — The price of bitcoin futures will become more important than the price of ‘real’ bitcoins
Why should people pay attention to the price of Bitcoin futures? At the moment, prices of bitcoin vary from one exchange to another.
When people talk about the price of oil, or the price of gold, very frequently, they are actually talking about the price of oil and gold futures. The reason why, is that it is much easier to trade a future, which is simply a promise, than it is to physically trade gold or oil from one place to another. Obviously this problem doesn’t arise with Bitcoin, but I’m using it to illustrate the point that people pay attention to the price of futures, when thinking about the actual, real product. Why should people pay attention to the price of Bitcoin futures? At the moment, prices of bitcoin vary from one exchange to another. Just a few days ago the GDAX bitcoin exchange was reporting prices of bitcoin around $19000, while other exchanges had prices much lower. With these price discrepancies, people don’t know where to look. If a bitcoin future should gain liquidity and volume, market watchers will begin to pay more attention to the bitcoin future price, than the bitcoin price that can be taken from one of over half a dozen different exchanges. This would be because of reliability and ease of trade. There are no delays when trading on the CME or CBOE, and the exchanges virtually never go down due to technical reasons.
Reason #3 — The price of bitcoin futures will affect the price of bitcoin
This phenomenon is frequently called “the tail wagging the dog”. The meaning behind this statement is that the bitcoin future, which is a derivative of bitcoins will begin to affect the price of bitcoins. How can this happen? Well, it’s all to do with how bitcoin futures are traded, and how they are settled. The simple explanation is that bitcoin futures are promises that don’t actually involve bitcoins at all, and are simply bets made with dollars on the price of bitcoins. Confused? Walk with me through this example:
You own 1 bitcoin, and it’s value is $20,000. However, you see on the futures market that the value of a bitcoin future is only $18,000. Knowing that the future is a promise of a bitcoins value at a future date, and wanting to make money now, you decide to sell your bitcoin, and buy the bitcoin future. You sell your bitcoin for $20,000 and buy the future for $18,000 and pocket the difference. You’ve just made an easy $2000! This phenomenon can occur when there is backwardation on the futures market. It just means that the futures price is lower than the ‘physical’ price of bitcoin.
Dollar based markets [like futures] are governed by who holds the most dollars, and if those with more money want to push the price of bitcoin futures down, they will be able to do so by shorting the market
Why does it matter if the future price is lower than the bitcoin price? The bitcoin price is directly connected to its market capitalization. The higher the bitcoin market cap, the more expensive each bitcoin is. You can see this by periodically checking coinmarketcap.com. At the time of writing, the bitcoin price is around 15,000/BTC, and its market cap is around $250 billion. If the market cap increased to 10 times its current size, and reached $2.5 trillion, each bitcoin would be worth $150,000. Likewise, if the bitcoin market cap shrunk to 1/10th its size, each bitcoin would only be worth $1500.
Every time you sell bitcoin, and buy a bitcoin future, you are transferring money out of the real bitcoin market cap and putting it into the futures market. This decreases the size of the bitcoin market and thus its importance, and increases the size and importance of the futures market.The futures market is entirely based on dollars, and dollars will determine the price rise and fall of the market. Dollar based markets [like futures] are governed by who holds the most dollars, and if those with more money want to push the price of bitcoin down, they will be able to do so by shorting the market. As long as they have more money than the buyers, the price of the futures will go down.
Reason #4 Central banks want to gain exposure to bitcoin, and it could hurt the price.
Central banks are perplexed by bitcoin. They know that the more people use cryptocurrencies and not their own currencies, the less belief and importance people will place in their dollars, euros and yen. Because of this, they might try to lower the price and demand for bitcoins. At the moment, as bitcoin sees its price rise and rise, it only attracts the attention of people, and takes attention away from other, government backed currencies. People who use cryptocurrencies have seen a rise in value, and cryptocurrencies have been especially helpful for people who live in countries with unstable currencies. People are awakening to the alternatives of cryptocurrencies. Central banks don’t want everybody turning away from their currencies and going into crypto, and they are scared that people could do so. So what can they do? One potential theory says that central banks can create/print money and then use that money to go ‘short’ the bitcoin futures market, creating backwardation in the futures market. Because they own the printing press, they can just print dollars/euros etc and use that currency as infinite ammunition to attack the futures price with. You can’t do this on the real bitcoin market, but you can short sell a bitcoin future. If they lower the price of the futures, it will affect the price of real bitcoins. As I’ve outlined above, this will cause the price of bitcoins to go down, and the central banks hope, lower the interest in cryptocurrencies in general and bitcoins in particular. When will it happen? Maybe not on the first day, or first week, but certainly at some point in the future. I predict if there is a big fall in the bitcoin price, it will be led by the bitcoin futures price.
If you think central banks wouldn’t print money, it’s worth noting that since 2008 the federal reserve alone has printed well over $4,500,000,000,000 (4.5 trillion!) dollars since the beginning of it’s quantitative easing program in 2008.
Reason #5 Human fear, through bitcoin futures, will ultimately tank the price of bitcoins
When regular traders and speculators see the price of bitcoin futures trading at a discount to the real price of bitcoins, they will sell their bitcoins and buy the futures. Even though they know doing so will lower the bitcoin price, they won’t be able to ‘hodl’ because they will be afraid that everybody else will sell. Ultimately, greed and fear dominate markets and market movements, and the bitcoin futures will allow short selling speculators, and market manipulation by central banks to occur. All of this could be solved if futures weren’t cash settled but physically settled, but I will go into that in a future article.
Conclusion
If you have read my article in numerical order you’ll see the scenario that I’ve laid out can and will impact the price of bitcoins negatively. I hope I’ve helped some people understand one potential scenario that I believe will happen in the weeks and months after the inclusion of bitcoin futures tomorrow.