A more recent version of this story appeared on Cointelegraph.
Yesterday, the Chicago Board of Exchange (CBOE) opened up its doors to trading Bitcoin Futures (under ISO code XBT), and the Chicago Mercantile Exchange (CME) is planning it’s launch of the same in just a weeks time. As a former FINRA-licensed, managed futures broker, and a cryptocurrency enthusiast, I thought I might explore just how this might potentially effect the current Bitcoin ecosystem.
Let’s back up here a little bit. I’m going to assume you know what Bitcoin is but don’t have a clue about what a future’s contract is or how it’s used, so I’m going to spend a bit of time with you to explain just that.
The Best Crop
A future contract is simply a contract to buy or sell a financial instrument or other underlying asset at a predetermined price in the future. They can be settled by the physical delivery of the underlying goods, or in cash.
Let’s imagine a real world scenario of such a use case. Imagine a grower of oranges in Florida. Forecasting a gloomy next year — one in which the weather will not produce the best tasting, best looking and largest yielding crop of oranges, the grower seeks to protect against this potential loss, by locking in a favorable price for next years crop, this year. The grower can do this by entering into a futures contract with another party — to sell his crop of oranges at a specific price, say the same price as his yield this year, at some time in the future, we’ll say one year from now.
For practical purposes, let’s say the entire crop would sell for $100 in the current year. The grower, forecasting that next year’s crop will be abysmal, locks in the same value of $100 for the entire crop, exactly one year from now. A year passes by, and his prediction becomes reality, his entire crop is worth $20 in the current market. Without his futures contract, he would not be protected from this downside. Yet, as prescient as he is, through the contract, he has locked in an $80 spread against the current market price, and the value of agreed contract. If the futures contract is cash settled, he will receive the difference between the current market rate of the underlying asset, and the contract value previously agreed upon. If the contract is settled in the delivery of the underlying asset, he will receive $80 worth of oranges, so he can sell with his current yield, for the equivalent of $100.
In the above case, the buyer of the contract believes that the crop will be worth more than what he paid, say $120, and hopes to make a profit of $20. The seller, in this case the grower, believes the crop will be worth less than what he sold it for, thereby earning the difference.
The buyer is speculating on the increase of the value of oranges, and the seller is hedging against the potential loss of value of his crop. So the futures contract rewards the party that makes the most accurate prediction of the future value of the underlying asset.
Make sense?
Got It — So What Does this Mean for Bitcoin?
Just a little less than a year ago, when I made my first Bitcoin transaction, it was trading at $822 per coin. At that time, Bitcoin was largely a phenomena of early adopters, speculators and overseas money launderers, with China representing some 90% of the trade. It was largely ignored by both Wall St. and Main. St (everyday folk), and saw little adoption in the U.S.. Browsing r/BTC and chatting on Poloniex’s Troll Box, I was quickly convinced that the median age of ‘hodlers’ was in the range of 18–24 years. In fact, most comments on the Troll Box were related to “leaving to study for my exams” or “to go to class.”
Yet, in just one short year, Bitcoin is trading over $17,200 per coin, a 21x surge in market value, attracting a frenzy of new interest, the most important, arguably, being Wall St.
In the case of Bitcoin, a futures contract would allow two parties to speculate or hedge on the price of Bitcoin at some point in the future.
The important part of the above, are the parties that would be speculating or hedging. Futures contracts are largely trade agreements for big money professional traders and institutional investors. By allowing for these contracts to be traded in a regulated market, CBOE and CME have both opened up the doors for professional traders to participate in the Bitcoin game and indirectly legitimize it as an asset class. Keep in mind that because these contracts are settled in cash, the funds are not actually used to buy the underlying asset, only speculate on its price movement. As such, introducing Bitcoin futures trading doesn’t necessarily directly improve the capital flow of Wall St. money into Bitcoin, but it can be expected to have tangential effects. For example, a hedge fund that previously abstained from going long Bitcoin, due to the lack of hedging tools, might now consider allocating Bitcoin it to its fund, using a series of futures contracts to protect against downside risk.
Also, Bitcoin futures contracts should, in effect, reduce the pricing volatility of Bitcoin, since the speculation allows the market to be more efficient, leading to better pricing discovery. With a reduction in the massive pricing swings, Bitcoin could become a more trusted medium of currency, as the durability of its short term pricing increases its utility value — in plain terms, allowing two parties to transact in Bitcoin without having to worry that it will be a vastly different price moments before or after the transaction.
Additionally, the public gains some additional insight into the combined market’s expectation of Bitcoin’s future performance. While futures market’s are not necessarily always correct in their prediction, they do provide valuable data for traders and hodlers looking to gain some understanding of the current market sentiment of the cryptocurrency. At the time of this article’s writing, it seems that the January contracts (XBT/F8) are putting a premium on the current price of Bitcoin, just one month out. In fact, yesterday, around 6PM EST, just as the futures market’s opened, the market price of Bitcoin on Coinbase, jumped from $14,810 to $16,171 in a matter of minutes, demonstrating that, despite light volume, the futures prices may have some effect on its underlying asset.
A Case for Manipulation
Despite the potential for huge benefits to the Bitcoin ecosystem, there may be a few tradeoff’s. The Bitcoin markets are still immature in comparison to a well-regulated, long time tested equities market like the NYSE Arca or NASDAQ. It was introduced in complete antithesis to these markets, and as such, lacks a lot of regulation needed to protect the market from unscrupulous entities. Despite what appears to be a healthy total circulation of coins, currently around $275 billion worth, the Futures Contracts are pegged off of a blended rate (CME calls this its Bitcoin Reference Rate (BRF)), sourced from just a handful of exchanges, or in the case of CBOE, just one exchange.
The issue with this is that these exchanges only trade a fraction of the total circulation. Gemini’s 24 hour Bitcoin volume represented just 1.6% of the global Bitcoin trade. With such small volumes and a thin order book, Bitcoin’s price could be subject to manipulation by a series of unscrupulous traders, attempting to move the market in order to obtain favorable execution on highly leveraged futures contracts. A number of techniques might be employed, such as order book spoofing, or wash trading — strategies that are downright illegal on a regulated exchange like NASDAQ but are fair game in the cryptocurrency markets. Additionally, the Bitcoin market has proved to be sensitive to media coverage, even a single CEO of a globally recognized financial services firm has been proven to move the market using just a few words.
While it is the hope that futures trading helps to set the stage for a more regulated trading environment, we must not ignore the motivation by speculators to make large sums of money. As the saying goes, “where there is a will, there is a way” and it has happened on a number of occasions on well-regulated U.S. markets.
Final Thoughts
It’s still too early to definitively know how Bitcoin futures will affect the Bitcoin market. There are just a handful of Wall St. firms that have signaled interest in allowing their customers to trade on the CBOE. The larger markets are currently employing a “wait and see” approach. Some warn that the Bitcoin markets are still too fragile for prime time, citing the many outages that have plagued the major exchanges in recent times, as user growth has been exponential.
My thoughts are that, while Bitcoin’s intent was to allow for parties to transact “without going through a financial institution,” the blessing by Wall St. and the U.S. government is a necessary evil, to allow for more widespread use, protection to the public, and eventually more confidence by a wider range of investors. We need to be cognizant of the macroeconomic implications of this. Consistent and strong capital flows into Bitcoin will support a strong upward trend, and perceived legitimacy will not only open up investments from large funds, but also late adoption retail investors moving money through traditional brokerages and wirehouses. If you’re in Bitcoin to ride the price to new highs, this is essential. If you’re in Bitcoin because you philosophically agree with its design and original intent, the argument is no different. Wider adoption will encourage merchants and individuals to accept it as a form of payment, and will further increase its utility value. Bitcoin futures represents an early case-study that if successful, may help to pave the way for approval of ETF’s and other investment vehicles, further growing the ecosystem. If we’re lucky, this creates a virtuous, self-sustaining cycle of wealth creation, awareness and value as a fungible instrument.
