Futures? Stocks? Which is a better investment, or are they the same? (Part 1)
Many investors today are surprised by how futures may trade so differently from the underlying instrument they reference. We don’t have to go too far back in time to find an example that best signifies the extreme discrepancy which can occur: April 2020 a few months ago. That was the fateful spring day in April when WTI futures on CME actually traded to -$37 (yes, negative!). Of course, the reason why that happened, in retrospect, is obvious: speculators in WTI futures had no means to take delivery or store the barrels of crude oil and thus had to liquidate the futures, no matter the price, prior to expiration. After all, a futures contract is just an agreement, enforceable by law, to buy or sell something at a fixed price at a fixed time in the future. If you have no means to store it, you have to get rid of such contracts, no matter what the cost is, even when it is negative $37!
It makes sense why commodity or physical-based futures can trade differently from the underlying products they reference. After all, there are costs necessary for delivering or storing the products or the products themselves can go bad or become useless after a certain period of time (which is especially the case for futures referencing agricultural products). What about bitcoin futures?
The simple answer is: yes, they can be different, and there are various reasons for this phenomenon, particularly more so for cryptocurrencies! Firstly, bitcoin futures trade on different exchanges all over the world! For example, we have bitcoin futures trading in the US (CME, ICE Bakkt, etc), Asia (Huobi, etc), Panama (Deribit), and so on. Different countries have different rules for the types of investors allowed to trade on their platforms. For example, Huobi does not allow investors based in the US, Hong Kong, and a few other countries. This is understandable as different countries (and platforms) have their own AML (anti-money laundering) and KYC (know your client) requirements. Also, different investors have different levels of comfort with trading on exchanges in countries that may be less financially sophisticated. For example, a US-based investor who intends to trade bitcoin futures may choose to do so only on US-based exchanges, simply because he/she is more comfortable with the rule of law of the United States.
Secondly, the types of investors involved in the futures markets vs. the cash markets are motivated to trade their respective products for different reasons. For example, participants in the futures markets are typically viewed as speculators (though some participants certainly use futures for hedging purposes), while cash investors are viewed as being more “long-term” focused. Futures investors are typically more sophisticated, or at least possess more trading experience, primarily because futures trading can be highly-levered and require a significantly less amount of margin as compared to regular cash investment. To further complicate the matter, different bitcoin exchanges in different countries may require different levels of leverage and margin requirements. For example, CME requires approximately 30–40% in initial margin whereas Deribit may require an initial margin of as low as 1% (which scales up with size). Even if an investor is fully comfortable with trading on all exchanges, the different levels of initial margin required certainly may impact their risk/reward considerations, and hence dictate their exchange of choice.
Lastly, futures contracts are also taxed differently compared to cash stock investments. For example, in the US, cash stock and bitcoin investments can enjoy a much lower level of capital gains tax for longer-term investors and such taxes are only payable when gains are realized. Futures contracts, on the other hand, are usually taxed on a mark-to-market basis at the end of the year, whether or not the futures contracts have been unwound. Some countries do not even tax bitcoin capital gains (such as Singapore, Malta, etc)!
For the above reasons, the types of investors involved in cash and futures investments are fundamentally different, so a discrepancy in their prices may not be that surprising. For this reason, Digital Gamma publishes a weekly basis report on the basis between cash and futures that may exist on different exchanges which includes an annualized yield calculation (we have also previously published reports that detailed the exact calculations). Hopefully, this report may be helpful for discerning investors who are trying to figure out whether it is more desirable to invest in bitcoin cash or futures, and if futures are the desired choice, which exchange is best, at least purely on a price basis.
