The Phantom Bull of Bitcoin Futures

The idea that follows is almost too simple to deserve an article.

Or it would be…except for the fact that it’s misunderstood by people betting up to half a billion dollar daily. So a quick explanation seems to be in order.

What are these half-billion dollars’ worth of bets? That’s what we hear from the Chicago Mercantile Exchange (CME), which boasted Bitcoin Futures trading worth over 112,700 BTC on April 4th.

Admittedly, this was a record number on a particularly active day. But any way you slice it, that’s a heck of a lot of money.

The uptick in futures interest almost certainly correlates to Bitcoin’s recent jump in price; Bitcoin is up nearly 50% on the year, with most of those gains coming in this still-young second fiscal quarter.

Unsurprisingly, market bulls are sniffing around, pawing their hooves, doing what optimistic-but-cautious bulls do…

And some of them are buying futures.

A USD bet on BTC’s future price.

That is what a “future” is — at least if you’re trading Bitcoin futures through the CME, the only place that currently offers them. By placing a “long” (optimistic) or “short” (pessimistic) bet, you’re gambling in dollars on the future market price of a single bitcoin.

Bitcoin is a widely misunderstood asset — and to be fair, its ecosystem is damned complicated — but if there’s one fact a Bitcoin investor should understand, it’s this:

Bitcoin’s value proposition is its provable, enforced scarcity. Like everything else, Bitcoin’s price obeys the “Law of Supply and Demand.” But unlike any other commodity ever, Bitcoin has a fixed issuance schedule and a totally inelastic supply.

This has serious implications — I would say obvious implications, except that nine figures’ worth of Bitcoin futures proves this isn’t true — for people making side bets on Bitcoin’s price.

If you want to short Bitcoin—i.e., to bet against it — then, by all means, it is rational to do so using futures. This allows you to place a bet about Bitcoin without actually owning any bitcoins, and thus taking them off the market, restricting their supply…and driving up the price.*

* Clever readers may see where this is going now.

But if, on the other hand, you want to bet on Bitcoin, and you’re willing to put your money where your mouth is…then why wouldn’t you just buy Bitcoin directly rather than making a side bet in a dollar-denominated futures market?

(Yes, this is a rhetorical question. And no, there’s not a good answer.)

By buying the asset itself (Bitcoin) instead of a derivative (Bitcoin futures), you’re exchanging your dollars for bitcoin — which is exactly what a “long” futures-bet is asserting that other people will do.

Furthermore, by holding your bitcoin, you’re restricting the supply available to future buyers — which subsequently requires higher bidding from the next buyer to arrive at market.

Rather than just betting on the market, you’re participating in the market — while simultaneously pushing the price in the direction you want it to go.

In most other contexts, this would be cheating.

If this were horse-racing, buying Bitcoin would be like going to the track early and placing a bet on a horse…and stipulating that your funds get spent on superior oats and steroid injections for your chosen steed.

You’d still collect your winnings if you’re right — but you’re also making winning more likely.

All of this simply by buying directly rather than placing a side bet.

Isn’t this true of any Futures Contract?

To an extent, yes. The Law of Supply and Demand is universal, and you could make a similar argument for futures-buyers on any commodity.

But I would argue that Bitcoin is a special case.

The constriction of its floating supply is even more valuable because — unlike traditional commodities (corn, oil, etc.) — the “manufacture” of bitcoins can’t be ramped-up, accelerated, or changed in any way.

Some feisty readers might point out that call options on a stock are the same as a futures bet (true), and that a publicly-traded company’s board of directors is unlikely to recklessly issue more stock and thereby dilute its existing shareholders.

This is true, but it’s not exactly a fair comparison.

Because Bitcoin’s entire raison d’etre is its strictly limited supply.

If you buy futures in Apple stock, you’re betting on computers, connectivity, yada yada. If you buy futures in General Motors, you’re betting on cars. With Bitcoin, you’re simply betting on the market’s growing recognition that a fixed-supply digital commodity is a sort of magic. That’s the entire bet.

To state this another way: while you can’t use the same money to both buy a new GM truck (slightly boosting the value of GM stock) and also place a bet on the future value of GM stock…with Bitcoin, you can do exactly that.

By simply buying-and-holding the asset itself — Bitcoin.

What about Leverage?

There’s a “but” coming: leverage.

Buying a long futures contract gives you exposure to the future price movement without ponying up the full price of the asset.

Leverage is risky, but it’s also powerful, right?

Strangely, not with Bitcoin futures. Not really.

Because Bitcoin is relatively new, highly volatile, and polarizes financial know-it-alls into wildly divergent camps (e.g. “It’s going to zero” vs. “It could become the global reserve currency”), the CME has decided that their futures, each representing 5 BTC in value, need to be collateralized at 80%.

In other words, at today’s prices, to get profit exposure to around $29,000 in Bitcoin, you need to put up about $23,200 in collateral.

And if you can’t put up 4 BTC worth of collateral for your extra 1 BTC of leveraged exposure…tough.

The CME’s futures come in 5 BTC blocks, take it or leave it.

If this sounds like an utterly underwhelming deal, I agree.

By contrast, as I wrote about here, when Bitcoin’s price shot upward on April 1st, every single bitcoin purchased during that fateful hour boosted the market price by 3.4 cents.

Now that’s leverage.

With that same $23,200 you’d lock up to buy a futures contract, you — yes, you, personally — could drive up Bitcoin’s global price by $0.136.

13.6 cents may not sound like much, but spread over the 17.6 million bitcoins currently in circulation, this would mean a $2.4 million bump in market cap. Not too shabby.

And this is a direct result of buying the actual asset; there’s no equivalent boost from buying a futures contract.

If you really believe the premise that “Bitcoin is digital gold,” then Bitcoin futures are digital fool’s gold — a look-alike substitute that misunderstands Bitcoin’s basic value proposition: a provably-scarce virtual commodity that there simply won’t be enough of to go ‘round.