Bitcoin Futures: the Potential and the Risk
What Bitcoin futures could mean for the crypto economy
Bitcoin Gains Legitimacy
Bitcoin continues to captivate the interest of the financially-minded as well as curious and often skeptical bystanders. Bitcoin is well on its way to becoming more than just a hot topic.
The cryptocurrency’s legitimacy, along with its price, is on the rise. This month, the US Commodity Futures Trading Commission announced that Bitcoin futures have been self-certified by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME). This announcement was a significant milestone for Bitcoin because these two institutions are trusted pillars within the financial industry.
What is a Futures Contract?
Futures are contracts that receive their value based on an overall performance of an asset. That asset can be anything from oil to corn. Futures contracts are simply agreements to sell or buy an asset at a price that has already been agreed upon, at some time in the future. Futures contracts are often used for security or speculation.
In the case of Bitcoin futures, if an investor believes the price of Bitcoin will be elevated to a certain price in the future, that investor can use this prediction to their advantage. The investor can sign a futures contract for Bitcoin at a lower price than their prediction, then when the price is higher than their futures contract price agreement, they can profit from the price difference.
Futures are appealing to investors for their leverage, meaning investors can trade on multiple Bitcoins while only actually paying for a portion of them. While leverage is a benefit, it can also be dire if played wrong. In the same way that you can amplify your profit potential betting on futures, you can lose a large amount very quickly.
The Benefit: Added Stability
In addition to elevating the legitimacy of Bitcoin, the addition of Bitcoin futures could introduce needed stability to the market. Powerful investors will now have the ability to join the Bitcoin trading arena with the traditional characteristics they are used to like risk management and hedging ability.
The Risk: Slim But Real
Not everyone is so optimistic about the Bitcoin futures. The so called “father of high speed trading”, Thomas Peterffy believes there is a slim but real possibility that Bitcoin futures trading could cause a Lehman-style crisis. Recall in 2008 when bad mortgages led to mass insolvency and an economic chain reaction. Peterffy warns that the volatility of Bitcoin could leave clearing with a burden they can’t cover.
He took out an editorial in the Wall Street Journal recently. In it he spoke of his unease at young currency stating,
“Cryptocurrencies do not have a mature, regulated and tested underlying market,” he said. “The products and their markets have existed for fewer than 10 years and bear little if any relationship to any economic circumstance or reality in the world.”
He has a point, especially regarding how new and unprecedented Bitcoin is in relation to traditional currency and assets like gold and oil.
Bitcoin Price Limits
Given the potential risk of implementing futures for such a volatile asset, protections are set to be added. Price limits will be leveraged in which trading is suspended when certain milestones are hit on the up and downside.
Price limits for a given Business Day are calculated in relation to a reference price, which generally will be set at the most recent Bitcoin Futures settlement price, calculated at 4:00 p.m. London time each Business Day. The reference price may be adjusted at the sole discretion of the Exchange to incorporate BRR changes on non-trading days. A price limit of 20% above or below the reference price and special price fluctuation limits equal to 7% above or below the reference price and 13% above or below the reference price apply. Trading will not be permitted outside of the 20% range above or below the reference price.
The Future Is (Almost) Here
The good news is we won’t have to wait long to find out exactly how Bitcoin futures will play out. On December 10th the first Bitcoin futures product will launch. As with most cryptocurrency developments, there will likely be volatility and even surprises. One thing is certain, though, Bitcoin will continue to be the hottest financial topic of this millennium.