Why Bitcoin Futures?

I’m a simple guy. I like to keep things simple. I also like to break down things that seem complicated into simple parts. There’s been so much excitement over recent Bitcoin futures listings but how much do people really understand what futures are and the role futures contracts play versus underlying markets?

When you first study derivatives one of the first things you learn are about futures contracts. Very simply, they preform 3 functions:

1. A hedge.
2. Speculation.
3. Arbitrage.

Year 1697 Osaka, Doshima Rice Exchange

Forward and futures contracts on physical commodities such as crops and grains have existed for centuries. One of the world’s first organized commodity futures exchanges was the Doshima Rice Exchange of Japan. This was established by the Samurai in the late 1600s. The purpose of these futures contracts was for producers to be able to protect themselves from price swings in their rice crops before they had to harvest and deliver them. For instance, if the the rice producers felt that the weather had been so good and there would be a glut of rice supply in the market, they could hedge themselves from price drops by selling futures before delivery. Thus, the hedge part. Some Samurai loved to gamble, and so if they had some insider information or maybe simply knew the weather would cause a bad harvest, they could speculate on a price rise and buy rice futures on the exchange — this is the speculative part. Also, if there were rice producers sitting on a pile of rice but saw that the crazy Samurai speculators were pushing futures way above what the rice farmers thought were reasonable or fair prices, then they could sell futures against their physical rice supply and make a profit when the futures settle at the delivery date, because by then the prices would be the same. In trading, this is what we call arbitrage.

Another important characteristic of modern futures contracts is leverage. In many cases futures contracts these days are based on an index, or basket, of underlying assets such as stocks. The Nikkei 225 index of Japan comprises 225 big Japanese stocks and is seen as one the benchmark indicators. Since it is too expensive to buy and sell the entire basket of 225 stocks, you could trade the futures contract for a fraction of the amount by posting margin and getting 25x leverage. It’s great for speculators of the overall market, and it’s great for hedgers who own a portfolio of stocks that reasonably track the Nikkei index, or even if it doesn’t it’s great for people who just need a hedge for psychological comfort.

Hedging

So how does all this fit in with Bitcoin and the new futures contracts? First, Bitcoin is a long only speculative instrument. Meaning people mostly buy and hold, or mine and hold. If they wanted to hedge their Bitcoin holdings they could easily sell some of their Bitcoins since the liquidity in the market is quite large. You could even do things like buying another currency, perhaps Bitcoin Cash, because in some specific cases the correlation between Bitcoin and another coin could go negative, effectively becoming a Bitcoin hedge even if you are long both. If you try to use futures to hedge then that means already you are long Bitcoin (meaning you are trading it already), and if you used futures there would be the trouble of constantly monitoring your margin requirements and would need to roll contracts every expiry. Seems rather unnecessarily complicated as compared to simply adjusting your underlying crypto portfolio.

Speculation

In terms of speculation, well, other than feeling comfort from using an “established” mainstream exchange and not having to worry about physical delivery, it seems perfectly simple just speculating in Bitcoin itself because there is no need to leverage. If you really wanted to leverage Bitcoin, which personally I think is quite insane, there are already many exchanges that offer up to 100x leverage without even using futures. Good luck with that.

Arbitrage

Lastly, the arbitrage part. The underlying Bitcoin market is fragmented across dozens of large exchanges around the world. Now I’m not the expert here and I’m still discovering new things everyday, but with no reliable underlying benchmark to price a reliably liquid future market, futures markets will probably go down the same path of being confusing and fragmented. The new CBOE Bitcoin futures contracts get settled off of an auction price at an obscure Bitcoin exchanged called Gemini. It has a 10% circuit breaker which sounds ridiculously small given how large Bitcoin price swings can be, and I wouldn’t be surprised if this causes even more unexpected volatility when unknowing futures traders panic when the futures market locks up after a 10% move and spill over into Bitcoin markets. Great opportunities for the experienced trader with time and resources.

Expert Opinion

Marco Guerreiro, Head of Quantitative Strategies at Swissborg, points out “If you are a bitcoin miner you will have a relatively predictable future stream of BTC that you might want to hedge. I know this is not the main purpose of this contract like in other commodities, the CME and CBOE are issuing this for pure speculation. But you could make the case that these contracts will be similar to Gold futures. There is a future stream to be hedged for some participants, but the futures are mainly used to speculate instead of hedging. In the case of Gold futures for example, the daily trading volume of a couple of days is already larger than the annual mining output of Gold. I suspect the same thing will happen in Bitcoin Futures.”

In any case, this is all very interesting to watch develop. Personally, options on Bitcoin are much much more fascinating and practical for Bitcoin holders. But, that I will save for another story.

www.swissborg.com