In recent days a rather stunning arbitrage has developed in the Bitcoin futures market. To analyze this arbitrage, it is critical to understand that a forward price for any asset is not the market’s prediction of where the spot price for the asset will be at the forward date; rather, it is the market’s assessment of the fair value of owning the asset forward given the current spot market for the asset.
Determining this forward fair value can be more or less complex depending on the nature of the asset. Assets that are considered “consumption” assets (i.e., where the asset is consumed and therefore the total supply available varies widely) or that involve significant storage or transportation costs require more complex forward pricing. On the other hand, assets that are not consumed and that require little to no storage or transportation costs are fairly straightforward to price.
One of the most common approaches to pricing an asset forward is the “cost of carry” methodology. In cost of carry pricing, one looks at all of the costs associated with purchasing an asset in the spot market and holding that asset until the forward pricing date. We can use this approach to calculate a theoretical forward price for Bitcoin.
On July 9, 2019, at 4pm EDT, the spot price for Bitcoin was $12,505.97, according to trueDIGITAL Index Services, and the July expiration CME Bitcoin futures contract settled at $12,760.00, according to CME — giving a cash/futures spread price of $254.03.
To demonstrate the arbitrage inherent in this relationship between spot price and forward price, we can construct a market neutral “convergence” trade and look at the various costs associated with implementing and holding this trade.
In a convergence trade, one asset is purchased and another asset (or another form of the first asset) is sold at a higher price with the expectation that the price spread will narrow. In the case of our Bitcoin arbitrage trade, we will purchase spot Bitcoin at $12,505.97 and sell the July expiration Bitcoin future at $12,760.00. This spread trade is considered market neutral as we are both long and short Bitcoin (the long in actual Bitcoin and the short in Bitcoin futures).
Because the Bitcoin future settles to the spot price of Bitcoin at the final settlement time on the future’s expiration date, the cash/futures spread price will narrow from $254.03 to $0 between now and the July 26, 2019 expiration. This profit will be realized by selling the spot Bitcoin position evenly over the one-hour fixing window which the futures settlement price is based on, and letting the future expire and settle to its final settlement price.
However, the $254.03 is not completely profit. We must figure in the cost of holding this position from now through expiration. This cost is composed of the borrowing costs on the money needed to fund the spot Bitcoin purchase and to fund the Initial Margin requirement for holding the short futures position. There are further smaller costs, such as execution fees and slippage in execution of the two legs of the trade, but we’ll ignore those for now.
To calculate the funding costs, we’ll assume that we must borrow both the spot Bitcoin purchase price and the Initial Margin for the future at an unsecured funding rate of 6.0%. (In reality, the funding cost should be significantly less than this, as there are multiple lenders offering Fed Funds or near Fed Funds loans collateralized by Bitcoin with roughly 25% haircuts.)
To fund the spot purchase of Bitcoin, we will borrow $12,505.97 at 6.0% from July 9 to July 26. Calculated on an Actual/360 interest basis, the interest cost on this loan will be $35.43.
For the futures leg, we must borrow approximately 40% of the price of the future, also at 6.0% unsecured funding rate over the same period (current Initial Margin rates for Bitcoin futures are around 40%). This results in a further funding cost of $14.46.
Therefore, ignoring execution fees and slippage, we can generate a riskless profit of $254.03 for a total cost of $49.89, resulting in an almost pure arbitrage of more than $200. Even if we assume significant slippage of $20 on each leg of the trade and factor in execution fees on both legs, the arbitrage is still well over $150 per Bitcoin.
Another way of viewing this same data is to say the arbitrage free forward price for Bitcoin with a forward date of July 26, 2019 is:
Under either lens, the relationship between spot Bitcoin and the July expiration Bitcoin futures contract represents a large, nearly riskless arbitrage opportunity. We expect this arbitrage to collapse well before the structural convergence at expiration.