The Ins and Outs of Bitcoin Futures Contracts

Will Wall Street succeed in taming the volatile cryptocurrency?
November 18, 2017 10:10, Last Updated: November 18, 2017 10:10

Mainstream finance views bitcoin with suspicion, and some people like JPMorgan CEO Jamie Dimon even think it’s a fraud that only exists so criminals can use it to deal in drugs and illegal firearms. Now the world’s largest derivative exchange, the Chicago Mercantile Exchange (CME), has put an end to these conspiracy theories.

It announced the launch of a bitcoin futures contract slated to start trading before the end of the year, thus legitimizing the cryptocurrency as a financial instrument.

“That’s a very important step for bitcoin’s history. … We will regulate, make bitcoin not wild, nor wilder. We’ll tame it into a regular type instrument of trade with rules,” CME Chairman Emeritus Leo Melamed told Reuters.

So bitcoin will trade as a derivative alongside gold, copper, the euro, and pork bellies on the electronic trading system of the CME. Hedge funds are happy because they can now participate in bitcoin’s price move without having to amend their statutes for the complicated trading that occurs on traditional bitcoin exchanges.

Some bitcoiners think the Wall Street money will push up the price. Some others think Wall Street will now be able to manipulate the price downward, as many believe it has done with gold.

Neither is likely going to happen, and one needs to understand the mechanics of futures contracts to understand why.

Futures Contracts

CME’s predecessor, the Chicago Board of Trade, was founded in 1848 with the goal of “[advancing] the prosperity of the mercantile and commercial community.”

Futures contracts can serve that purpose by giving producers the ability to sell future production at any point in time and lock in a price. For example, if you are a wheat farmer and expect to harvest 10 bushels in three months’ time but need the money now to buy some capital equipment, you can sell those 10 bushels in advance.

Although producers could make that bargain with any counterparty at any time, exchanges like the CME standardized the contracts and also provided a backstop in case one of the contract signers went bankrupt.

Because the bitcoin contract is cash settled, the effects on bitcoin, whether positive or negative, will likely be small.

On the other side of the trade would be either consumers of the wheat who wanted to lock in a price and quantity before they actually needed the product, or speculators who would buy the wheat hoping to sell it at higher prices later. It’s important to note that an open position in the futures market can only be created if there is a long side (the buyer) and a short side (the seller), just as any other contract needs at least two parties to make it valid.

And while the speculators are purely in it for the profit, they provide liquidity for producers and consumers, and real products do change hands at the end of the contract, if it includes physical delivery, which most commodity contracts do. Some of them also include an option for cash settlement.

With the financialization of the economy, however, more futures trading is done in foreign currencies and stock indices. Most of these are dominated by speculators, and none of these trades have physical settlement, because it is impractical and sometimes impossible.

At the end of the contract, buyers and sellers just calculate the loss or gain, and the money moves from the losing party to the winning party. All this is done with leverage supplied by the exchange, so speculators can control a lot of assets without putting up much capital. Once the initial capital is depleted however, the exchange will force the loser to put up more capital or liquidate the position, a process that is called a “margin call.”

Effects on Bitcoin

Because the bitcoin contract is cash settled, the effects on bitcoin, whether positive or negative, will likely be small.

First, the dream of many bitcoiners—that trillions in Wall Street money will now push the price higher—is nothing but a dream.

Sure, hedge funds and other large institutions that are allowed to trade on the CME can now buy bitcoin futures for speculation. However, they will just “paper” trade bitcoin with each other on the CME, rather than go out to buy bitcoin on an exchange like Coinbase.

At the end of the contract, the counterparties will settle in cash based on the CME’s Bitcoin Reference Rate, which is an average of several bitcoin exchanges, also called the spot price.

So you could have hedge funds buying $1 trillion worth of bitcoin on the CME and, because there needs to be a corresponding paper seller for every futures contract, not a single bitcoin would change hands.

In fact, because the CME makes it easy for Wall Street to participate in the bitcoin upside or speculate on its demise, the move will likely divert resources away from real buy and hold demand. Instead of going through the complicated procedure of buying bitcoin outright on an exchange, large money managers can just buy the futures contract.

On the flip side, the argument of skeptics that now Wall Street can hijack the bitcoin price, as they allegedly have done with gold, is also flawed for the same reason.

If someone wants to suppress the futures price by selling bitcoin short, there needs to be a buyer on the other side. And even though large amounts of paper selling may depress the futures price, it won’t have any effect on the real price, except for maybe psychological pressure.

Arbitrage

There is one technique, however, that will make sure the futures price and the reference price don’t diverge too wildly and will lead to temporary demand for bitcoin on the real exchanges. It’s called arbitrage.

Let’s assume Wall Street money pushes up the futures price to a premium of 50 percent over the spot price.

A speculator could sell the futures and buy bitcoin on an exchange, then wait until the contract settles for the spot price.

If the price moves higher, the speculator gains on his real holdings and loses on his futures contract. If the price moves lower, he loses on his real holdings but gains on the futures contract. In both cases, his net profit from any synchronous price movement should be zero.

If more people do this arbitrage trade, however, the price of the futures should go lower and the spot price should go higher so the arbitrageur wins on both legs. The prices should converge toward the settlement date.

If the premium of 50 percent stays until the contract settles for the lower reference spot price, the speculator will sell his real holdings and win the bet on the futures market—which he sold for a 50 percent higher price—pocketing the premium from the beginning of his trade.

Of course, the opportunity for risk-free profit will never allow the premium to become this big, and particularly this example will result in some temporary demand for bitcoin.

However, the emphasis here is temporary, as the arbitrageur will close his long leg (the bitcoin he holds on an exchange) after the trade is over.

Real demand that pushes up the price over the long-term comes from investors who buy and hold and don’t sell before their price target is reached.

On the other hand, if the CME futures trades below the reference price, there is an incentive to buy the futures and sell real bitcoin, again closing the gap. It is possible to short-sell bitcoin on the major exchanges, but the short position would have to be covered at the end of the arbitrage trade, leading to a net volume of zero. It is possible that this is a temporary method bad actors could use to push down the price.

So expect some shenanigans with both the spot and futures price once the CME contract launches this year, but nothing bitcoin holders and traders aren’t already used to.