Bitcoin Futures Raise Complex Questions

December 08, 2017

The hottest financial asset of 2017 keeps getting hotter. Bitcoin, the world's first and largest cryptocurrency, surged to nearly $17,000 on Thursday, more than double the price from two weeks ago and 20 times the price from a year ago. On Friday, bitcoin's price stood at $15,676.

If anything, the parabolic move higher in bitcoin seems to be accelerating, which few would have thought possible after the cryptocurrency shattered previous milestones with ease. The latest push to new records is being fueled by one thing, according to analysts: anticipation of bitcoin futures.

On Sunday, the Cboe Futures Exchange will begin trading bitcoin futures (ticker symbol XBT), the first mainstream financial products tied to bitcoin. CFE is owned by Cboe Global Markets, one of the largest exchange operators in the world, and the parent company of ETF.com. Cboe's bitcoin futures contracts will launch one week ahead of similar products from the competing Chicago Mercantile Exchange.

Bitcoin bulls are betting that the introduction of bitcoin futures will ignite a new wave of demand from institutions and other investors who were unable or unwilling to buy bitcoin outside of the highly regulated, traditional financial system.

A successful launch of bitcoin futures could also open the door to a bitcoin ETF sometime next year, which could then invite billions of more dollars into the cryptocurrency.

More Balanced Market

However, there are those who are not convinced that bitcoin futures will undoubtedly send prices up. In fact, some believe bitcoin futures could put downward pressure on bitcoin prices, or at the very least, create a more balanced market with less volatility.

"Futures are most useful when the market for the underlying asset is volatile, and that's certainly the case with bitcoin," said David Yermack, professor of finance and business transformation at New York University Stern School of Business. "These products are likely to stabilize the market and provide ways for people to bet against the continued rise of bitcoin—something that has been missing from the market up to now. I expect a lot of investor interest in these contracts, and subsequent futures listings for other cryptocurrencies such as ethereum."

Currently, the vast majority of market participants in bitcoin own the digital currency outright. In trading parlance, they are “long,” which means they profit when the price rises.

It's possible to do the opposite, go “short” bitcoin and profit from price declines. Certain exchanges, such as Bitfinex—the world's largest cryptocurrency exchange—provide the option to borrow bitcoin and sell short, but it requires a margin account and is not widely used.

In contrast, in the futures market, there will always be a long and a short for every bitcoin futures contract.

Cboe's bitcoin futures contracts will be settled in cash after their expiration date, with the value of the contracts determined based on bitcoin prices at the Gemini Exchange.

 

Shorting Bitcoin 'Extremely Risky'

But just because people will soon have the ability to easily short bitcoin doesn't mean they should do it. Spencer Bogart, head of research for Blockchain Capital, cautions that shorting bitcoin is "extremely risky."

He compared shorting bitcoin to shorting stocks to make his case: "In equities, there’s some natural point where most people in the market start to perceive it as overvalued (P/E or EV/revs get way too high), but in bitcoin, there aren’t those kind of fundamentals that make giant head winds to moving higher. The reality is that very few people and institutions own any bitcoin today, but many have indicated interest in purchasing, so bitcoin can easily move significantly higher at any point in time."

Bogart believes that bitcoin futures are more likely to add upside than downside pressure to prices.

"I’m not sure what futures will mean for bitcoin price short term, but overall, I think it’s bullish because it’s the beginning of the institutionalization of bitcoin," he said. "I think once these futures markets develop deep liquidity and robust markets, we’ll see the approval of a futures-based ETF in the next six to 18 months."

Futures Curve Question

Aside from the impact on prices, another thing people will be closely watching after Sunday is what shape the bitcoin futures curve takes once trading begins. Cboe said it may list up to 10 futures contracts with various expirations. People are eager to know where those contracts trade in relation to each other and to the spot price of bitcoin.

Some believe that bitcoin futures could initially trade in backwardation―where subsequent contracts trade at lower prices―on expectations that prices could fall after their steep ascent.

Gold, which bitcoin has often been compared to, has almost always traded in contango, where contract prices increase over time. Oil, another heavily traded commodity, has fluctuated between contango and backwardation, depending on market fundamentals. Meanwhile, futures on the VIX, an index measuring the implied volatility of the stock market, are usually in contango when values are low, and in backwardation when values are high.

Russell Rhoads, director, product advancement, global derivatives at Cboe Global Markets, said that the only way to find out what shape the bitcoin curve takes is to wait until trading begins.

"The question I’m constantly hearing is, 'how will the futures prices relate to spot bitcoin pricing,' and the best (and most honest) answer I can give is, 'I don’t know,'" he said.

"I’ve done academic work on the launch of new listed products in the past, and prior assumptions about new markets often are off the mark,” he concluded. “I’ve heard arguments for the futures trading at both a premium and a discount to the spot price. Personally, I think the best strategy is to see what the market tells us when bitcoin futures are available for trading."

Contact Sumit Roy at [email protected]

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