How Will the Futures Impact Bitcoin Prices?

by: Tam Ging Wien


All examples and stocks quoted here in this article and on the ProButterflyTM site are for learning purposes; it does NOT constitute financial advice or a Buy/Sell recommendation. Contents are reflective of personal views and readers are responsible for their own investments and are advised to perform their own independent due diligence and take into account their own financial situation. If in any doubt about the investment action you should take, you should consult a professional certified financial advisor.


 

Just last week saw the world’s first Bitcoin futures will be launched.

For the past month, there was a flurry of press releases, media reports and analyst opinions over the introduction of the Bitcoin futures to be introduced by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) on 10th and 18th of December 2017 respectively. 

But what exactly is a Bitcoin future and what are the implications to Bitcoin? We explore and discuss this topic here in this week's post.

What are Future Contracts?

In a normal transaction, settlement takes place immediately. For example, at the market I hand the seller $50.00 for 2kg of fish. I get the fish and the seller gets the cash immediately. Both parties walk away satisfied. Similarly on the stock market, when we pay for a specific stock, say Amazon, a seller will “Ask” for a specific price for the stock. If you are comfortable, you will “Bid” at the price and the transaction will take place with you getting the shares while the seller gets your money.

However in futures contracts, the payment takes place immediately, but the settlement for fulfilment of the goods, services, product takes place in the future. Reusing the example of the fish above, in a futures contract, I would still hand $50 to the seller at the agreed price for the fish; but instead of receiving the fish immediately, the seller promises to deliver the fish at my home 2 weeks later.

A futures contract therefore not only has the element of price, it also has an additional element of fulfilment date.

How are Futures used?

Reusing the example of the fish from above, let’s say that there is a famous Japanese sashimi restaurant which will need to get a constant supply of fish to prepare to serve its customers. However, prices of fish in the market to vary daily depending on the haul and quantity brought in by the fishermen. With such daily uncertainly in fish prices, menu prices at the restaurant would need to be updated on a daily basis resulting is much hassle, inconvenience and uncertainty to both the restaurant and its customers.

The resolve the problem, a restaurant owner could use future contracts to guarantee that he gets a constant supply of fish at a specific price in the future. He could negotiate with his supplier to order the exact amount of salmon and tuna for the next 3 to 6 months at an agreed price.

By utilizing futures the restaurant owner has the advantage of ensure that the prices and supply of his fish is guaranteed, does not need to store stock of fish until required and able reliability price his menu items taking into account the desired profit margin, affordability of his customers and competitor’s pricing.

Futures are quite commonly used in all industries. For example the airlines industry frequently uses oil futures to hedge their fuel prices to ensure that their cost of fuel is predictable and hence the tickets sold to customers would be earn them their required margin. A chip manufacturer may use futures contracts to ensure a steady and predictable supply and price of its raw materials such as gold and silver.

With Futures, Comes the Traders and Speculators

The real world uses of futures are practical and necessary as it gives a certain stability to commodity prices. However as with all things, futures also attract a different breed of market participants, primarily the traders and speculators.

Traders have no desire to take possession of the actual underlying asset or commodity. Instead, they either buy or sell the futures contract itself in order to profit from the different in prices.

Speculators on the other hand have a specific view on the future prices of the underlying asset or commodity and is able to use futures to make a bet on the price direction.

Bitcoin and other cryptocurrencies have split the community right down the middle with strong Supporters and Skeptics each making their own case for what they think would be the future prices of Bitcoin. The Supporters view Bitcoin as a major breakthrough in the financial world as for the first time, we are able to have a network to transaction value without the need for a trusted 3rd party. The Skeptics on the other hand point to Bitcoin’s parabolic price chart and calling it’s a bubble and the repeat of the Tulip Mania.

Prior to the introduction to these futures, there were little options and instruments available in the market for Skeptics to bet against the Bitcoin. They could only sit at the sidelines and watch the Supporters bid up the prices of Bitcoin. Prior to the introduction of the futures, there is only one way for Bitcoin – up!

With the introduction of Bitcoin futures, the Skeptics would now be able to put their money where their mouth is and take a short position using the futures.

There is a large number of people who would like to get into this current crypto crazy and ride the upside but are not entirely sure how to purchase their Bitcoins or secure them properly. The futures would be a good platform to allow these Supporters to take a long position using the futures to profit from the price gains.

There is however a 3rd group of people who haven’t quite made up their minds yet and are currently holding on tight to their cash and trying to decide if they should join the Supporters or Skeptics. The introduction of futures through both CME and CBOE, both which are reputable, regulated and liquid exchanges for futures will lend legitimacy to Bitcoin. This may change their mind and encourage fund flows.

Specifics of the Bitcoin Futures

The Bitcoin futures offered by CBOE was launched just last week. CME will be launching their futures tomorrow.

The size of each future contract is 5 Bitcoins. Traders who buy or sell each contract will need to maintain at least 35% of the contract size in cash; otherwise known as the margin requirement. The tick size of each contract is $25 which translates to $5 per Bitcoin. There is a daily price fluctuation cap of 20% above or below the previous day’s settlement price. This limit was placed into the futures contract to limit impact should there be unexpected flash crashes on cryptocurrency exchanges.

The Bitcoin futures are cash settled – instead of fulfilling the delivery of those 5 Bitcoins, on the date of fulfilment, only the price difference is made. Therefore in cash settled future contracts, no actual commodity is transacted, settlement is based on the cash value of the price differential.

At time of writing, Bitcoin is presently trading at about $19,500. This means that a single futures contract is valued at $97,500 as of time of writing. A trader wishing to trade this contract would require to put up at least $34,125 in cash to maintain their margins. Should prices move against the bet, they will be required to top up this margin to maintain the contract.

Effects of the Futures on Bitcoin Prices

Prices of the futures trade independently from the prices of Bitcoin as it depends on the markets perspective and price action. But before we understand how the futures will affect Bitcoin, we must first understand the implications of the price differentials between Bitcoin and the futures. To keep the discussion simple, the concepts illustrated will simply use 2 prices, the Spot price and Futures price and ignore all transaction fees, margin requirements and spread between Spot and Futures price.

When futures price traded are higher than the spot price of Bitcoin, we have a situation known as a Backwardation.

For the simplicity of this example, we will assume Bitcoin spot price is presently at $20,000.

Assuming the spot price of Bitcoin is $20,000, in a backwardation scenario the futures would trade at say $22,500.

When future prices traded are lower than the spot price of Bitcoin, we have a situation known as a Contango. Assuming the spot price of Bitcoin is $20,000, in a contango scenario the futures would trade at say $18,000.

Under a normal scenario, the prices of futures should trade with a small premium to the spot price.

Due to the extreme volatility of Bitcoin, most hedge funds would not risk their client’s money betting on cryptocurrencies. However, with futures, it allows hedge funds to profit when there is a backwardation or contango affect. For a hedge fund to make a guaranteed profit from Bitcoin, they would need to take the following action:

  • Backwardation: Buy “physical” Bitcoin and Short futures
  • Contango: Sell “physical” Bitcoin and Long futures

Let’s examine the first action. Let’s say a hedge fund bought 1 Bitcoins at $20,000 while simultaneously shorted the Bitcoin futures contract at $22,500. Bitcoin prices could however rise or fall in the future, let’s examine what happens in this 2 scenarios:

  • Bitcoin spot prices rise to $23,500: The hedge fund would have gained a total of $3500 from buying the Bitcoins but would have lost $1000 from shorting the Bitcoin futures.
  • Bitcoin spot prices fall to $18,000: The hedge fund would have lost a total of $2000 from buying the Bitcoins but would have gained $4500 from shorting the Bitcoin futures.

In both the above scenarios, the net profit is always $2500 regardless of how much the price gain or fell.

Let’s examine the second action. Let’s say a hedge fund sold 1 Bitcoins at $20,000 while simultaneously going long the Bitcoin futures contract at $18,000. Similarly, below would be the 2 scenarios:

  • Bitcoin spot prices rise to $23,500: The hedge fund would have lost a total of $3500 from selling the Bitcoins but would have gained $5500 from going long on the Bitcoin futures.
  • Bitcoin spot prices fall to $18,000: The hedge fund would have gained a total of $2000 from selling the Bitcoins but would have no losses or gains from going long on the Bitcoin futures.

In both the above scenarios, the net profit is always $2000 regardless of how much the price gain or fell.

Notice that when either a backwardation or contango scenario show up, funds would quickly be able to move in and make a trade and guarantee a profit regardless of the direction of asset price moment. 

However, in today’s market, these large institutions and hedge funds would only be able to profit from the backwardation scenario to buy Bitcoin at spot prices while simultaneously shorting the futures. This is because the funds have yet to accumulate enough Bitcoins to be able to sell their holdings in a contango situation. Bitcoin today is largely owned by early adopters who purchased them early on when prices of Bitcoin was less than a thousand dollars.

Therefore in order to profit from the contango affect, they would need to accumulate enough “physical” Bitcoin from now on. This accumulation phase could last a fairly extended period, perhaps 12 months to 18 months as the supply of Bitcoin is scarce. While this accumulation is happening, the inflow of institutional money will likely continue to bid up the prices of Bitcoin over the accumulation phase. Perhaps we could see Bitcoin price continue to rise in the near future.

However once the accumulation phase is over and there is sufficient hedge funds holding Bitcoins, they will be able to both buy in a backwardation and sell in a contango scenario. This would result in stability in Bitcoin prices and the meteoric price rises in Bitcoin would likely stop. It would likely trade like any other commodity in the present markets and be moved based on the demand and supply curve and price action on the open market.

Other Participants of the Bitcoin Futures

In the most traditional use of futures, firms use them to ensure predictability of supply and prices to raw materials essential to their businesses.

In the case of Bitcoin, these firms would be the miners who will benefit from the predictability of Bitcoin prices in order to ensure a steady cash flow which they can use to reinvest into purchasing more mining equipment and determine payout to their investors.

For example, a miner is able to reliability predict the amount of Bitcoins that they would mine over the course of the week but is unable to predict the price of Bitcoin in the future. Therefore having a futures contract would greatly benefit the miner as they are now able to purchase/sell futures contracts to lock in thier future cash flow.

Another significant participant in the futures are the traders who are simply interested in profiting from any difference in the price direction of the futures. These traders could bid up or sell down the prices of the futures resulting in either a backwardation or contango scenario to show up.

Lastly, the speculators who are either the Supporters or Skeptics would be able to trade the futures in hopes to profit should their views materialize.

The way we view it, the fund managers, traders, miners and speculators all are able to benefit in their own respective ways from the introduction of the Bitcoin futures. This will have a positive impact on Bitcoin prices over the near future, however the long term accumulation of Bitcoins by the large institutions with significant funding is likely to end the many-fold returns any crypto-investors are currently used to.

The Uncertainty that Futures Bring

While we have only discussed the fund managers, traders, miners and speculators, there is one major market participant that we have yet to discuss – the market manipulators.

These market manipulators are able to influence the prices of Bitcoin through their extremely large buy or sell actions. Armed with large amount of funding, these manipulators could bid up the spot prices of Bitcoin on various exchanges. With large amount of Bitcoin holdings, these manipulators could also easily force down the spot price of Bitcoins by dumping their significant holdings.

Buy having a futures market, these market manipulators could impact the prices of both the futures market to create the desired profits that they are seeking.

For example, a market manipulator with large funding and holdings of Bitcoin could simultaneously short the futures while dumping their large supply of Bitcoins on the market. This would force down the spot prices of Bitcoin drastically while simultaneously profiting from the short positions on the futures. With prices sufficiently suppressed, the profits gained from the futures could be used to repurchase the Bitcoins back cheaply from the open market and they could initiate another trade in the reverse direction profiting from the large up and down swing in prices.

Would this scenario be real? Could market manipulator already be preparing for a massive short on Bitcoin and manipulation of its prices? Perhaps.

According to various news reports such as this one, the CBOE Bitcoin futures has a tie-up with the Winklevoss brothers who are widely reported to be the first Bitcoin billionaires. With such a close tie-up and such a large supply of Bitcoins at their disposal obtained cheap many years back, could we perhaps see a major short initiation on Bitcoin in the near future after the introduction of the futures?

Barring any unforeseen or unanticipated mass manipulation of Bitcoin prices on the open market, we are on the view that the futures are in general positive support for Bitcoin prices throughout 2018. But over the longer term, don’t expect to see the same sort of triple or quadruple digit gains seen throughout 2017. The introduction of the Bitcoin futures is likely the beginning of an end to Bitcoin phenomenal price gains.

Ironically, future contracts are meant to bring stability and predictability to the prices of commodities. With Bitcoin, it seem that it brings us more uncertainty. We will have to wait to see how the future unfolds for Bitcoin.

At ProButterflyTM, we encourage all our readers to dabble a little into the cryptocurrency space as we believe that asset class has a long term potential and the wave has only just started. We encourage you to read our introduction to blockchains and cryptocurrencies and have even written out a guide to help you through the process of buying your first Bitcoin:

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