Bitcoin Futures and institutional investment

Posted on Posted in News, Research

Jeffrey Chen

Bitcoin futures contracts will begin trading on major derivatives exchanges this month, signaling growing institutional interest in cryptocurrency as a new asset class. Futures begin trading on Sunday, December 10, for CBOE and on Monday, December 18, for CME. Nasdaq plans to launch bitcoin futures trading in Q2 2018.
A regulated derivatives market brings “Wall Street” money to the table and, more broadly, gives legitimacy to cryptocurrency as an asset class for mainstream investment. Earlier this year CBOE’s application for a bitcoin ETF was rejected by the SEC; futures trading may open the doors for bitcoin ETFs in 2018.
The impact on bitcoin price in the short term is unpredictable but could be significant. What is clear is that an influx of “big money” will increase liquidity.
Last week, the Commodity Futures Trading Commission (CFTC) granted regulatory approval for listing of bitcoin futures on two of the world’s largest futures exchanges. The CBOE announced it would begin trading bitcoin futures on December 10. The CME would launch bitcoin futures contracts on December 18. Nasdaq is planning to launch bitcoin futures as early as Q2 2018.

Futures are financial derivatives – contracts that have value based on the performance of an underlying asset, not the asset itself. Futures are agreements to buy or sell an asset at a pre-determined price at some point in the future, which allows investors to lock in a price.

“Given the unprecedented interest in bitcoin, it’s vital we provide clients the trading tools to help them express their views and hedge their exposure,” says CBOE Chairman Ed Tilly.①

CFE claims that the XBT futures contracts will provide:

More price discovery and price transparency
An exchange listed, regulated and surveilled bitcoin product
A risk management tool for cryptocurrency-holding participants
Access to the bitcoin sector without a digital wallet requirement
Settlement directly to the Gemini bitcoin auction price, rather than an average price②“Developing a regulated derivatives market is the next logical and crucial step towards advancing the broader digital asset market.” — Tyler Winklevoss, CEO, Gemini Trust Company③
CBOE head Ed Tilly said he plans to reapply with the SEC for a bitcoin ETF which was rejected earlier this year.④

Futures: a heavy, double-edged sword
Bitcoin futures will allow speculators who want exposure to the asset to profit from an increase in bitcoin price without actually owning bitcoin. This will be attractive to “traditional” investors who have until now avoided the cryptocurrency economy due to unfamiliarity, lack of regulation, and extreme volatility. It will also allow investors who expect the price to go down to sell short without owning bitcoin – “naked shorting” – an option that did not exist to investors before. In addition to this added flexibility, futures are also usually characterized by massive leverage.

Not surprisingly, this has generated both optimistic and pessimistic sentiment. Optimists believe that an influx of “big money” into the cryptocurrency market will push bitcoin price up. Indeed, Bitcoin’s explosive rise this year has arguably been due to increasing exposure to mainstream media and investment. According to a report earlier this year by Autonomous NEXT, a total of 110 crypto hedge funds hold between 1-2% of all cryptocurrency assets.⑤ – a small fraction of the total cryptocurrency market cap. Institutional investment near ~10% market cap could dramatically increase the price.

Many financial experts believe, however, that futures will not necessarily cause significant price increase in the near-term. As one professional put it, “cash markets were created for investors, while futures market were created to hedge against risk.”⑥ In other words, the fundamental difference between cash markets and futures markets is between investors and hedgers, respectively. The latter are naturally more pessimistic.

Moreover, the market will be exposed to market manipulation. The bitcoin market remains relatively small at $293 billion USD; Wall Street firms have almost unlimited capital in comparison and use high-frequency trading algorithms to control the market. In other words, Wall Street firms and computers could take the dominant role of market influencer away from millionaire and billionaire cryptocurrency investors.⑦ These views point to potential for increased volatility in the short term as large players establish a new equilibrium between supply and demand.

More moderate views suggest that the impact of futures trading on bitcoin price may be overstated. Bitcoin guru Andreas Antonopolous points out that in fact, short selling bitcoin futures without actually holding the asset incurs an unlimited amount of risk. The ones who can most utilize short futures are in fact miners, and large bitcoin holders, who can hedge against market downturn and improve their cash liquidity.

Finally, a historical perspective suggests that adding CME futures for gold, silver, and platinum had little or no impact on price compared to major international, political and economic events. For example, Gold Futures had only a slight impact compared to the 1970 US recession, the 1973 Oil Embargo, the 1979 Soviet-Afghan war, and the 1987 Black Monday stock market crash. ⑧

According to a historical approach, CBOE/CME futures will have only marginal impact on BTC price compared to other events such as:

* Cryptocurrency community politics, including Bitcoin hard forks * Government regulations * Competition among cryptocurrencies themselves (i.e. success of a new platform, catastrophic network failure of another etc.)

There are several conclusions we can make about the effect of bitcoin futures listings.

First, it is an important step towards legitimacy and adoption by mainstream investors. A regulated derivatives market, if successful, will show regulators that Bitcoin and other cryptocurrencies are viable as an asset class. Overall positive for the market.

Second, liquidity will increase. In the long-term, this could possibly result in reduced volatility.

Third, market dynamics will change. The big players in cryptocurrency today will be small in comparison to Wall Street firms. We should pay close attention to how these dynamics develop and adapt strategy accordingly.

Finally, it is important to remember that futures contracts are just a tool. By themselves they do guarantee mass adoption or institutional investment; these are outcomes that could take months or years to fully develop. The week-long rally in BTC price after the CME announcement is based on speculation about the launch rather than the futures product itself.

⑤ This study is several months old, actually value is probably different now.

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