On Tuesday, October 31, 2017, the Chicago Mercantile Exchange (CME), the world’s largest derivatives trader, announced the launch of a derivative future on Bitcoin, with huge effects on the entire crypto market.
More than two years later, Bitcoin futures remain a hot topic in the cryptocurrencies world. This subject is quite complicated, so let’s try simplifying to fully understand it. Buckle up and enjoy reading!
How bitcoin futures work?
Let’s start from the basics: a derivative is a financial instrument that derives its value from something else, as a currency or an asset of some kind, called the “underlying”. Futures are the most common type of derivative. They consist of a contract between two parties for the exchange of a certain underlying (in this case Bitcoin), under defined conditions, including price. These exchanges are scheduled for a specific date, which is defined as the “maturity” of the future: on that date, the positions of buyers and sellers are “closed”.If, for example, the future expires in May 2020, on that date, who went short/long on the future will liquidate his position. Basically, with futures on Bitcoin, you could speculate on the price or hedge against particular risks related to the fluctuation of Bitcoin price. An important thing to mention is that Bitcoin futures are “cash-settled”, i.e., at the moment of maturity, investors don’t trade Bitcoins, but dollars. This leads us to an important consideration:
Bitcoin has a limited supply as a currency, and not like a speculative asset
This is a very important aspect: when it comes to getting institutional investors into Bitcoin, there are two alternatives: give them “real” Bitcoins to buy with a special financial vehicle or print “paper bitcoins” suitable for the traditional market. The second option is the simplest and is the one adopted for Bitcoin futures. This is important because futures don’t increase the demand for Bitcoins; on the contrary, they’re an alternative to Bitcoin, so much so that we speak – in these cases – of “paper dilution”: futures are like “paper bitcoins”, which are added to real Bitcoins, increasing the supply for institutional investors who prefer these “paper bitcoins” because they are safer. Of course, the launch of the future was very important as a moment when Bitcoin was elevated to the status of “legit” financial asset, equivalent to other traditional assets that were also traded – among other methods – via futures.
Futures and financial adoption
The launch of Bitcoin futures was the first occasion in which Bitcoin was traded (albeit indirectly) in traditional financial markets, opening new opportunities for global adoption and further speculative interest, with potentially positive effects on its price. The launch of the derivative coincided with a huge increase in interest in Bitcoin: Terry Duffy, the CEO of CME, said in the official announcement that the decision to launch the future follows the growing interest of customers in the evolution of cryptocurrency markets:
“Given increasing client interest in the evolving cryptocurrency markets, we have decided to introduce a bitcoin futures contract,”
In this regard, the launch of futures was a further step of a trend in which price and speculative euphoria fed each other, with positive repercussions also on the Bitcoin image, which was seen as something closer and used in every area, from payments to speculation. An advance on all fronts. In the following days, however, the Bitcoin market peaked (mid-December 2017: the price reaches $20,000) followed 1-2 weeks later by the peak of speculative activity on altcoins (especially Ripple). This moment of euphoria was followed by a devastating crash, which saw Bitcoin lose 70% of its highs. One of the explanations of this collapse are futures. Let’s see it better:
Who’s heading the crypto market?
One of the great advantages of the futures market is that it allows you to go short on Bitcoin in a secure way (the platform on which futures are traded is much more reliable than traditional exchanges). Therefore, what could have happened is something like this: it’s much easier to buy than to go short, and the Bitcoin market goes up. Then futures come, which allow you to short; someone does it, and this leads to the decline of the BTC price. These shorts would have two impacts on the price: 1) They would be a ‘signal’ for those who trade on the exchanges. Bitcoin market participants see that the futures fall and so they sell. 2) They allow whales to go long and pump the Bitcoin market, and then point down using derivatives.
Both of these two assumptions have serious flaws: 1) First, the price of futures does NOT drive the BTC price. while this is very discussed, many studies argue that the prices of the CME futures follow the price provided by other sources, particullary the spot market (it’s the so-called “price discovery”). Check for example here 2) Bitcoin market volume is much, much higher than the futures market volume. If you were to bet on the drop in the market, it’d make more sense to go to the “real” market, which is much more liquid (find HERE more about market liquidity)
The disproportion between the huge capital on the BTC market and the low profits that would be obtained by going short on futures (which is a relatively small market) should make us think. Let’s also remember that to profit from a short position you have to close it, that’s the equivalent of a buyback: you need a very large market to make sure that, after a fall, closing the short position does not cause the market to rise again. It’s even true that the asset management of the company “Bitwise” published a study according to which 95% of the cryptocurrency trading volumes are false. This is a problem for the whole market, but in this regard, it means that futures volumes are more relevant than we think compared to the bitcoin market: while it is certain that fake volumes lead us to underestimate the relative importance of the derivatives market, it’s clear that this aspect needs further research.
A few final thoughts…
The events involving Bitcoin futures should also make us reflect on the fact that when it comes to speculation, it’s difficult to distinguish between causes and consequences. The announcement of the futures led Bitcoin to rise further, but at the same time futures were announced because Bitcoin was going up, and there was a lot of interest. Often when we analyze the markets, we talk about the “feedback system”: circumstances in which events affect each other, making the situation evolve quickly. There was speculative interest for BTC -> futures -> more speculative interest was created -> the premises for ETF -> and so on.
When we look at the crypto markets, we’re talking about something extraordinarily tangled: let’s avoid any simplification. That’s what we’ve tried to avoid in this article, and we hope it has been useful to you. Tell us what you think!