This one turned out to be a lot longer than expected, so here’s a TL;DR for those of you that are time constrained:
The traditional futures market is composed of hedgers, speculators, and arbitrageurs. There are very few hedgers in the bitcoin market. Speculators follow trends, they don’t create them – either in the futures or spot markets. Arbitrageurs however do have the ability to affect both the spot and futures markets, but there are structural problems that impede the effectiveness of their strategy.
All told, the trading of bitcoin futures by institutional investors is unlikely to create a directional impact on the bitcoin price. The tail doesn’t wag the dog. Instead, the most significant impact of the announcement has been the increased confidence in bitcoin resulting from the endorsement regulators have effectively given to bitcoin.
The crypto community is very excited about the CME’s announcement to list bitcoin futures.
Futures are one of the most important risk management tools in the financial system. They allow buyers and sellers of commodities to set prices today, for transactions that will occur sometime in the future. In doing so, both sides remove the risk that prices may move adversely, thus smoothing their cashflows, and allowing them to plan and operate more effectively.
But I don’t think anyone in the bitcoin community cares about smoothing cashflows or operational efficiency!
As we know, futures are also used to speculate, and that is why the community is so excited. Institutional investors can now get leveraged exposure to bitcoin, and the inevitable wall of money they will bring will ensure bitcoin continues its surge into 2018.
That, at least, is one perspective.
There are some contrarians, and they noted that speculation occurs in both directions. These institutions now had a tool to short bitcoin, and they would use it when bitcoin was overvalued. This selling would weigh on the price.
Others still did some googling and discovered that it is theoretically possible to arbitrage the spot and futures markets (i.e. create a risk-free profit by trading both the current and futures price) and that this could cause some volatility in the spot market.
Up? Down? More Volatile?
Well, they are all valid perspectives. Each of these trading strategies will be at play when trading goes live. Whether any will impart a systematic bias to either the future or spot price remains to be seen. I certainly won’t be making any firm predictions.
Instead, I thought it would be useful to explain how the traditional finance community views the futures market. In particular, I’d like to describe the players and their motivations. This will be a high-level summary, and inevitably incomplete, but hopefully it will provide some useful context.
Finance 101: The Futures Market
Futures prices are determined by the interaction of three groups1:
• Hedgers
• Speculators
• Arbitrageurs
Hedgers
Hedgers are producers and consumers of the underlying commodity. A farmer is a producer. He agrees to sell his wheat 6 months from now for $5 a bushel. He shorts the 6-month wheat future. On the other side of that trade is a flour mill. The flour mill is a consumer – it buys and processes wheat. The mill doesn’t want to gamble so it locks-in the cost by going long the 6-month wheat future.
In the bitcoin economy, bitcoins first appear on the miners’ balance sheets. They are the producers. But unlike a farmer selling his crops, miners don’t necessarily produce bitcoins with the intention of selling them. A bitcoin isn’t a perishable good. The miners can store them indefinitely, and many will be held in expectation of further price increases.
That said, they can’t keep them all. The miners have costs and they must be paid in fiat currency. With revenues denominated in BTC and costs denominated in fiat, the miners are exposed to exchange risk. To the extent that miners use futures to reduce this risk, they will add selling pressure to the futures price.
Now, who are the “consumers” of bitcoin?
I’m not talking about investors who want to use bitcoin as a store of value, or to speculate on its price (more on them later). What I’m asking is, who uses bitcoin as part of their day-to-day commercial operations? Do any businesses have their costs denominated in bitcoin? Do they need to hold bitcoin as part of their capital structure?
Perhaps it’s my lack of experience, but I’m struggling to see much demand for commercial reasons. Maybe that will change – if it does it will be positive for the futures price – but until then it’s difficult to see much impact from “consumers”.
Overall, demand for hedging could be a small negative for the futures price.
Speculators
Speculators don't spend their days twirling their moustaches while devising nefarious schemes.
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In the futures market, speculators are mostly “smart money” institutions like hedge funds that trade for profit. These funds employ various strategies, but I’ll discuss just one for illustration.
Commodity Trading Advisors (CTAs) trade futures, options and swaps, and are one of the biggest players in the futures market. They use mathematical models to determine whether the market is trending and if so, they join in. When the price is rising they go long, when the price is falling they go short.
If CTAs were to trade bitcoin futures, what affect would they have on price?
It’s difficult to argue that they would impart a directional bias. CTAs follow trends, they don’t create them. They could magnify an existing trend, but they wouldn’t attempt to push the price in the opposite direction. Perhaps this could increase the volatility of the futures price, but it’s unlikely to put systematic pressure on it in either direction, much less the spot price2.
Ultimately, speculators speculate. They don’t much care what direction the price moves as long as they are on the right side of it.
Arbitrageurs
Strictly speaking arbitrageurs are speculators. They haven’t come to the market to hedge risk. Like the speculators just discussed, they are here to profit. However, they employ a very specific strategy, one that creates a “risk-free” profit and could be said to remove the “speculation” from the trade.
Let’s look at an example…
If the price of the asset is $100 and the 1 month future is selling for $120, the arbitrageur will buy the asset and sell the future. If the price of the asset is $140 in a month he will make $40 on the asset, lose $20 on the future for a $20 profit. Alternatively, if the price of the asset is $70 in a month, he will lose $30 on the asset, make $50 on the future, and again make profit of $203.
Whatever the price at the end of the month, the combination of positions in the spot and futures market mean the arbitrageur pockets a risk-free $20 profit .
This risk-free profit will attract new arbitrageurs who deploy more capital into the trade i.e. they will sell more futures and buy more of the underlying asset. This will cause the futures price to fall, the spot price to increase, and eventually the relative mispricing disappears.
What could that do to bitcoin?
If the futures price is too high, arbitrageurs will sell the future and buy bitcoin in the spot market, and vice versa. So here we have a mechanism connecting the spot and futures market.
Does that mean the tail can wag the dog?
Well, there are some caveats.
Firstly, it is not easy to short sell bitcoin in the volume that would be required to remove the mispricings. That means bitcoin overvaluations are harder to arbitrage away. Going in the other direction (long the underlying and shorting the future) is easier. So arbitrage is more likely to depress the futures price and support the spot price than vice versa.
Secondly, the bitcoin price in the futures contract is the CME Bitcoin Reference Rate (BRR). The CME BRR is an average of the bitcoin price on four different exchanges. It is not tradable in the spot market. It is not the same price that an arbitrageur would pay on GDAX or Kraken for bitcoin.
That creates a discrepancy between the arbitrageur’s long and short positions. In finance we call this mismatch a “basis risk” – the risk that your hedge will not work.
While we would expect the CME BRR to be highly correlated to the bitcoin price on the arbitrageur’s preferred exchange, it will not be exactly the same. Worse still, the largest discrepancies will occur during the periods of highest volatility – exactly when you don’t want them!
It may seem like I’m quibbling here, but these are the kinds of things that really matter to people in finance. The key point is that this strategy isn’t entirely “risk-free”, which makes it less attractive to arbitrageurs as it is not a pure arbitrage trade.
Arbitrageurs will still come to the market (they can also arbitrage between different futures expiry) but they may not have the ability or the inclination to remove mispricings entirely.
Whither bitcoin?
It’s difficult to see how trading in the futures market will have any significant impact on the bitcoin price. Hedgers’ impact should be marginal. Speculators may add some volatility, but they are unlikely to create a systematic bias to the futures price – much less the spot price. Finally, arbitrageurs do have the potential to move the spot price, but their strategy is hampered by structural issues, and only time will tell whether it can be implemented effectively and in sufficient size.
Despite all that, bitcoin futures may still have a large effect on the bitcoin price. As I said in the introduction, the fact that regulators have given the CME (and the CBOE and the NASDAQ) permission to list bitcoin futures is tantamount to an official endorsement of bitcoin. Regulators are telling the world that bitcoin isn’t a scam, it isn’t a Ponzi scheme; it’s a financial instrument (for want of a better phrase) that is here to stay.
Moreover, bitcoin futures are likely to pave the way for further financial innovation in the crypto sector. I think that's something we are all looking forward to!
Footnotes
1 Depending on the market, there may also be market-makers or specialists. Their job is to provide liquidity and thereby reduce volatility. They do not create a directional bias in the price of either the future or the underlying asset so I have left them out. You can read more about them here
2 Whenever commodity prices spike the media claim that speculators are using derivatives to drive prices higher. It makes a good headline, but the research is less clear. An enormous amount of time has been devoted to studying the relationship between spot and futures prices. Different markets give different results, but overall the evidence suggests that futures do not have a meaningful effect on spot prices.
3 This is a simplified example. There are other variables that would affect the calculations IRL, notably margin and funding costs, but the principle remains.