This is what futures will mean for bitcoin

Bitcoin has spent the past eight years on the sidelines of international finance.

It’s been mocked and ridiculed by some of the biggest financial minds out there.

And now, bitcoin is going mainstream as bitcoin futures contracts on some of the largest U.S. exchanges (the Chicago Mercantile Exchange and Chicago Board Options Exchange) begin trading this week.

The key question on everyone’s mind is this: how will the launch of bitcoin futures affect both the volatility and price trajectory of bitcoin?
This is a future

First, what is a futures contract? A futures contract represents an agreement to buy or sell an underlying asset at a given point in time in the future.

In most cases, futures are cash settled which means you don’t actually have to exchange (i.e. deliver or take delivery of) the underlying asset.

For example, if a 1-month oil futures contract is trading at US$50 and you go long (i.e., buy) a futures contract, in 1-months’ time the futures contract will settle depending on the prevailing spot oil price at the time.

If the spot price is at US$55, then you’ll receive $5 (i.e., $55 minus $50).
If the spot price is at US$45, then you’ll pay US$5 (i.e., $45 minus $50).
Futures contracts are used as both speculative and risk-management tools. For example, futures allow an airline company to lock in its fuel costs years in advance – allowing predictability to its projected expenditures in an otherwise volatile commodities market.

Equity index futures allow traders to make huge directional bets on equity markets. There are futures contracts trading across every major financial asset class.

But it’s difficult to assess the potential impact right now on bitcoin. That’s because we’re looking at an institutional asset class (futures, which are traded by banks and funds) centred around an extremely non-institutional (and unconventional) asset.

As I’ve written before (see here and here), it seems many of the lords of finance don’t have a clue about bitcoin at all. And few of them own it.

I happened across the opinions of another highly visible financial pundit last week, Jim “Bear Stearns is fine” Cramer (a long-time CNBC market analyst), who weighed in on what he thinks is going to happen when bitcoin futures start trading:

“They’ve been waiting to short it to you… I think the short selling is just going to annihilate people when you can start trading it"

So that’s an interesting view for sure. But it doesn’t appear to be backed up by anything.

And what’s more, it’s hard to take Cramer’s views on bitcoin seriously considering he wrote this about bitcoin recently (my comments in red):

“First, no one knows who created it [Satoshi Nakamoto, but “who” created it is irrelevant]. Second, no one knows how much the creator reserved or took [he didn’t “reserve” anything. There are early addresses with substantial holdings assumed to belong to Satoshi. The blockchain is transparent]. Third, there is virtually no transparency into the underlying system. None whatsoever [umm… Bitcoin is the very definition of transparency] . Fourth, there is no government backing – obviously, there are no underlying assets and there is no military support for the bitcoin system, unlike legitimate currencies [this is literally the entire point of bitcoin]. Fifth, despite the allegiance its buyers swear to blockchain as the secure way to transact, it is software – and the one thing we know about software is that it can be hacked [bitcoin has already proven itself to be one of the most secure financial systems ever created]. When, not if, but when, it will be a total loss as there is no insurance and no fiat backing.”

Cramer is right about one thing – bitcoin futures do allow individuals or institutions to easily short bitcoin for the first time through a familiar investment product.

But there’s a difference between speculative (or “naked”) shorting and hedging with a short position.

Let me explain.
Hedging a long bitcoin position with a short futures position

Let’s say bitcoin’s trading at US$10,000 and you own a hundred bitcoin – for a position size of (let’s say for simplicity’s sake) US$1 million.

Let’s also assume a 3-month bitcoin futures contract is trading at US$13,000 – in other words, the futures market sees bitcoin up 30 percent in three months.

If you are bearish, or think bitcoin prices won’t move much, then you can sell (short) a hundred bitcoin futures at US$13,000 – this will “lock in” your 3-month bitcoin price.

After 3 months, the futures contract will settle (in US$) depending on the prevailing bitcoin fixing.

If bitcoin fixes at US$13,000, then the futures contract will expire without payment.
If bitcoin fixes at US$10,000, then you’ll receive (US$13,000 – US$10,000) * 100 = US$300,000.
If bitcoin fixes at US$15,000, then you will pay (US$13,000 – US$15,000) * 100 = US$200,000.
But note: Your underlying bitcoin position will be worth US$1.5mn. So you can sell US$200,000 worth of bitcoin to settle the contract, leaving you with US$1.3 million.

Naked shorting

Naked shorting, on the other hand – the kind that Jim Cramer seems to be concerned about – is a different matter altogether. This involves selling the futures contract without holding the underlying asset (i.e., bitcoin).

The risk here is that your loss is potentially unlimited. As the price of bitcoin rises, you lose more and more money.

I don’t envisage, at least early on, much in the way of large-scale naked shorts in the bitcoin futures market. It’s such a risky trade to make in an asset class that has in the past exhibited extraordinary amounts of volatility (bitcoin is up over 100 percent in the past month).

If anything, I would expect to see substantial long positions instead. You see, from an institutional perspective, the amount of internal controls and compliance/operational hurdles you have to clear to own bitcoin are substantial. Remember, custody services are still relatively new in the space.

But futures make it very easy for asset managers to diversify into bitcoin now – and an asset like bitcoin, that is volatile and uncorrelated with all other major asset classes, makes for a potentially attractive investment prospect.

What to look out for

There are three things we’ll be looking out for:

Volumes – how much notional value of bitcoin is being traded in the futures market.
Net long vs shorts – this will give us an early idea of whether futures are being used for hedging or speculative shorts, or as a means of going long bitcoin.
Shape of the futures curve – as contracts trade out a few months in advance, we’ll get an idea of where the market prices in bitcoin prices across the term structure of the futures curve. The curve will either be upward sloping, where futures prices are progressively higher than spot (also known as “contango”) – or it will be in “backwardation”, where futures prices are lower than spot.
Within the next week or two, we’ll be able to address each three of these points.

Good investing,