Futures & Crypto
An exotic financial product category meets Bitcoin
When the Chicago Mercantile Exchange (CME) launched the first Bitcoin futures contract in December 2017, it was a big step for the crypto industry. For the first time, a cryptoasset would be available as a commodity that could be traded via futures at the CME.
So what are futures?
A futures contract is a contractual agreement to transact at a later date. You choose the goods, a price, and a future date and agree to settle when that date rolls around. One party agrees to sell the goods at the agreed price to the other party. These agreements allow businesses to lower their uncertainty. Both the buyer and seller lock in a price for the future transaction.
These agreements also provide a way for traders to access leverage. Imagine a trader who believes that the price of copper will increase in the next three months. In the past, they may have had to buy copper or a shares in a copper company to execute on their idea. With futures, a new strategy opens. With a $10,000 budget, the trader could purchase $10,000 worth of copper and wait, but now they may be able to access a futures contract to agree to buy $100,000. They can buy a $100,000 contract with only $10,000 in their account, because most of the time the settlement amount will be within $10,000 in either direction. In the event the price moves aggressively against the buyer or seller, positions can be force liquidated to protect all counterparties.
To illustrate the potential for leverage, if the price of copper goes up 10% in the timeframe, buying copper would yield $11,000. But with a $100,000 futures contract, your account would have become worth $20,000. Notice that if the price of copper would have decreased by 10%, our trader would have been wiped out with $0 in account value — leverage can backfire.
Cash Settled
Futures contracts come in two formats: cash settled and physically delivered. The CME contracts are cash settled. With a cash settled contract, at the settlement date the current market value is compared to the agreed upon price, and the difference is transferred. If the value is higher, then the buyer did well to lock in the lower price and the seller pays the buyer. The inverse is true if the current price is lower than the agreed on price.
These contracts allow institutions and other futures traders the chance to bet on the price of bitcoin without having to hold bitcoin. These contracts are useful. With them institutions can get price exposure on a regulated exchange comfortable to them and miners can smooth out their income. However, they face criticism. A common criticism of cash settled futures is that there is no transfer of the underlying, and ultimately no requirement that either party have any bitcoin at all. Some fear that this could be used to dilute bitcoin’s supply since people can use this contract to get bitcoin price action and wouldn’t actually be buying real bitcoin from the market.
This criticism glosses over the fact that in order to have synthetic bitcoin, someone has to have the short side — a party that’s willing to take the opposite side on bitcoin’s performance. Far from creating bitcoin from thin air, it’s creating new bitcoin exposure from people who want the inverse of that price exposure. Futures markets can provide better liquidity and price discovery for the underlying regardless of whether the underlying is transferred.
Physically Delivered
Bakkt had made headlines for gaining clearance to issue their physically delivered futures contract on September 23rd. As the name suggests, when a physically delivered contract is settled, the physical goods come due. In this case, physical bitcoin simply refers to an on chain transaction — the coins remain digital. Rather than settle the difference in cash, the futures contract seller must sell and transfer the underlying asset to the buyer for the previously agreed on price.
In order to facilitate this delivery, Bakkt will launch a warehouse with $125M in insurance for its clients to post bitcoin for custody and transfer. Getting warehouse approval took many months of back and forth and delays with the CFTC. This wait will soon be over and Bakkt will become the first venue primarily regulated by a federal agency (the CFTC) to buy bitcoins.
So what?
Why do futures matter? Futures offer a standard contract for people to trade on the future price of an asset. The time duration allows for parties to hedge risk and express a variety of views that help the market with price discovery. Futures have done dramatic things for gold’s liquidity as its futures trading volume soundly eclipses the spot market.
The global futures markets are enormous and these markets are a powerful tool for reducing or taking on risk. Over time, we expect these futures markets to expand access to cryptoassets. We can expect more mainstream comfort with the asset class as large players get behind these products. Crypto is getting harder to ignore and meeting Wall St where it is.
