12.08.2020

Are Bitcoin Futures The Future of Bitcoin? Pun Intended

Have you ever seen a horse? The question may sound silly in 2020 but it was a complete nonsense in 1820. World horse population is estimated at 58 million. Ten countries in the world have a horse population of more than a million. This means about one gracious animal per 140 people on Earth. Things looked way different two centuries ago. For example, Paris in 1820 had approximately 725,000 human residents. Every day, as many as 35,000 horses would be in the city, doing the work now performed by trucks, buses, cars, subways, streetcars, and trains. The proportion between human and horse residents of the city was about 1:20.

Cars became widely available in the early 20th century. One of the first cars accessible to the masses was the 1908 Model T, an American car manufactured by the Ford Motor Company. Americans bought nearly 26 million cars and 3 million trucks in the 1920s. Popularity and demand for horses declined significantly. So, imagine yourself in some time around January 1920 talking to a rancho owner who offers you to buy a horse, not a grown up one but a foal which matures in, say, five years. Will you be willing to pay a full price for the animal? Or will you expect it to cost less by the time you get to ride it?

Bets on upcoming value of some asset are called futures, and they are one of many financial instruments generally named derivatives. In many cases it doesn’t mean a dime what are physical assets behind your bet, the only thing that matters will the price go up or down.

Financial derivatives explained for dummies

A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price. In our imaginary case, you were ready to buy “a five year contract on the horse”.

Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Still others use interest rates, such as the yield on the 10-year Treasury note.

Financial Derivatives

Some more exoti options which are already widely accepted in the financial community are weather derivatives which are financial products that derive their values from weather-related variables such as temperature, rainfall, snowfall, frost and wind.

Weather derivatives are typically used by organisations to hedge or mitigate the risks associated with adverse or unexpected weather conditions. Typical users of weather derivatives include farmers, to hedge against poor harvests caused by frosts or low rainfall, and energy companies that may use weather derivatives to smooth earnings caused by unseasonably warm or cool temperatures.

With financial tools like this, the contract’s seller doesn’t have to own the underlying asset. He can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. He can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself.

For different markets there are very different minimum investment required. It really depends on the regulation on particular stock or currency exchanges, and specific terms proposed by brokers. Keep this in mind as at helps understand how to trade bitcoin futures.

So, here are key takeaways on the futures market:

  • Futures markets have been active over 150 years as a means for managing price risk
  • Futures contracts are agreements and allow dealers in commodities to offset risk
  • E.g. crops producers SELL futures (short hedgers) to protect against price decline
  • Purchasers who need constant commodity supply BUY futures to protect against price rise and called long hedgers
  • Futures contracts are “supporting” instruments, which are liquidated when cash purchase or sale is completed

Futures for Bitcoin and other cryptos

The introduction of Bitcoin futures on regulated trading venues was regarded as a significant milestone in bringing the digital currency closer to mainstream investing. While some skeptics still believe that crypto assets are too risky and speculative for long-term investment purposes, crypto enthusiasts hope that futures trading would bring institutional money to the industry.

You might be surprised but regulators in many countries give futures, options, forwards and other non-direct contract more freedom that to the assets they represent. The logic behind this may be tricky but take it or leave it: derivatives are considered an important part of the risk-hedging industry and financial institutions in many cases have a right to make a bet on some price moves even if they can’t invest into the underlying asset.

This opportunity was all eyes of the crypto market for several years. Since 2017 onwards, everyone were mumbling “bakkt, bakkt” like they were trying to summon some hidden creature. Bakkt is a subsidiary of the Intercontinental Exchange (ICE) designed to create an open ecosystem that allows for the buying and selling of Bitcoin, as well as custody and consumer purchases using digital assets. It launched one-day and 30-day bitcoin futures contracts on September 22, 2019, with physical delivery of the digital asset and its custody services in November 2019. This happened with a nearly year delay compared to their initial plans.

So, speaking in terms of horses, Bakkt represents a solid trading venue where all respectable rancho owners will be happy to present their views on the price estimates. BTC futures contracts are traded on ICE Futures US and cleared on ICE Clear US, which provides a guarantee fund plus an additional $35 million by Bakkt. Bakkt Warehouse, which provides custody services for bitcoin through its chartered bank called Bakkt Trust Co., has a $125 million insurance protection fund. The warehouse moves the Bitcoins at expire date, which is the physical delivery of the asset.

Other big players

In December 2017, two Chicago exchanges, CME and CBOE, launched Bitcoin futures trading, and thus unlocked the cryptocurrency market for institutional investors. The exchanges guarantee that the parties of the futures contract fulfill their respective obligations based on the applicable legislation. It means that the market players that were discouraged by an unregulated stance of the digital asset got a handy tool to gain exposure or hedge Bitcoin and benefit from the price fluctuations.

CME and CBOE

Things are active in other countries as well. One of the leading places to trade Bitcoin futures  remain BitMEX, a Bitcoin-based trading platform that is wholly owned by its founders. Is is, however, incorporated under the International Business Companies Act of the Republic of Seychelles, and despite solid transparency, remains an uncharted territory for many regulated investors.

Nevertheless, EU funds and individuals are active on the platform. New data shows European bitcoin traders became active in the past month, making up the bulk of volumes on the BitMEX  XBT/USD perpetual contract. Europe has stood out as one of the hotter crypto spaces in the past year. More favorable banking services, as well as growing wealth and a tech sector, have grown European interest in crypto trading.

How it works

Bitcoin futures are used to bet on future price movements either to hedge spot market positions or to benefit from both growing and falling market trends without actually owning the underlying asset. Let’s suppose you expect that the price of Bitcoin will grow. To buy a futures contract, you have to provide marginal collateral in the amount of 50% from the contractual value, pay a brokerage fee and exchange fee from $15 to $30 depending on the trading venue.

how bitcoin futures works

Contango and backwardation are terms used to define the structure of the forward curve. When a market is in contango, the forward price of a futures contract is higher than the spot price. Conversely, when a market is in backwardation, the forward price of the futures contract is lower than the spot price.

If the Bitcoin is higher than your futures contract price agreement, you can profit from the surplus. However, if the Bitcoin’s exchange rate goes down, you’ll incur substantial losses as you will have to pay out the difference and maintain the collateral at the required level.

Apart from betting on the way the market for an underlying asset product is going to move, investors can profit from trading futures contracts during their lifetime before expiration. While the price of a futures contract is based on the value of the underlying asset, it may vary depending on the cost of the asset specified in the contract and on the sentiment of the spot market.

There were quite a few loud bitcoin future price predictions made by analysts. celebrities, crypto gurus and recognized tech entrepreneurs. Like, Kay Van-Petersen, an analyst at Saxo Bank, believes that Bitcoin could reach $100,000 in 2018, also adding that other rival coins could outperform it as well. The recognized investor, former hedge fund manager and Bitcoin (BTC) supporter, Michael Novogratz, considers that Bitcoin is going to be reaching and even surpassing its previous all-time high registered in 2017.

Bitcoin Futures Contract Specifications

Large trading venues, like CME and CBOE, set rather high market entry barriers, affordable mostly for wealthy individuals or institutional investors. Currently, CME offers two-month future contracts for 5 BTC with minimum price fluctuation $5 per Bitcoin or $25 per contract and maintenance margin 50%. The futures price is based on the Bitcoin Reference Rate (BRR), an aggregated rate across major bitcoin spot exchanges between 3:00 p.m. and 4:00 p.m. London time. That is how are Bitcoin futures settled.

You may also want to know when do Bitcoin futures close. On CME, trading in expiring futures terminates at 4:00 p.m. London time on Last Day of Trading. 

If you want to track aggregated prices for top cryptos, never hesitate to try several most popular websites that have comprehensive data and statistics. An interesting fact: being market data sources, those got very influential. To give you an idea of magnitude of that influence, in 2018, CoinMarketCap.com wiped out $100 billion off the total crypto market capitalization after suddenly delisting South Korean exchanges without warning.

Regulation

The futures markets are regulated by Commodity Futures Trading Commission (CFTC), which is not as strict as SEC in terms of oversight. It sets the rules to be observed by all participants, ensuring equal opportunities for investors and speculators, fraud protection and predictability. The Commission is open for innovations. On its website it says, in relations to cryptocurrencies and other digital assets, that today, FinTech is driving innovation in financial markets across the globe.

CFTC

New technologies are wide-ranging in scope, and have the potential for significant or even transformational impact on CFTC-regulated markets and the agency itself. One of the most recent marketplace developments driving a lot of interest is the rise in prominence of virtual currencies, specifically Bitcoin.

Professional trading and risks

Leveraged trading allows buying and selling (i.e. short or long the position) many Bitcoins while paying only a portion of the real price. It makes futures trading more appealing to investors as they don’t have to pay the full cost of the asset to profit from the price movements. At the same time, it makes trading riskier and may cause significant losses if a trader gets it wrong.

Professional trading and risks

Multiple factors can affect price of digital assets. As cryptocurrencies are not yet fully recognized in the world, news and even rumors from some government bodies may be a threat. In April 2019, the market moved down seriously on the news that China’s state planner wanted to eliminate Bitcoin mining in the country. According to a draft list of industrial activities the agency was seeking to stop in a sign of growing government pressure on the cryptocurrency sector.

Both CBOE and CME try to mitigate the risks with so-called price limits of 7%, 13% and 20% They are applied both to upside and downside movements relative to the prior day’s Bitcoin futures settlement price. Basically, it means that the exchange freezes the price for two minutes if it goes 7 or 13% up or down and won’t allow it to change it more than 20% on a daily basis.

Conclusion and key takeaways

Whether you are up for horse trading, want to make a bet on copper or cobalt market (as you may foresee deficit of that metal for electric engines’ batteries) or you want to trade crypto derivatives, keep in mind those simple rules:

  • Bet smart and don’t let emotions control you
  • Trade regularly and keep yourself disciplined (we’ll be running a separate article on that shortly)
  • Be prepared to have your contracts cash settled, even in case of losses
  • Bitcoin is a quick jumper, so be careful with short positions
  • Mind systemic risk and watch the news

And make profit to take it home for some leisure time!

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