The first ever Chicago Mercantile Exchange (CME) bitcoin futures contract expires today. Granted, it’s not the first bitcoin contract. That went to Chicago Board Options Exchange (Cboe) last week. Nonetheless, it’s a historic moment.
The first month of bitcoin futures trading has been interesting to say the least. It’s taken place against a backdrop of bitcoin rising 50% in a few weeks, only to fall 50% weeks later.
So, what do we know now that bitcoin futures have been around for over a month?
Well, the Cboe contracts dropped US$7,000 (AU$8,701) in value in that time. At time of expiry, there were around 4,000 contracts in total. And almost 2,000 of those contracts were short positions (when a trader takes out a short position, they are expecting the market to fall).
Furthermore, many brokers weren’t offering short position on futures. Meaning there are very few people outside institutional investors that would have been able to place these short contracts.
Daily volume for bitcoin shows that there are about 230 February bitcoin futures going through the CME. And about 70 for the March expiry.
To put this in perspective, there are roughly 400,000 contracts on gold going through the CME today. And another 868,000 for oil futures for the February expiry. That makes the 4,000 bitcoin futures on the Cboe look small by comparison.
What was most interesting, however, was how the bitcoin price traded compared to the futures price.
For a couple of weeks in January, the bitcoin futures price traded in what’s called ‘backwardation’. This describes a situation in which the price of a physical item is higher than the price of the futures contract. Typically, the futures price and the physical price of a commodity are closely matched, but slightly different nonetheless.
The reason is because the futures price has what’s known as a ‘cost of carry’ factored into it. Cost of carry is a theoretical value of what it would cost to store a commodity until the contract expires. The smaller the item, the smaller the cost of carry.
So, the cost of carry for gold is much smaller than the cost of carry for oil.
Generally speaking, the futures price is higher than the spot price. With gold, for example, physical bullion is trading at US$1,300 (AU$1,616) an ounce, but the futures price is US$1,302.
The US$2 difference between the two prices is the cost of carry.
When the price of a futures contract is above the physical price, this is called ‘contango’.
The cost of carry is supposedly there to cover the risks of long-term storage of physical commodities. However, when the futures price is below the price of the physical item, it’s backwardation.
Let’s use an example: Say that gold is trading at US$1,300. But the futures price is trading at US$1,295. Here, the futures price is less than the physical item.
When markets see commodities in backwardation, they tend to take it as a bullish signal.
Professional traders use this as an arbitrage opportunity — to buy and sell futures contracts for minimal risk. The point is, this doesn’t last long, and backwardation normally disappears in a few days.
Old thinking versus new thinking
I recently read some market commentary about the bitcoin futures being in backwardation for a couple of weeks.
Given that bitcoin futures contracts are in their infancy, it’s a bit too early to start analysing the bitcoin futures market. More so when the volume is so low.
In other words, six weeks of a few thousand contracts trading doesn’t give you enough data to analyse the market and its future direction.
After all, the bitcoin futures market is no normal market.
The are two key differences to bitcoin futures that’ don’t apply to any commodity trading on the futures exchange.
The first one is the cost of carry. There is no cost to hold bitcoin. Once the bitcoin is mined, it can sit anywhere. An old computer at the back of your house. A USB key in the top drawer. Or lost to the internet until you use your ‘key’ to retrieve it.
Bitcoin is code. A bunch of numbers in a set order. That’s it. The cost of holding bitcoin is zero. There should be no cost of carry with the futures contracts. However, old-timers in the market can’t imagine a futures market without the cost of carry. Old habits die hard it seems.
Yet the biggest difference of all is that there is no physical settlement option. All futures contracts based on a currency or commodity (and bitcoin can be both) can be either settled in cash or received via physical delivery of the product.
Bitcoin futures do not have this option.
This separates the bitcoin futures market from actual bitcoin. Without a physical settlement option, futures traders have no obligation to hold the ‘physical’ bitcoin. Basically, futures contracts are purely a speculative tool. A punt on the bitcoin price.
This sort of disconnection between the physical and futures market means that a different type of thinking is needed.
19th Century economic models and forecasts aren’t going to help anyone understand this. Traditional methods don’t cut it with bitcoin futures.
It’s time for a new way thinking, and a new type of analysis.
Editor, Markets & Money