Bitcoin Futures Are Coming. Are You Ready?

There are three ways to trade futures coming on Bitcoin.  The most under-reported one is Ledger X.  It’s not a true future, but a swap.  Technically they call it a SEF, or a “swap execution facility”.  Most of the time, swaps are exchanges of cash flows of an underlying financial instrument.  In Bitcoin swaps, it’s really only a long vs a short since there is no underlying cash flow.

CBOE and CME both announced futures contracts.  Both are settled in cash-US dollars.  Or, if you are a crypto-fanboy fiat currency.

A long time ago I had a meeting with Leo Melamed about listing Bitcoin futures.  Leo is a good friend and invented FOREX futures.  He is an innovator.  We talked at length about it but it was pretty clear CME wasn’t going to take the risk at that time to list them.  The market demand is there so both CBOE and CME are listing.  I am somewhat surprised ICE or some international exchanges based outside the US didn’t go for it as well.

Here is a video put out by the WSJ highlighting Bitcoin volatility.  Futures will dampen that volatility.  Futures help people manage risk and they will create a space for holders of Bitcoin to actually HOLD the asset with less fear.  Bitcoin currently is not a store of value because of the underlying volatility.

Here is a link to the CBOE specs.  The Final Settlement Value of an expiring XBT futures contract shall be the official auction price for bitcoin in U.S. dollars determined at 4:00 p.m. Eastern Time on the Final Settlement Date by the Gemini Exchange (the “Gemini Exchange Auction”). If they can’t find a settlement price, they will utilize other contingencies to settle the contract.  The price will move in .01 increments and be valued at $10 per tick.  Buy a Bitcoin at 10,000, sell it at 10,000.01, you make ten bucks (if I am reading it right).  No more than 5000 contracts in your account, so there are position limits just like any futures contract.  There are NO price limits, but there are circuit breakers at both 10% and 20% with a 2-minute halt at each.  No margin rate has been published that I can find as of this writing.

Here is a link to the CME specs.   All contract months settle to the volume-weighted average price (VWAP) of outright trades between 15:59:00 and 16:00:00 London Time, the settlement period, rounded to the nearest tradable tick. If the VWAP is equidistant between two ticks it will be rounded towards the prior day settlement price.  In the absence of trades during the settlement period, the contract month settles to the midpoint of the Bid/Ask between 15:59:00 and 16:00:00 London Time, the settlement period. If there are no two-sided markets available during the settlement period in a particular contract month, then the settlement price will be the net change of the CME Bitcoin Reference Rate (BRR) added to the prior day futures contract settlement (provided that settlement is within the Bitcoin futures price limits), adjusted to the Bid/Ask if one side is present.  Price limits for a given Business Day are calculated in relation to a reference price. The reference price may be adjusted at the sole discretion of the Exchange to incorporate BRR changes on non-trading days. A price limit of 20% above or below the reference price and special price fluctuation limits equal to 7% above or below the reference price and 13% above or below the reference price applies. Trading will not be permitted outside of the 20% range above or below the reference price.  Position limits are 5000, but spot (the expiring contract) position limits are 1000.  The initial margin rate will be 35% of the value of the trade but I assume that will change when the clearinghouse has a good handle on the underlying volatility of the contract along with position concentration.  CME’s price change is larger than CBOE’s at $25/contract.  The price fluctuation is $5.00 per contract.  It will look more like an emini S&P.

CBOE will clear the OCC presumably, and CME will have its own clearinghouse clear the trades.  I presume all existing cross-margining agreements that exist for other contracts will also include Bitcoin.  They are all taxed at 60/40 since they are futures and not equities or options.

Which exchange wins? It’s a parlor game. It all depends on liquidity. Whoever can get the most liquidity will win.  I think the retail investor will determine that, not the pros.  Which contract best suits the sentiment of the retail guy?  Pros all want to trade against order flow.  They don’t want to be the order flow. The retail guy gives up the edge and the pros take it.  DRW has a huge edge over everyone in the market because they took a gigantic risk a bunch of years ago with Cumberland Mining and they see order flow others don’t see.  Can other institutional investors compete?

I was on the CME Board when we released emini Currency futures.   Our board was relatively split on how to price them and structure them.  We wound up going 2:1 instead of 5:1 because of contract size and intraday volatility.  I was persuaded by Paul Kimball then head of FOREX at Morgan Stanley and Leo.  We made a mistake. 5:1 would have been a successful contract. It’s instructive to see CME not make the same mistake again.

The CBOE contract movement in pennies will be easier to understand for retail investors.

The brokerage community that sells these will have huge influence.  Where do brokers make bigger commissions?  They will push that product.  Which of the existing exchange broker networks have better ties into a community that will provide early liquidity?  For example, no one can take US Treasuries away from the CBOT (ie CME).  The network effects were established back in 1973 and even the change to electronic trading doesn’t change the existing network effects.  The fact you have cross margining via the clearinghouse with every other futures contract

I think it would be great to have a liquid options market on Bitcoin.  It would allow more precise management of risk and allow for even more arbitrage which brings more liquidity and tightens markets.

There will be an arbitrage between both futures contracts, and there will be an arb between cash/futures.  You can also execute a multi-channel arb strategy between cash, cash order flow, and each futures contract.

My friend Professor Craig Pirrong wrote about Bitcoin futures here.  He says, “If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.”

He is totally 100% spot on when it comes to analyzing the Bitcoin market economics.  It’s terrifically hard to short and incurs all sorts of transaction costs futures don’t have.  Craig is also right to worry about the settlement procedures at each exchange which is why I spent so much space on them.  If the index price for some reason gets manipulated, it will affect settlement and will be a disconnected from the cash market.  That is not healthy.  CME saw this happen in the cattle market years ago and it hurt the contract.

Unlike fiat currency, crypto’s are generally backed by nothing.  It’s the trust of a network. It’s hope.  Almost every crypto I have looked at recently isn’t tied to any cash flow.

Should you go in and short Bitcoin?  I have no idea.  I don’t like to step in front of freight trains myself but the market certainly seems really frothy.  If I was going to trade it I would be a spreader and buy one month against another trying to get the edge on one side.  The best strategy might be to butterfly or double butterfly the product.  If Bitcoin futures are like other future contracts the true edge will be in the back months, not the front month.

Andy Kessler thinks Bitcoin is a bubble.  He received a lot of criticism because of the way he defined the market.

There are other elements baked into the Bitcoin price. One is scarcity. There is a limited supply.  If you think that it’s not just a way to transact but a new technology, the price might make more sense. The other big problem with Bitcoin is there is not a great ability to transact in it.  As the price moves higher and higher, transacting gets really expensive.  Tip your golf caddy in bitcoin and it could really have a large opportunity cost.  Is Bitcoin/Blockchain a new TCP/IP? Which chain will dominate?  Until those questions are answered we won’t know the real value.

Additionally, new companies and technologies are always met with disbelief. The best investments at early stages are where really dumb stupid ideas intersect with “hey if it worked it would be pretty cool.” Bitcoin/Blockchain looks like one of those ideas.

I spoke with an entrepreneur who asked me what I thought of the price. As a trader, I told him rallies like Bitcoin had are unsustainable. Historically, we can go far beyond tulip bulbs and look at any new technology to see bubbles. However, you only see bubbles in the rearview mirror. If Bitcoin is truly in a bubble, shorting it on the futures market is a way to take advantage and if it’s a bubble, very few people will short it.  They told me I was nuts and it was going to trade $100,000.   When can I short at that price?

An old Peter Lynch adage was if you went to a cocktail party and everyone wanted to talk stocks it was time to sell.  Have we gotten to that point in Bitcoin yet?

It’s also important to remember these are very very early days in crypto. This is NOT a big deep liquid cash market.  Yes, there is a lot of largesse when it comes to ICOs. It’s like the internet in 1997. How do you pick a winner? To illustrate where crypto is, We are probably not even at the point where pitchers and catchers are reporting for Spring Training yet-much less play the top inning of a game.  We might even be playing Little League t-ball.

In the entrepreneurial community, we are just starting to see coders switch from coding in Java to coding for blockchain. The high price of many of the cryptos is driving that. Irrational exuberance is bringing them into the market-now we will see if some companies can be built to make them stay.

At West Loop Ventures we look at a lot of crypto companies. Some of our LPs are very active in the crypto space.  That’s great for us because we have a lot of local knowledge at our fingertips to help diligence a company.  We haven’t pulled the trigger yet but we are actively seeking out something cool. Personally, I pulled the trigger on Bitnomial a couple of years ago and it’s winding its way through the process. If you are disciplined and understand markets there are opportunities to be had. They will be outsized.