The Bitcoin Future

Yesterday CME announced they were going to list Bitcoin futures.  I was surprised it took this long.  For entrepreneurs, it shows how slow big corporates move to make decisions.  It also shows that when they decide to move, they create a lot of ripples.

In 2013 I went to speak with my friend Leo Melamed about listing Bitcoin futures.  Leo created the initial financial futures CME traded in 1971 with his friend Milton Friedman.  They were Forex futures.  He changed the world.  At the same time, the CBOT was listing futures based on debt instruments and the CBOE was created.  When Leo and I talked about Bitcoin he asked, “My friend Vinnie is on the phone.  Can he launder $25M via Bitcoin?”  I retorted, “Yes and he can do it a lot cheaper in Bitcoin than he can in the S&P’s”.  CME started looking at it but it wasn’t until yesterday that they announced anything meaningful.  I think CME should do an ICO.

If you don’t know why this is important, let me explain.

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.

They were actually invented in Japan back in the 18th century, rice futures. The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the needs of samurai who – being paid in rice, and after a series of bad harvests – needed a stable conversion to coin.  In the US it was Chicago that led the way back in 1848 when a warehouse receipt was created to make all grain fungible.  The CBOT was created and the city of Chicago was created on the back of the CBOT.

The introduction of futures tightened bid/ask spreads on all markets all across the entire world and made the cost of accessing and exiting those markets more affordable to all traders.

What do they do?  Help people manage risk.  They lock in a stable price so producers can turn variable costs into fixed costs of production.  They are a hedge to asset holders.

In the Bitcoin world, there is no hedge.  If you own Bitcoin you are what traders would call “naked long”.  What do you do to protect yourself if the price of Bitcoin were to plummet to $1000 from where it is today?  Currently, the only out is sell.

Let’s look at some simple math.

Suppose you bought one Bitcoin at $1000.  At the current price, you have a profit of about $5300. What if you wanted to lock in that profit?  You’d sell a Bitcoin future at the current prevailing price; it would be between $6300-$6500 depending on how tight the spreads are and how much the future trades at a premium or discount to cash.  If the future is trading at a discount to cash, you’d just sell the cash market or buy futures and sell cash simultaneously.  If you sold at $6400 for March delivery, you’d have locked in a profit of $5300.  The market could trade wherever it wanted and you’d be locked in.  You would have to deposit, or you’d receive money in your margin account depending on the price relative to where you sold it.

In March when the contract settled you would get money or pay some money depending on the settlement price.  If it settled below $6400, you’d receive the difference.  If it was above, you’d pay the difference but you’d still own the underlying asset.  If you wanted, you could hedge again.

Ironically, the Bitcoin contract at CME is going to be settled in fiat currency, US Dollars.  Kind of ironic when you think of it.

The next step to deepen liquidity is to list options on futures and cash options on Bitcoin. That allows the market to really target specific risks and really micromanage risk.  Having a futures contract on CME should give Bitcoin holders some security.  CME will have to fend off hackers like any other exchange but at least they have the resources.  They also aren’t holding and delivering actual Bitcoin, so that eliminates some danger.

Selling futures against a cash position isn’t “portfolio insurance”.   It’s a hedge.  There is a difference.  Insurance leaves you whole.  Hedging doesn’t necessarily leave you whole but limits your downside risk.

I worry about this new cadre of traders.  They haven’t really seen a bear market in anything since 2009.

Futures tend to dampen the volatility of underlying markets.  For a clearer example of this, let’s look at onions and oil. There are deep liquid derivative markets in oil. There aren’t in onions. Onion prices have far more volatility than oil prices. You might not notice as much because it’s pennies versus larger ten cent moves, but they do.

The introduction of futures will dampen the intraday volatility of Bitcoin allowing more people to accept it.  Right now, only 100,000 merchants accept it.  My guess is that the number will expand exponentially as the derivative market gets more liquid and risk is managed.  That doesn’t mean the short-term price of Bitcoin is higher.  A bull can only go so high before it’s gored.  But, with a liquid futures market, the fall of the price of Bitcoin will be softer than it otherwise would have been.