If you haven’t been reading the news, two major Chicago exchanges CME Group and CBOE Global Markets, have been given the green signal from the Commodity Futures Trading Commission (CFTC) to launch bitcoin futures which is a huge step in the direction of legitimating cryptocurrency. But everything doesn’t seem to be going right for the much-hyped debut with concerns being raised by major institutional investors over the possibility of market manipulation with loosely regulated cryptocurrency exchanges.

Recently, bitcoin prices have zoomed up to almost $20k from $15k in matter of 90 minutes on popular crypto exchanges only to crash back down raising doubts in the future traders community about BTC futures debut

Before we go deep down in the story, we want our readers to first develop some understanding about future contracts as a financial instrument and underlying benefits and risks.

Future Contracts

A future contract is basically a legal agreement to buy or sell something at a predetermined price at some specific time in future. It is a derivative product which means its value is determined by the price movement of the underlying asset. Agreed price to buy or sell the asset is called forward price and the date of the transaction to actually proceed is called delivery date.
Future contracts though started primarily for agricultural commodities providing an assurance to farmers to buy out their yield at a predetermined price, can now be seen as heavily traded in stocks, indices, commodities, currency pairs and now hopefully in cryptocurrency.

The difference with other financial instruments

  1. Value is determined by the price movement of the underlying asset — a future contract itself has no intrinsic value.
  2. Futures have a finite life and have a set expiration date. Unlike stocks, which can be in existence forever, a future cease to exist upon reaching the expiration date
  3. Future contracts come with leverage meaning you don’t have to pay the entire amount at once and take a position by making a small up-front payment

If you can predict the price movement of an asset to a very good extent, you can benefit significantly by entering into a future contract.

Let’s take an example to understand it better

Consider a stock of a company called “Hello world” being traded at a future price of Rs.950. Now, reading up the past price movements of the company and recent announcements, we are of the view that the current future price is undervalued and it can go up significantly in upcoming time. To go forward with placing the trade, we will do the following steps:

  1. Lot size: It is the minimum number of shares that have to be bought. Let’s say it is about 100 shares per lot and we move forward with purchasing of 1 lot. Contract value will then be equal to current price * lot size = Rs. 950 * 100 = Rs. 95,000.
  2. Margin requirement: As told earlier, in order to buy a futures contract, we need to deposit only a fraction of the contract value. Suppose, the leverage available to place the order is 10X, which means we would need to deposit 1/10 of the contract value i.e. Rs. 9,500.
  3. Expiry date: As stated earlier, the future contract is valid only for limited period of time. Let’s say the contract we have entered into will expire on 25th Dec 2017.

Possible scenarios post the agreement

As for any trade executed, there are only 3 scenarios possible, price go up, the price goes down and price remains unchanged. Let’s take some arbitrary numbers to understand the implications of price movements in more detail

  1. Price goes up: let’s say on the date of 25th dec, the price moves up from the value of Rs. 950 to Rs. 1000 per share. This means that as per the agreement, we would be entitled to buy out the “Hello World” share at a much cheaper rate giving us a profit of Rs. 50 per share and overall benefit of Rs. 50*100 =Rs. 5000.
  2. Price goes down: Now instead of price moving up if it goes down to the level of Rs. 900 per share, then I would have to buy out the shares at a premium of Rs. 50 incurring me a loss of Rs. 5000.
  3. Price remains unchanged: No impact on either party involved in the contract.

Future contracts can exited at any point of time before the contract expiration date depending on the availability of the buyers at that point of time.

The implication of Bitcoin futures on bitcoin prices

There exist only two possibilities here, either the bitcoin price will move up or move down and nobody can say sure on which side the pendulum will swing. So to answer this question better, we would need to look back at the history and see how other commodities prices moved when futures were introduced first. We have taken reference of the study done by masterthecrypto.com on the price movements of gold at the time of the future announcement.

Long Term:

Looking at the chart below, it looks like immediately after the ‘Gold Futures’ were launched there was a small bump in ‘Gold Prices’, but a year later gold prices fell, and 5-years afterward gold was back up at the highest level.

Source: https://masterthecrypto.com

So looking back at the long-term view historically for gold— we see that adding futures for each asset had little or barely any impact on price compared to political, international, and economic events; in fact, these other events were the reasons for major price fluctuations.

Short Term: As per the data available with USA Gold & the ICE Benchmark Administration and London Bullion Market Association, below graphs depict the price movements of gold before and after the debut of futures in gold.

Source: https://masterthecrypto.com

As can be seen, there was a large run-up in prices prior to launch of gold futures and then a quick downfall in prices afterwards. If we compare this to current scenario in bitcoin, we have already witnessed a huge appreciation in the pricing just before the futures going live on one of the exchange.

Source: https://www.coinbase.com/charts

Given we only have data for gold prices daily, we saw that there was quite a bit of volatility when Futures were introduced. There was a run-up to the Gold Futures launch — followed by a dip in prices for about 2 years. After which, gold prices started to come back to all-time high levels.

Concerns about bitcoin futures

Risk of market manipulation:

Members of Future Industry Association (FIA), a global future trade organization have written an open letter to the US derivatives watchdog to provide more safeguards to protect the investor interests from the highly manipulative and unregulated spot market of bitcoin.

Bitcoin distribution is highly concentrated with nearly 4% of total bitcoin addresses owing as much as 96% of the total supply.

We have seen in previous times, a sudden jump in the trading volume triggered by major players flooding the network with new cash and thus manipulating the market.

Now with availability of bitcoin futures, it is easy for a major player to buy into futures market first and then create a massive number of buys or sells of Bitcoin to ensure the price swings in favor of your futures contract.

Cascading effect:

A clearinghouse is a 3rd party agency or entity between buyers and sellers of financial instruments. They act as a middleman between the parties to futures transactions. If there comes a scenario of a wild price swing in bitcoin and a smaller brokerage failed to meet its margin call, the clearinghouse would have to take over the position, further moving the price of bitcoin, which could cause other brokers to fail, Peterffy said.

Such situations can easily get out of control due to lack of regulation on the cryptocurrency exchanges involved in the spot market leading to flash crashes.

Price limits cutting into trading profits:

CME’s contracts have a limit of 20% from the reference price under which the trades can be placed. This limits the trader’s profit as on the spot markets, the bitcoin prices can be seen going up or down significantly and thus future traders will not be able to take the extra benefit.

How to determine value:

One of the most basic issues for any crypto investor is how to determine the correct price of the bitcoin. There is no balance sheet, no quarterly numbers, no growth forecasts or sales targets. There is simply no way to do a fundamental analysis for the valuation of cryptocurrencies, they can assume any price from one day to next.

References

https://zerodha.com/varsity/chapter/futures-trade/

https://www.investopedia.com/university/beginners-guide-to-trading-futures/

https://en.wikipedia.org/wiki/Futures_contract

https://masterthecrypto.com/will-bitcoin-futures-affect-bitcoin-prices/

http://www.livemint.com/Money/C1XX1yECByVINx4gzzBzyH/Bitcoin-wildness-highlights-worries-as-futures-trading-nears.html

http://www.livemint.com/Money/Br0L4LERX89bb3OCGduntL/Bitcoin-to-start-futures-trading-in-US-stoking-Wild-West-wo.html

https://masterthecrypto.com/will-bitcoin-futures-affect-bitcoin-prices/

https://www.ft.com/content/5ee5fda2-daa7-11e7-a039-c64b1c09b482

https://buttercoinmarketupdate.posthaven.com/cascading-margin-calls-and-the-flash-crash

https://www.investopedia.com/news/four-problems-bitcoin-futures/

https://www.kotaksecurities.com/ksweb/Research/Investment-Knowledge-Bank/what-are-futures-contracts

Tell us in comments how much it was helpful or if we missed covering any important terms.

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