Some Thoughts On Bitcoin Futures

I am increasingly involved in discussions about how futures trading will impact the spot price of Bitcoin. While I am far from a Bitcoin bull, I have attacked the notion that futures trading will somehow trigger a major correction in spot Bitcoin prices. This post will explain why.

First things first.

This is an intellectual exercise. It is not an investment recommendation. Do not under any circumstances make any decisions with real money (crypto or fiat) based on what you read here. See also my disclaimer at right. If you are serious about putting money into cryptocurrency, do you yourself a big favor and consult with a professional advisor who can provide guidance based on your unique circumstances.

Also, if you are not familiar with futures terminology, you are going to have to bone up on the following:

  • Futures
  • Term Structure of Futures
  • Contango
  • Backwardation
  • Futures Arbitrage

Khan Academy has a series of videos that looks decent. I simply don’t have the time to post a comprehensive introduction to futures on this blog. And frankly, if you are not willing to invest some time learning about markets and investing, you probably shouldn’t be spending time reading about digital lottery tickets in the first place.

Now, if you can explain to me why there is no arbitrage opportunity available on a 1-year Bitcoin forward priced at $12,600 with spot Bitcoin at $12,000, assuming a riskfree interest rate of 5%, you will follow my argument.

Why Bitcoin Futures Trading Will Not Trigger A Selloff

Whether the addition of futures trading will be bullish or bearish for Bitcoin depends entirely on the marginal trader of Bitcoin futures. The bear case assumes the market for Bitcoin futures will be dominated by hedgers and short speculators, and that this in turn will exert downward pressure on spot Bitcoin prices.

I disagree for two reasons:

First, market sentiment is euphoric. While there are certainly Bitcoin bears out there, it is difficult to imagine that they will dominate in futures trading. More likely futures will be viewed as a cheap way to get (leveraged) exposure to Bitcoin without the custody issues associated with owning Bitcoin outright in the spot market. I simply do not believe a bunch of professional traders are going to come out of the woodwork to short an asset with no intrinsic value, that people feel justified owning at $10 or $400,000. As a directional short Bitcoin is potentially lethal. Doubly so due to the leverage embedded in futures trading.

Thus, the term structure of Bitcoin futures is likely to be contango. Other than volatility and uncertainty there isn’t much reason for Bitcoin futures to trade in backwardation. If the spot market were wavering there might be an argument otherwise. But as noted above the spot market is euphoric. Therefore, futures traders looking for arbitrage opportunities will most likely be shorting longer dated Bitcoin futures and buying spot Bitcoin as a hedge (the goal being to earn roll yield with no directional exposure to Bitcoin prices). This argues for upward pressure on Bitcoin prices in the short term.

In order for futures trading to pressure spot Bitcoin downward, the term structure of Bitcoin futures will have to backwardate. This will encourage arbitrageurs to sell Bitcoin in the spot market and go long Bitcoin futures, putting downward pressure on spot Bitcoin prices.

What would cause the Bitcoin futures curve to backwardate? The Bitcoin narrative would have to break. Apologies in advance to enthusiasts but Bitcoin doesn’t trade on fundamentals right now. It trades on momentum (a.k.a sentiment). Skilled short sellers are not going to put big positions on unless the narrative breaks and sentiment turns. Otherwise they are going to get squeezed. Hard.

As equity short seller Marc Cohodes puts it:

I never, ever, ever get involved in what I would call open-ended situations. . . . I have avoided pie-in-the-sky names. To use an analogy, I’m not interested in climbing into a tree and wrestling the jaguar out of the tree. I’m interested in someone shooting the jaguar out of the tree, and then I will go cut the thing apart once it hits the ground. Instead of open-ended situations, I like to short complete pieces of garbage with fraudulent management and horrifically bad balance sheets. I look for change, I look for ‘if this goes away tomorrow will anyone miss them’?

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