In case you thought the whole concept of bitcoin was already too difficult to grasp for the average person, it is about to make friends with traditional financial products that very few people understand. Cboe Global Markets will be launching bitcoin futures trading later today, followed by CME Group Inc (Chicago Mercantile Exchange) also in December, and Nasdaq later in 2018. The move is certain to bring institutional investors into bitcoin, but whether or not it will bring the predicted stability to the market remains to be seen. Is adding leverage to an already volatile (unstable) market really going to help stabilize it? We are about to find out.
The easiest way to understand what futures are is to go back to their pre-financial origin. Any regular purchaser of a large quantity of raw material such as agricultural products, metals, or oil & gas, needs to know that their costs will be somewhat predictable month to month. They would rather pay a slightly higher amount than the current market price for the guarantee of no price spikes before they take delivery and pay for that material at a future date. A futures contract requires you to give the exchange a deposit (called margin), and maintain that percentage for as long as you own the contract. At the end of the contract, the holder either cash settles (receives or pays depending on profit or loss), or takes delivery of the commodity. The following is an easy to understand example of why a business may use futures contracts:
The leading cookie company in America doesn’t want to be faced with unknown swings in the prices of sugar, cocoa, and flour. A futures contract on sugar or cocoa would guarantee a certain price for delivery of those goods at some point in the future. There are no futures contracts on flour, but the flour milling company that supplies the cookie company with flour, likely has a futures contract on the price of wheat. In order to do the business with the cookie company, the flour mill may have promised them a certain price on flour. In order to do that, they need to know how much they will be paying for wheat during that time period.
In the 1970’s, financial products began trading on futures markets. Fast forward to 2017, and you will see commodity based futures absolutely dwarfed by a bloated quadrillion dollar financial derivatives market. You may recognize some of the derivative terminology mentioned in the quote below because of their connection to the 2009 financial crisis.
“In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the “underlying”. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or market. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps.” Wikipedia
While many institutional investment firms are holding back with a ‘wait and see’ attitude, or limiting bitcoin futures to select customers only, the media is certainly ready to follow this development. CNBC has added Bitcoin Futures to their Currency Futures chart, waiting on the first figures to fill in the blanks.
For those of you that are new to all of this, Bitcoin Futures are based on the rise or fall of price of bitcoin only, and do not actually hold any bitcoin. When the contract expires, the contract will be settled in cash, so once again there is no bitcoin bought or sold. Unlike the commodity futures market, the bitcoin futures market isn’t based on a demand for the the actual product (bitcoin). This type of speculative investment is best suited to a seasoned trader with a high appetite for risk.
Cboe Bitcoin Futures have a high margin rate on bitcoin futures of 44%, which is understandable considering the high volatility of bitcoin. There are trading halts in place should the price sway too far from the daily settlement price. The ticker symbol is XBT and all contracts are cash settled based on the fully regulated Gemini Exchange’s auction price for bitcoin.