How Futures Can Affect Bitcoin (Spot) Prices

It’s been awhile since I made a post on my blog due website issues. But now my site is back up, and I am ready to rock and roll.

Bitcoin Futures Launch

For those who do not know, Bitcoin futures just launched trading on the Chicago Board of Options Exchange (CBOE) right now as I am writing this, and will launch in the Chicago Mercantile Exchange (CME) eight days from now. Supposedly, the futures market will allow more liquidity and reduce volatility in Bitcoin, which as we all know is a crazy roller coaster ride. There’s a big argument between investors and speculators who disagree whether or not futures can actually affect the price of Bitcoin. So, I will give you my take on how this all works.

Cash Settlement

For starters, the futures market is cash-settled, meaning that there is no delivery or trading of actual Bitcoin in the Cryptocurrency Markets. In other words, if you purchase or short a futures contract on Bitcoin and, in the process, make a profit through a closing position or a contract settlement, you will not receive or lose any Bitcoin. Instead you will get your profits/losses in the form of a cash payment or a reduction in your margin account based on the closing price of Bitcoin at the time of settlement.

Here’s an example. If you purchase a Futures contract that will allow you to purchase Bitcoin for $15,000 @ the end of January 2018 for $1,000, and the price of Bitcoin goes up to $20,000 by then. Your profit would be about $4,000. In this case, your account will be credited an extra $4,000. The other side of the transaction will not have to buy Bitcoin to deliver to you. In other words, the futures contract is nothing more than a wager on the price movement of the underlying asset. People who are not familiar with how futures contracts work are afraid that institutions will short the heck out of Bitcoin futures, thereby driving Bitcoin prices down. Sorry, this is not how the Bitcoin futures work. Institutions can short the living daylights out of the futures, but if Bitcoin prices continue to go up, then they will lose their shirts on their short sales. They are essentially on the wrong side of the bet. It’s almost like betting for or against your sports team. You can make large wagers in either way, but it will most likely not affect the outcome of the game…of course, unless there’s some sort of collusion or funny business going on. But, that’s beside the point here.

Market Sentiment

OK, so there’s no direct impact from the futures market on Bitcoin prices, but can the futures market influence the underlying asset in any way? Well, there’s market sentiment. For instance, if the futures indicate a very bearish sentiment towards Bitcoin, then it will keep institutions and new retail investors at bay for the time being. In other words, it will stop further capital injection into the Cryptocurrency markets. Markets are very psychological, especially when the markets are driven by retail investors. Large short positions in the futures will create fear in new investors’ minds, which can stop new money from entering the Cryptomarkets. However, the reverse can be true. A bullish sentiment in the futures market can send Bitcoin prices to the moon. Hence, the futures market can really affect the general emotions and behaviors with what goes on in these markets. And let’s not forget, emotions and sentiment is a big big driver in markets.

Arbitrageurs

Perhaps a larger and more direct effect on how the futures market can play into Bitcoin prices involves the arbitrageurs. An arbitrage is riskless profit made through the exploitation of large price differentials in different exchanges, misevaluation of an asset, or just plain taking advantage of “dumb money”. An example of an arbitrage would be if Microsoft is selling at $100/share on the Nasdaq and $80/share on the NYSE. An arbitrageur would buy shares from the NYSE and sell them on the Nasdaq exchange for a quick $20 riskless profit. So, how does this all apply to Bitcoin futures?

Let’s say there a big price differential in the futures market, where institutions bid up the futures price to $20,000/Bitcoin. The current price of Bitcoin is about $16,000. Arbitrageurs would take this opportunity to short Bitcoin futures and buy up actual Bitcoin to close up the price gap, which would, most likely be somewhere in between the two prices. The opposite will be true if there’s a large downside price differential, where arbitrageurs will short Bitcoin and buy up futures contracts to meet at an “equilibrium” price. This system was inherently built in to smooth out the volatility of Bitcoin (or any other asset) over the long run. But, as we can see, arbitrage transactions do involve the actual purchase and sale of actual Bitcoin, which will, in fact, affect Bitcoin prices.

Problems

Although what I have written above makes sense…at least to me, it makes sense…there are inherent problems with the above scenario. First and foremost, will the Cryptocurrency exchanges be able to handle the new influx of institutional transactions caused by arbitrage opportunities? For instance, GDAX (which is owned by Coinbase) is one of the largest Cryptocurrency exchanges in the world. GDAX crashed multiple times when peak volumes occurred during the past year. Second, with the inherent volatility of Bitcoin, will the CBOE and CME be able to functionally operate with multiple price swings (with more that 10% deviation) occurring daily? As most of us know, the CBOE and CME have switches which halt trading when markets are too volatile. Switch limits are placed in the single-digit % category, which means that the switches can go off multiple times per day. Third, will the Cryptocurrency exchanges be quick enough to convert Bitcoin into cash and vice versa? Sometimes there are lags in transactions, being that Cryptocurrency exchanges are still relatively new. Arbitrage involves great speed. In fact, many arbitrage opportunities are conducted with bots nowadays. So, a lag in transaction speeds can really kill arbitrage trades. Forth, are the fees low enough to justify arbitrage trades? Some Cryptocurrency exchanges charge high fees on trades. So, would arbitrage trades yield big enough profits to justify the effort? Who knows? Nobody will know until we see how everything goes in real life.