As cryptocurrency markets continue to expand at unparalleled rates, an important development is unfolding this month – the official launch of bitcoin futures. Various announcements in recent weeks that bitcoin would soon enter the world of sophisticated financial derivatives have helped push the price of the currency to record highs above $11,000.
On December 1st, the US Commodity Futures Trading Commission released a statement declaring that contracts for futures and options have been self-certified by the Chicago Mercantile Exchange (CME), the CBOE Futures Exchange (CFE) and the Cantor Exchange. Nasdaq plans to be next to join the race.
The first launch is projected to take place on December 18th. Given the importance of these institutions, this huge step forward is expected to add a new level of legitimacy to cryptocurrencies and cement their position as an emerging asset class. However, the changes associated with bitcoin futures might not all be as rosy as they seem.
What Is a Futures Contract?
Financial derivatives are contracts that have value based on the performance of an underlying asset. Futures contracts are a type of derivative – agreements to buy or sell an asset at a pre-determined price at some point in the future. It allows investors to lock in a price for the asset, either for security purposes or for speculation.
If an investor expects the spot price of bitcoin to be high in the future, and they have the ability to enter into a futures contract at a price lower than the price they predict bitcoin will have in the future, they could profit from that price difference if they predicted it correctly. This can be used to create both long and short positions.
How Does This Change the Game?
Futures markets create an immense amount of flexibility. They enable investors to readily bet on an asset or bet against it (go long or go short), and they are usually characterised by an immense amount of leverage. In the case of bitcoin, this means one can trade a high volume of coins while only paying for a fraction of them, essentially operating with borrowed money. Leverage is used to amplify profits on a small volume of assets, but it is a double-edged sword in that it also amplifies losses.
Will This Benefit the Bitcoin Market?
Many expect bitcoin futures to stabilise the markets because big institutional investors will be able to trade bitcoin using all the flexibility present in sophisticated trading markets, with effective risk management and hedging strategies. Since the CME plans to set price limits on the trading range of bitcoin futures, the price of the coin is expected to become more stable. That is the optimistic outlook. It is reasonable to assume that if futures markets will indeed take off the way they are expected to, the market will eventually gravitate towards a less volatile state.
However, there could be a transition stage in which volatility could actually become worse. Large financial trading firms could enter the market to an extent that has not been seen yet, and because bitcoin is so difficult to value (as Warren Buffet put it: “You can’t value bitcoin because it’s not a value-producing asset.”), a lot of different forces will act on its price. Shorts will become more popular, and disagreements on pricing could manifest in the cryptocurrency markets in the form of extreme price jumps, more so than is already commonplace.
Ultimately, the big and yet unanswered question will continue to loom: is bitcoin indeed the millennials’ gold, as strategist Tom Lee suggests, and therefore has real and measurable value, or is it simply used for speculation as investors like Jack Bogle and Warren Buffet have implied? The answer that important investors will come up with for that question should have a significant impact on the price movement of bitcoin, and it is completely uncertain what it will look like.
What Does This Mean for Smaller Investors?
Words of caution are appropriate when talking about going short and using leverage. These strategies are incredibly effective because they allow investors to not only profit from a general upward trend in bitcoin but to profit from the fluctuations in the market. At first, it is hard to think of a more perfect asset than bitcoin for such purposes. The upward trends have been fast and extreme, yet fluctuations are very common and tend to be substantial.
If an investor gets the timing of the oscillations right, they can make money at every point along the way, going long when the market goes up and short when it drops. However, it is also difficult to come across any reliable strategy that has thus far been able to predict which events influence the price of bitcoin to which extent. The initial calling off of the Segwit2x fork is a good example of that. Shortly after the news broke, the market appeared to be divided into two camps – those who saw less value because they would not receive the equivalent amount of their holdings in the new currency (“dividends”), and those who saw the news as a consolidation of bitcoin’s strength. The two camps pushed the price in opposite directions in a way that made it hard to predict which side would have the upper hand at which point in time.
A large investor tends to have portfolios that are diversified enough that they can stomach deviations from expected price movements even with leverage. But smaller investors have smaller accounts, and that is where leverage can be fatal. This is because amplified losses can grow larger than the account balance and cause the need for a margin call when facing the prospect of going into severe debt.
For smaller investors, it may be wise to bet simply on long-term developments in the bitcoin markets by buying and holding. Thus far, the returns on this strategy have been large enough to justify at least the consideration of whether they would not outweigh the expected payoff of trading with leverage, taking the associated risk into account.
Bitcoin futures promise more flexibility for investors and potentially a more stable price. Yet, there is a chance that volatility could increase in the interim and while strategies like shorting and using leverage hold a lot of potential when used within the right infrastructure, they can be detrimental to smaller investors and, in the worst case scenario, could derail the market in dangerous ways.
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