Bitcoin Futures – Boom or Bust?

Since the approval of Bitcoin futures by US regulatory authorities, the price of the biggest cryptocurrency has seen several major boosts. First, the BTC/USD got buoyed on the news regarding the approval itself, and then on the CBOE’s successful completion of the first couple of BTC futures trading days.

Indeed, by and large, the Crypto community handled these events as net positives. In the wake of the initial euphoria though, dissenting and much more cautious opinions surfaced too, which saw in Bitcoin futures an impending doom, rather than the major step towards the mainstream, others touted.

The positives in this equation are obvious: by approving the Bitcoin-based derivatives, US regulatory authorities implicitly recognized the cryptocurrency as a legitimate financial entity. Furthermore, a red-hot derivatives market would inevitably lead to more liquidity being pumped into the crypto markets.

In the wake of the approval of bitcoin futures, and with the first handful of trading days now behind us, some already believe that a reevaluation of bitcoin ETFs is in the books as well.

The negatives are less obvious for those not familiar with the futures markets, and to understand these issues, we need to take a closer look at what futures are and how they work. Before we do that, let’s just put it forth though that futures experts are afraid that massively bankrolled financial interests will use the derivatives market to manipulate the price of the underlying asset (in this instance: Bitcoin). To put it in layman terms: before derivatives, bulls dominated the bitcoin market, because the best way to make money in it was by pumping the price. Derivatives mark the first time money can be made by betting against bitcoin.

How exactly do futures work though? After all, they’re derivatives and as such, they come with their own paper price, not directly linked to the value of the underlying asset. Things are a tad more complicated than that though.

A futures contract is essentially an agreement between two parties to transact physical commodities or financial instruments at a set date in the future, at a set price. Every such contract carries a number of risks for all parties involved, and that includes the exchange. The exchange is the entity that guarantees the contract, in the sense that if the “losing” party decides not to honor its contractual obligations, it will step in and pay out the “winner”.

Here’s an example: if a futures contract is traded at the $10,000 BTC price level, and the index goes to $16,000 (where it currently more or less resides), the seller of the contract will have to pay the buyer $6,000. In such a case, provided the seller eschews his obligations, the exchange (the CBOE and soon: the CME), will be stuck for $6,000. If you believe it will quietly write that off as losses though, you are mistaken.

The exchange works with an “exchange fee” as well as with entities called Futures Clearing Houses, who have their own fees, too. Introducing brokerage fees have to be added to the tally as well.
To pour some more cold water on the whole idea of bitcoin being legitimized by its regulatory approval, you should also know that the US authority responsible with the regulation of the activities of futures exchanges is the CFTC (Commodities Futures Trading Commission). In bitcoin’s case though, the CFTC essentially side-stepped the matter, handing it down to the National Futures Association, and the exchanges themselves.

The bottom line is that despite paying a long tally of fees to various clearing organizations, exchanges and brokers, the one left holding the bag at the end will still be the trader. The trader is required to have a deposit called the initial margin, which will in effect be used as a daily guarantor of the futures contract. Only those who have enough funds in their accounts to cover this initial margin (the extent of which is set by the exchange) can enter futures contracts.

Hot on the heels of the initial margin comes the maintenance margin, which means that to be able to keep the futures contract open, traders need to have the equivalent of the initial margin in their accounts at all times. If their balance dips below this level, they will be prompted to make another deposit, and if they fail to heed this call, their position will be closed by the exchange.

This is, in a nutshell, what bitcoin futures traders are looking at. This explains not only the risks involved in this type of activity, but also why some people call futures trading a “casino”.

This is what bitcoin has gotten involved with through the launch of CBOE futures a few days ago, and this is what it will sink deeper into, once the CME follows suit on December 18. What’s more: Cantor Fitzgerald are looking to launch bitcoin-based binary options soon.

The danger that the futures arena represents for bitcoin comes from several directions. Institutional investors with a pessimistic outlook on the long-term evolution of the currency are one source. By selling futures contracts at lower-than-market-price, these entities may generate signals that could easily spill over into the actual bitcoin markets, where prices could tumble. Since a crashing bitcoin can now be just as profitable for some as a soaring one, put two and two together..