Why the Bitcoin price may drop heavily once CME / CBOE / NASDAQ start future trading

in #bitcoin7 years ago (edited)

I actually thought the 10,000$ mark would be more difficult to take for Bitcoin. Now the fight took only a couple of hours and we've already seen prices above 11,000 on the major exchanges today. The party never stops, this time by NASDAQ also announcing to list Bitcoin futures in H1/2018. There's nothing that can stop Bitcoin, right?

Well, let's step back a little. Maybe there is. Let's try to understand what causes this steep price increase based on such news (after all, these futures are all cash-settled) and what might happen once they actually get traded. To understand this, let's first clarify how (cash-settled) futures work and why they can influence the Bitcoin market (and others, later on).

What is a future?

A future is a contract between two parties, Alice and Bob, where they agree on a definite price for an underlying good, typically a stock (but could be anything else like oil or potatoes), for delivery in the future. This contract is then binding for both parties, but it also has a price that needs to be paid betwwen Alice and Bob. Want an example?

Alice and Bob agree on the delivery of 100 Alphabet shares from Alice to Bob on December 31st, 2018, at a price of 1050$ each. As the price is likely to be higher than 1050$ by the end of 2018, this looks like a good deal to Bob. He'll buy shares from Alice at 1050 and sell them on the market right away at, let's say, 1200. That would mean he makes 150$ per share.
That's why Alice asks Bob for 10$ per share right here, right now, so she gets rewarded for her risk.

This, in essence, is a future. (Technically, some people might complain that there's a difference between call and put and between forwards and futures, but let's leave it at that for now).

Cash-settled futures


What does it mean if a future is cash-settled? It basically means that in our example above, Alice will not deliver actual Alphabet shares to Bob, by they agree that they will just settle on the price difference to the reference price. So if the price is at 1200$ by the end of 2018, Alice needs to pay Bob 150$ per share. Should the price be lower than 1050$, Bob would pay Alice the difference.

Why is this important? Cash-settled futures and other derivatives mean that you can trade a lot of future positions without ever touching the underlying. As a result, the amount of traded futures can be 10x or 100x the amount of available underlying. We'll see where this brings us wrt Bitcoin in minute.

Just...why?


Why would anyone be interested in trading cash-settled futures? The idea original idea was to hedge yourself against a potentially catastrophic price movement. A chemical company will need a lot of oil so they want to have certainty about their oil supply price a year from now (after all, they may have long-term contracts to sell their products at certain prices). A frozen-fries company may want to lock in the price for potatoes. A coffee roaster the price for raw coffee. Furthermore, they may not be interested in buying the actual material but a similar-but-different one instead. That way, at least a certain price movement will not suddenly be threatening their business.

How that all relates to the Bitcoin price


You may already see where this is going, but I'll explain that theory anyway:
Once there are futures on Bitcoin, people who want to invest in Bitcoin don't need to buy "physical" Bitcoin anymore, they can just buy a future. This opens up Bitcoin as an investment class to many more investor groups than before. This should be great for the Bitcoin price, no? Even more investors!

Nah, not really

This all could be an explanation to why the price is soaring, now more than ever. Imagine you want to bet on a price drop rather than an increase. This can be easily done with futures, as well. After all, Alice is doing exactly that. She could have done that with Margin trading or short selling (sell Bitcoins that she borrowed, and buy them back on the market later). But to short-sell, Alice needs to borrow actual Bitcoin. That way, she cannot short-sell more than, say 16,700,000 Bitcoin (the current theoratically available amount). However, with out cash-settled futures, she can do this with 1bn Bitcoin or more. After all, the real Bitcoins are never touched.

What hedge funds could do


Now a typical hedge fund is in exactly that kind of business. Furthermore, Bitcoin and crypto currencies in general are a rather unregulated market where market manipulation is not sanctioned. That way, they could be buying as much Bitcoin as they can now (which, as a nice side effect, will push the price up) and then open up short positions (bets on falling price) on the futures markets, but at 100x higher volume than the actual Bitcoin market. Once they've done that, they could start dumping their bought Bitcoins on the markets to drop the price and sell their short positions with a massive profit, leaving behind Bitcoin at 5000$ or even lower.

What we can do about it


Nothing much, really. However, the more liquid and efficient the markets and the more money is the market, the more difficult and expensive these price manipulations are. The market cap of Bitcoin may not be the ideal indicator for that, but an increase in that (meaning in the actual Bitcoin price) may be helpful for that. Plus, less hodling, more trading.

Oh, and wow, while I was writing this article, the Bitcoin price managed to drop 600$ ;-)!

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Excellent article. It gives me a good perspective of what to expect. I don't understand much about the financial market but I aways like the idea of be an investor and the crypto coins and exchanges makes it easy to jump in.

Thanks a lot. I've had a discussion with some colleagues about the current price increase and though I'd just write it down. Luckily, I used to work at a major European exchange provider for over 7 years... :-)

The prices are crazy now IMO. Looks at this screenshot a friend of mine sent me today. Do you believe is that possible?
WhatsApp Image 2017-11-29 at 17.52.32.jpeg

I'm not sure about that. I would like to understand how they would get Bitcoin down below 1000$ without having to invest a lot of money. What would that "margin tether trading" look like I wonder?

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