Bitcoin Musings on the Eve of the Futures Contracts

Based on the fact that I spent 30 minutes discussing Bitcoin’s utility as a store of value and the relative merits of the underlying blockchain technology at Thanksgiving dinner, it seems logical to collect and summarize my thoughts on the eve of the highly anticipated launch of the CME and CBOE futures contracts. In the interests of full disclosure, I do not own and have not transacted any Bitcoin or any other cryptocurrencies. My perspective is one of a highly interested market observer attempting to understand and contextualize these (relatively) new instruments against the backdrop of more traditional financial products.

There are a few key differences in how the CBOE and CME chose to define their respective instruments, the most significant of which are the contract sizes (1 Bitcoin for the CBOE vs. 5 Bitcoins for the CME), the intraday trading halt levels (10% and 20% vs. 7%, 13% and 20%), and the initial margin requirements (30% vs. 35%). On the surface, the CME seems to have designed a contract for larger, more sophisticated financial players with deeper pockets and an ability to manage intra-day risk, while the CBOE’s product seems geared toward smaller firms and/or individual investors. 

In Trader Construction Kit I assert that to be long run viable, a market must have a diverse group of participants, including natural players (frequently called hedgers) with a need to buy or sell to mitigate organic exposures, financial intermediaries like banks and merchants that facilitate transactions and transform risk for a fee, and speculators that seek risk for profit. Most markets are initially driven by the day-in, day-out transactional needs of hedgers, which are serviced by the banks and merchants, ultimately drawing in speculators that seek to profit from the inevitable price fluctuations. The cryptocurrency space (seems to have) evolved in reverse, with the speculators arriving first, then the banks and merchant players drawn in by the demands of their clients to participate in the space. The question remains, who are the naturals? In the early days of the market, it was possible to argue that the Bitcoin miners themselves were the naturals, with a long position that needed to be hedged. Given the reduced mining output relative to the total volume of Bitcoin extant, I am not sure that this is as operative an assumption now. Going forward, who needs the ability to transact in Bitcoin to facilitate their core business? 

Traditional market participants bemoan Bitcoin’s lack of fundamental information to analyze to develop a view on price. How do you trade a product with no fundamentals?!? Bitcoin does not have no fundamentals, it just doesn't have the same fundamentals as traditional currencies. For an instrument that is converging to a fixed volume of tradable supply, the key variable is money flow into/out of the product. For those with a long memory, this is the same inflationary force that drove oil prices from the low $60.00 range up to $145.00 in 2007-08 as the formerly $50B market tried to digest an incremental few hundred billion dollars of investment from pension funds desperate to increase their commodity allocations. Also worth considering, when those same funds re-allocated away from commodities after the financial crisis, the price of oil immediately crashed back down again. So, the first thing to watch is the relative money flows into/out of the space and the number of accounts opened up at the exchanges. 

A second variable worth considering is the relative percentage of Bitcoin held by “investors” vs. “traders”. According to recent media reports, the Winklevoss twins claim to have never sold any of their initial $11M investment in the space, which is currently valued at around $1B. Given the relative level of zealotry endemic to some of the early market participants, I am sure they are not the only ones in for the long haul. Given that, how much of the approximately $250B of Bitcoin is actually available to the market to absorb incremental buying and selling? Trying to purchase $1B of Bitcoin will have an entirely different price response if the available transactable volume is $100B vs. $10B. 

The law of one price has yet to be fully enforced by arbitrage agents in the cryptocurrency markets, leading to potentially significant simultaneous exchange-to-exchange price differentials. This makes sense, given the relative developmental state of the market, as much of the recent activity has been driven by the entrance of a large number of retail (i.e.: small and unsophisticated) accounts that will likely participate in and transact on only one exchange, which can lead to isolated pockets of intense buying/selling pressure that locally distorts price. The introduction of the CME and CBOE contracts may actually short-run exacerbate this phenomenon, but should in the long run help to stabilize prices via increasing the participation of sophisticated financial players for whom multi-exchange arbitrage is a standard business practice.

I am extremely curious to see what effect introducing the futures contracts will have on the existing cryptocurrency markets. Many members of the “traditional” financial markets view Bitcoin as an insane speculative bubble and assert that the ability to freely enter into short positions afforded by the futures market will instantly crush valuations. While it is certainly possible, I do not believe that an instant sell-off is as obvious an outcome, particularly given the (likely) small relative size of the futures market compared to the “tradable” portion of the volume held at the largest Bitcoin exchanges. There will likely be a protracted struggle to determine which is the tail and which is the dog, going forward. I also suspect that the fragmented high-volatility, low-liquidity Bitcoin market will provide unique challenges for financial players, particularly around survivable position sizing, efficient entry/exit execution, and institutional risk management. One distinct advantage of being an “unsophisticated” buy-and-forget individual investor oblivious to the minute-to-minute price fluctuations is not being forced out of the market when their overly-large position blows through their V@R and stop-loss limits fifteen minutes after they put it on. Given the prevailing level of volatility endemic to the cryptocurrency space, this is an all-too realistic possibility.

CBOT futures go live December 10th, with the CME futures following on December 17th. Bring your popcorn.