While Bitcoin’s mad rise in price is heating up minds and the question “Is Bitcoin a bubble?” is on everyone’s lips, two well-known financial mastodons have launched products derived from its valuation: futures. Before assessing their potential impact on the market, let us recall the substance of these financial instruments that are causing a lot of ink to flow.
The derivatives
It is always amusing to note that the fiercest criticisms made of Bitcoin concern its speculative aspect, or the lack of intrinsic value of its accounting unit. Many bankers and economists also refer to Bitcoin as a “Ponzi scheme”, a “bubble” or even a scam. In order to take a step back, let’s start by comparing a few figures:
- The global capitalization of Bitcoin is estimated at nearly $300 billion.
- The physical gold market would represent 3 trillion (trillion) dollars, according to the conservative estimates of the World Gold Council.
- The global equity market is valued at nearly $65 trillion.
- The cumulative external debt of all countries in the world is 75 trillion dollars.
- Derivatives account for about 1.2 quadrillion dollars (one million billion dollars and two trillion), more than fifteen times the world’s gross domestic product.
Derivatives are financial instruments that are difficult to grasp but are nonetheless very real. They are bets placed on just about any quantifiable asset, value or condition in this world. Let’s take for example the weather next spring let’s let investors bet on rain or shine, let’s contract all this and we have a derivative on the weather. It is possible to bet up or down on the price of a commodity, on a set of commodities or a credit default. By definition, derivatives have no intrinsic value: they are contracting whose value derives from that of an underlying asset or a future state of affairs. It is of course possible to create a derivative from a derivative. Banks can also create contracts that cancel each other out: for example, bank 1 pays X number of dollars to bank 2 if a given value increases, and conversely, bank 2 pays X number of dollars to bank 1 if the same value increases. All this makes this joyful and dangerous mess difficult to quantify. It is almost impossible to know who owns the collateral associated with this or that product. If a bank fails because of a bad bet, due to a domino effect, other financial institutions owning its stocks or assets will also go bankrupt.
Simply put, derivatives are the giant casino of globalized finance. Regulators, who are becoming increasingly strict with users of crypto money, seem very permissive towards bankers, who allow themselves economic aberrations such as negative interest loans and can construct esoteric financial instruments whose essence escapes the common man.
In 2012, the nine largest banks in the world were exposed to $228 trillion in derivatives: about three times the size of the world economy. This is enough to make one think about the notion of the Ponzi pyramid.
What is a future contract?
A futures contract is a special type of financial derivative: it allows two parties to set up an agreement to buy (or sell) an asset at a price and date set in advance.
Initially, this financial product was invented to allow certain market players to hedge against a risk: for example, a wheat producer, to protect himself from price variations between the time he plants his seeds and the day of harvest and then market launch, can subscribe to a futures contract that will then allow him to sell his crop at a determined price.
Today, futures contracts are primarily used by investors and traders to wildly speculate on price variations of any commodity in the market. The Chicago Mercantile Exchange, discussed below, offers futures on traditional commodities such as gold, oil or corn, but also on currencies or financial indices.
There are two types of futures settlement:
- Physical settlement – physical settlement: on the closing date, the commodity in question (e.g. oil) is delivered to the buyer.
- Financial settlement – financial settlement: the clearing mechanism simply credits or debits the different parts of the difference.
This is the method of financial settlement that is obviously preferred by investors. On the one hand because many futures contracts are indexed on assets that have no physical existence, and on the other hand because no trader wants to end up with a container of sacks of wheat at the foot of his building: it is estimated that the proportion of futures contracts settled by physical delivery represents only 2% of all such futures.
Trading futures contracts is not an easy task because these products have several particularities: they only exist for a defined period, the price of a contract generally increases with its duration, and marketplaces offer investors significant leverage. Leverage gives the trader the possibility of subscribing to many more contracts than his collateral alone would allow him, which has a multiplier effect on his gains and losses.
The Case of Bitcoin
In the unknown and rapidly expanding world of Bitcoin, it is even more difficult to make relevant analyses, and many contradictory assumptions can be made.
Many expect a massive influx of liquidity into the market and believe that the launch of futures will attract even more traditional investors into the “real” market, which would accelerate the rise in the price of Bitcoin.
However, the majority of the investors who will be positioning themselves in futures are accredited institutional investors, or brokers for high net worth clients. Small fish do not have the margin requirements – the collateral required to use leverage – which are higher in Bitcoin than in “traditional” futures because of the volatility of the price. These requirements are likely to be adjusted in the future, as experience is gained. Professional investors are cautious and distrustful of Bitcoin, and do not wish to buy the asset as such. They will therefore probably act cautiously during the early periods, to test the market volatility. There may therefore not be as much liquidity as expected, which could lead to a correction, because the crypto-currency market works according to the old adage “buy the rumor, sell the news”: the price is guided by the anticipation of upcoming news and then adjusts when it becomes reality.
Many purists have a negative view of the arrival of extremely rich speculators who could destabilize or even manipulate the current market by injecting massive liquidity. How could a bet on the price of Bitcoin affect it? By the arbitrage of market participants between the price of the futures contract and the price of the underlying. The economic incentive to manipulate the market of the underlying, so that a bet taken on the derivative market becomes self-realizing, is very strong.
Early adopters and whales hate to sell their precious bitcoins. Their mistrust of traditional finance and the wolves of Wall Street is such that some would sell them nothing, not even at a disproportionate price, but many now have an interesting exit point. Would keeping their Bitcoins be the best way to protect the decentralized network from the phagocyting of institutional investors? In any case, it is the big boys of finance who can give Bitcoin a capitalization comparable to that of traditional markets.
Futures contracts are fascinating financial products and dangerous for those who manipulate them. In quantitative terms, after a few days of existence on the largest futures markets, their trading volume is low compared to the volumes of Bitcoin traded on traditional platforms. The influence of these futures can therefore be described as slight at the moment.
In the long term, the existence of these financial products and the associated inflow of liquidity may improve the price discovery mechanism and reduce arbitrage opportunities. The market may become more efficient and the price of bitcoin less volatile, and the addition of new funds to the market will increase buying pressure.
Conclusion
Futures are the first financial derivatives to appear in the world of crypto currency; others will probably follow. The problem of exorbitant transaction costs on the Bitcoin network (and more generally, the problem of scalability) is getting worse and solutions take time to be deployed: in the short term, a period of uncertainty in the market is to be expected, although the buying fever of those who feel they have missed the train often compensates for the profit-taking.
