CME Group, the largest derivatives exchange in the world, as well as one of the oldest, will launch bitcoin futures trading on Dec. 18th, while CBOE Global Markets, which owns the Chicago Board Options Exchange (the largest U.S. options exchange) and BATS Global Markets, plans to beat CME to the punch by opening its own trading on Dec. 10th.
In theory, this opens the doors to institutional and retail investors who want exposure to bitcoin but for some reason (internal rules, or an aversion to risky and complex exchanges and wallets) can’t trade actual bitcoin.
And that expected flood of interest is, from what I hear, part of the reason that bitcoin’s price recently shot past $11,000 (which, considering it started the year at $1,000, is phenomenal).
But if that’s true, I’m missing something: I don’t understand why the market thinks there will be a huge demand for bitcoin itself as a result.
First, a brief overview on how futures work: Let’s say that I think that the price of XYZ which is currently trading at $50, will go up to $100 in two months.
Someone offers me the chance to commit to paying $80 for XYZ in two months’ time. I accept, which means that I’ve just “bought” a futures contract. If I’m right, I’ll be paying $80 for something that’s worth $100. If I’m wrong, and the price is lower, then I’ll be paying more than it’s worth in the market, and I will not be happy.
Alternatively, if I think that XYZ is going to go down in price, I can “sell” a futures contract: I commit to delivering an XYZ in two months’ time for a set price, say $80. When the contract is up, I buy an XYZ at the market price, and deliver it to the contract holder in return for the promised amount.
If I’m right and the market price is lower than $80, I’ve made a profit.
Beyond this basic premise, there are all sorts of hybrid strategies that involve holding the underlying asset and hedging: for instance, I hold XYZ and sell a futures contract (I commit to selling) at a higher price.
If the price goes up, I make money on the underlying asset but lose on the futures contract, and if it goes down the situation is reversed. Another common strategy involves simultaneously buying and selling futures contracts to “lock in” a price.
Futures contracts currently exist for a vast range of commodities and financial instruments, with different terms and conditions.
It’s a complex field that moves a lot of money. The futures market for gold is almost 10x the size (measuring the underlying asset of the contracts) of the physical gold market.
How can this be? How can you have more futures contracts for gold than actual gold? Because you don’t have to deliver a bar of gold when the contract matures. Many futures contracts settle on a “cash” basis – instead of physical delivery for the sale, the buyer receives the difference between the futures price (= the agreed-upon price) and the spot (= market) price.
If the aforementioned XYZ contract were on a cash settlement basis and the market price was $100 at the end of two months (as I had predicted), instead of an XYZ, I would receive $20 (the difference between the $100 market price and the $80 that I committed to pay).
Both the CME and the CBOE futures settle in cash, not in actual bitcoin. Just imagine the legal and logistical hassle if two reputable and regulated exchanges had to set up custodial wallets, with all the security that would entail.
So, it’s likely that the bitcoin futures market will end up being even larger than the actual bitcoin market…
Read Full: The Threat of Bitcoin Futures