The markets were euphoric. The community was cheer-leading the imminent launch of Bitcoin futures first on the CBOE and then on the CME. Bitcoin reached its all time high.
They saw this as an indication that institutional investors were just around the corner and that Bitcoin was about to “moon.” Fast forward to today and the feeling is quite the opposite: hodlers are left scratching their heads and licking their wounds.
So, what happened?
While there were a number of factors that drove Bitcoin into one of its worst bear markets to date, one cannot ignore the potential negative impact that these futures had on the market.
In this article, I will take a look at how futures contracts could have been used to skew the markets and why contract delivery is such an important distinction for a futures contract. But first, let’s start with a bit of futures theory.
Cash vs. Physical Delivery
When it comes to futures contracts, there are two main types that exist on the financial markets currently. These are cash settled futures and those that involve physical delivery of the underlying asset.
When you enter into a cash future, you are merely placing a “side bet” on the price of an underlying asset. You will post a certain amount of collateral for the futures contract which will be adjusted based on the profit / loss of the contract going forward.
On the expiry of the contract, the exchange will settle the futures trade purely with cash. There will be no exchange of any of the underlying asset. This is mostly used in cases where the underlying asset is hard or impracticable to deliver.
Cash futures are often used in the Equities futures markets when the traders are taking positions on an equity index such as the S&P500. In this case, it is much simpler to just settle the trade with cash.
This is in stark contrast to the physically settled futures contracts where the counter-parties are agreeing to exchange the asset at the end of the contract. The long party will take delivery of the asset from the short party on the expiry of the contract.
The delivery location and terms will be stipulated in the contract and the exchange will enforce the underlying rules. This is mainly used in the commodities markets as well as the forex markets.
So why is deliverability of the contract important for the underlying market?
Cash Future Manipulation
Given that a cash settled future involves no transaction on the underlying asset itself, there are no parameters that are set as to how the futures contracts will be used. The only variables that are stipulated in the contract are the expiry price and time.
This basically means that anyone with a large enough position in the underlying asset can impact on the price in the futures market by buying and selling in the physical market.
How do we know that this can happen?
It is a well-known market manipulation tactic that is called “banging the close”. There has been research done on the potential for this manipulation. There is also precedent of it being used in the past by some firms.
Hedge funds with large positions in the underlying asset could create activity in the price prior to future expiry dates. They will try to use their position as well as other tactics such as negative marketing campaigns to drive the price down. You can read more about some of the tactics that were used on Herbalife shares in the past.
Of course, this is very risky in the transparent and very public equities markets. People can see in the order books who is trading what and when. Regulators such as the SEC and CFTC have actively pursued market manipulation cases.
But what about in the unregulated and opaque cryptocurrency markets?
BTC Futures Manipulation
Even before the launch of the CBOE and CME futures there were many investors who were looking for a method to short Bitcoin. The introduction of an exchange listed futures contract was an open invitation.
Moreover, given that these futures were cash settled, hedge funds and crypto whales saw a lucrative opportunity for dubious tactics. This was even postulated prior to the launch by the Wall Street Journal as they talked about the risk of manipulation.
Indeed, it seemed quite suspicious that the price of Bitcoin reached its all-time highs just prior to the CME launch. It is entirely feasible that large investors were accumulating physical Bitcoin thereby increasing the Spot price and, subsequently, the future price.
Banging the “open” so to speak.
As the contracts opened up for trade, those same individuals started accumulating short positions in the cash futures market. They locked in futures expiry prices of close to $20,000 for contracts ending in January.
Then, they start banging down the price on the way to the close.
Those who had accumulated their Bitcoin holdings in the run up the futures open could now start selling them in the spot market. They locked in higher price levels on these physical holdings while tanking the price and profiteering in cash on the futures market.
Cash in, buy again. Rinse, repeat.
The CBOE and CME were aware of these risks and hence they decided to use exchanges that did full KYC as the reference point for the futures prices. For example, the CME referenced a collection of 5 reputable exchanges including Coinbase, Bitstamp and Kraken. The CBOE referenced the Gemini Exchange.
However, there is no way to contain a large and opaque global market. Most of the Bitcoin trading volume was being done on offshore exchanges where there were less thorough KYC practices. If global prices start falling, so will those on the reference exchanges.
In theory, it sounds plausible. But did it actually happen?
Correlation or Causation?
If one were to take a look at the Bitcoin peak and then fall, it seems to perfectly map the introduction of the contracts. While there was not an explosion in futures open interest when the CBOE contracts went live, volume steadily picked up when the CME futures started trading.
We need look no further than the comments by the Federal reserve bank of San Francisco. They feel confident enough in their assertions that the futures markets had a significant impact on the Bitcoin markets. The piece states that:
“The new investment opportunity led to a fall in demand in the spot bitcoin market and therefore a drop in price. With falling prices, pessimists started to make money on their bets, fueling further short selling and further downward pressure on prices.”
So, while they are not laying out a case for any sort of coordinated manipulation, they are explaining the exact dynamic that would take place if it were happening.
One can also observe the large uptick in the volatility of the spot market on the expiry dates of the futures markets. As noted by Tom Lee of Fundstrat Global Advisors, this shows that traders could have been actively trading the physical market to impact on the cash futures market.
So while this is not decisive evidence of manipulation, it does paint a dire picture for the listing of Nasdaq cash futures and the impact that this could have to further drive unnecessary volatility.
So what can be done about this?
Bitcoin is an asset that is incredibly easy to transfer. It is easier to transfer than shares, commodities and even fiat currency.
Hence, it seems to be an ideal candidate for physically delivered Bitcoin futures. The counter-parties to the derivative contract will enter a futures contract as it was intended. They will agree to physically buy or sell the asset on expiry.
This will also mean that the individual who is shorting (selling) the Bitcoin in the future will have to place the Bitcoin into storage to physically send it to the buyer on the expiry of the contract. They cannot use that Bitcoin separately to create buying pressure in the physical market.
More transparency, more certainty, less volatility. Physically delivered Bitcoin futures could actually contribute to a reduction of volatility as businesses and investors secure guaranteed future prices for their eventual transaction.
So, when can we expect to see physically settled contracts?
You will no doubt have heard of the exciting products and technology that is being developed by Bakkt. This is a digital currency initiative that is being backed by ICE (Intercontinental Exchange).
One of the most important things that they will be launching is their physically delivered Bakkt Bitcoin (USD) Daily Futures Contract. These call for delivery of one bitcoin held in a Bakkt Warehouse.
This means that counterparties will store their physical Bitcoin at Bakkt which will be held in fully transparent manner prior to the expiry. The future seller cannot use that Bitcoin in any capacity in the physical market before termination of the contract.
These contracts will allow for block trades and will take advantage of ICE’s proven financial market infrastructure and technology.
The Bakkt Bitcoin futures are set to launch on the 24th of January next year. It will be interesting to see whether these products will be able to tame any of the volatility that the cash futures helped spurn.
It has no doubt been a tough year for cryptocurrency markets. The community was hailing any sort of potential institutional adoption without consideration to the impact that it could have on the markets.
Cash futures were one of those products.
The markets are comprised of some really smart hedge funds, crypto whales and algorithmic traders. They knew the exact dynamics that cash futures could bring to the still nascent Bitcoin markets.
Whether they actively took advantage of this to enrich themselves, no one can really tell. What is clear though is that cash futures didn’t bring the avalanche of institutional adoption many were hoping for.
So, as we usher in the new year, let’s focus our attention on the types of financial products that actually bring value to the ecosystem and aid adoption.
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