Lanre Sarumi is the CEO of Level Trading Field, an interactive online platform for professionals in the finance industry.
For bitcoin traders, all eyes should be on Dec. 10 and Dec. 18.
That’s when former self-styled bitcoin whales will be swallowed up like plankton as the CBOE and CME Group launch bitcoin futures contracts for the first time in history.
Over the next few days, I will be providing information on trading in the bitcoin futures market. My goal is to shed some light on its peculiarities and hopefully help people avoid mistakes. To start, it won’t just be the whales that will be devoured, but any other smaller crustaceans that choose to ignore the potential impact a derivatives market can have on an underlying commodity.
You see, in bitcoin’s cash market, where these whales exist, they swim amongst other bitcoin marine lives without necessarily attacking their co-habitants. The reason is simple. Everyone in bitcoin’s cash market is financially incentivized to keep the price of bitcoin high.
Sure, the market sometimes takes a dip, but that’s because some bitcoin holders are taking profits off the table. In the futures market, there is as much reward for the creatures on the downside as well as the upside. Tremendous wealth can be created in a falling market as it can be in a rising market. There are incentives on either side.
Essentially, bitcoin’s cash market is like a river. Its flow is dependent on constants and so it generally flows in one direction. The bitcoin futures market, on the other hand, is like an ocean with thermohaline circulation: its flow is dependent on several variables.
Marine life in the futures market is not as friendly. The waters are infested with killer whales. Apex predators that feed on other whales. They even feed on themselves.
Alright, enough of the marine analogy…
Journey through any of the bitcoin forums on Slack, Reddit and Telegram, and there is general happiness and optimism about the value of bitcoin with the advent of a futures market.
This is born from a lack of understanding of how futures markets work.
There is this misguided perception that the futures markets work in a similar fashion to the cash market. In fact, both markets are diametrically opposite.
Cash markets (e.g. stock exchanges and bitcoin exchanges) are primarily populated with optimists. Futures markets, on the other hand, are primarily populated with pessimists.
Put another way, cash markets were created for investors, while futures market were created to hedge against risk. Investors go to the cash markets because they believe the value of the assets will rise. Hedgers go to the futures market because they don’t want the price of the asset to move against them. You can’t “sell” in the cash markets if you don’t already own the underlying asset. Even the short sellers borrow those assets from owners before shorting.
The futures market has no such constraint. You can sell whether you own the underlying asset or not. A corn farmer sells futures contract because he is afraid the price may fall and wants to guarantee a price for his corn when he eventually harvests it.
A manufacturer that uses corn buys a futures contract because he is afraid the price of corn will rise and wants to cap the price he pays for corn.
Both buyers and sellers in their own way are pessimistic.
In the corn futures market, the farmer and the manufacturer are natural hedgers on opposite sides of the market. Thus, they create some sort of equilibrium.
Of course, market makers and speculators are required to create additional liquidity, but they, for the most part, rely on the existence of the true hedgers.
In the bitcoin futures market, the only groups that need to hedge are the miners and current bitcoin holders. Miners will sell futures contracts to guarantee they get at least the given price for the bitcoins they plan to mine in the future. Bitcoin owners will do the same to hedge their downside.
There are no natural hedgers on the buy side. This will inadvertently create pressure on the downside.
The only group left to keep the price steady and maybe even cause the price to rise is the group of speculators. Unlike the miners and bitcoin holders, the speculators will comprise of both bulls and bears. For the most part, we have seen the power of the bulls in the cash market, but until the introduction of the futures market, we had not seen the power of the bears.
Could the bears overwhelm the bulls? Vice versa? No one knows. Is the introduction of futures going to lead to an increase in bitcoin price? No one knows.
What is clear though is if you currently hold enough bitcoin to be classified a whale, you better familiarize yourself with the futures market. Simply drifting in the ocean hoping for the best is not a strategy. Well, it is a strategy, just not a very good one.
Disclosure: CME Group is an investor in Digital Currency Group, of which CoinDesk is a subsidiary.
Shipwreck image via Shutterstock