Why You Shouldn’t Look at Bitcoin Backwardation Like an Oil Trader

Backwardation refers to a downward sloping futures curve where front-month contracts trade at a higher price than far-maturity contracts.

AccessTimeIconMay 18, 2021 at 8:05 p.m. UTC
Updated Sep 14, 2021 at 12:57 p.m. UTC

Bitcoin (BTC) futures on the Chicago-based CME exchange slipped for a few days into "backwardation," a condition sometimes observed in commodities markets where prices on near-month contracts exceed those for further-out delivery dates.

The backwardation appears to have started late last week and continued through early Tuesday. The unusual condition might have been an indication that immediate demand for the cryptocurrency was outstripping supply. Crypto analysts, however, aren’t sure if the interpretation holds for bitcoin. 

"BTC's backwardation does not necessarily imply tighter supply conditions," Nathan Cox, CIO at Two Prime Digital Assets, said. 

Bitcoin's CME-based futures backwardation was relatively short-lived, as is often the case: The May contract is back to trading at a slight discount to the June contract (this structure is known as contango).

Backwardation refers to a downward sloping futures curve where front-month contracts trade at a higher price than far-maturity contracts. For example, bitcoin's May expiry futures contract traded at a premium of $15 to the June contract early Monday, per data source TradingView. At one point on Friday, the June contract drew a premium of $55 over the July futures. 

Backwardation in bitcoin vs. oil

Per Investopedia, backwardation results from "higher demand for an asset currently than the contracts maturing in the coming months through the futures market." However, that definition is more applicable to oil markets, where demand is a function of economic growth, and the market often faces tighter supply conditions due to production cuts or a sudden surge in economic activity. 

Analysts sometimes also attribute the opposite condition, known as contango, to the cost of storing commodities for longer time periods. 

One point of reference might be the futures market for West Texas Intermediate (WTI) crude – the primary benchmark for U.S. oil prices. That market slipped into backwardation in November 2020, reflecting a supply shortage at the time, in the wake of the Organization of Petroleum Exporting Countries' sustained production cuts. WTI prices rallied from $44 in late November to hit multi-month highs near $68 in March this year.

"Oil spot and futures markets have very different inputs into the calculation, and the oil demand outlook can be quantified much more explicitly than digital assets, which tend to be an indication of pure price expectation versus actual usage or demand," Cox said. 

West Texas Intermediate futures, which are listed on the New York Mercantile Exchange (NYMEX), are settled physically. 

"When the WTI contract expires, a quantity of the oil that previously existed only on paper is converted into physical barrels that need to be used or else stored at a major U.S. storage site," Reuters noted last year. 

However, bitcoin futures listed on the Chicago Mercantile Exchange (CME) are cash-settled, meaning a credit or debit is issued, marking either a profit or loss in the trading account. In other words, the buyer does not get the actual delivery of coins, which makes the CME futures more of a speculative instrument. 

"Bitcoin is different than oil in that it's mainly speculative,” Ben Lilly, crypto economist at Jarvis Labs, told CoinDesk in a Telegram chat. "What we find is backwardation tends to be more predictive of a reversal or buying opportunity, especially in a bull market."

BTC backwardation bearish?

So far, the bullish sentiment supposedly conveyed by the recent futures backwardation has failed to translate into higher prices. Bitcoin was trading near $43,000 at press time, having printed a 3.5-month low of $42,142 on Monday, according to CoinDesk 20 data. 

"It points to the fact that future price expectations for BTC are actually lower than spot," Cox said.

According to Gamma Point Managing Partner Rahul Rai, the backwardation is hardly a bullish sign. To wit, the condition might represent a bearish sentiment among institutions.

"CME is a venue for them to get short BTC exposure at scale," Rai said. 

The carry trade

Rai added that backwardation is not the result of immediate supply squeeze but is driven by institutional arbitrage flow – cash and carry trades, also known as basis trades, seeking to profit from the spread between futures and spot market prices. 

"CME is where institutions execute the short futures leg of the basis arbitrage trade, and hence there is constant selling pressure coming from funds running the cash and carry trade at scale," Rai said. 

A cash and carry strategy involves selling a futures contract against a long position in the spot market. That way, fund houses pocket a fixed return, as the premium decays over time and converges with the spot price on the expiry date. 

Carry traders usually execute the short futures leg in far-month contracts, offering higher premiums than near ones. In the process, they end up pushing the premium on far-month contracts lower. 

Another factor that makes the CME futures vulnerable to backwardation is the low retail participation. Despite the bigger lot size, the exchange offers relatively low leverage than its unregulated peers, such as Binance. 

"As CME futures have a minimum trade size of five contracts, i.e., 5 BTC, (micro futures only just launched) retail leverage seeking flow, that typically bids up futures over the spot and widens the basis, has primarily been on centralized exchanges rather than CME," Rai said. 

"Bitcoin markets statistically spend less than 10% of their time in backwardation," Cox said. 


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