Outside the Box: This new way to trade bitcoin could kill its rally

Bitcoin trading is about to enter a future dimension.

CBOE Global Markets Inc. CBOE, -0.29% is due to launch trading of  bitcoin futureson Sunday, Dec. 10. under the ticker symbol “XBT.” The following week, on Dec. 18, rival Chicago Mercantile Exchange is slated to introduce its own bitcoin futures contract. Bitcoin BTCUSD, +5.26% futures on both exchanges will be cash-settled.

These futures contracts on mainstream exchanges will bring a new type of investor into the bitcoin market, which in itself has major implications: It legitimizes bitcoin and vastly simplifies the process of gaining exposure to bitcoin for both retail and institutional investors. For speculators, the futures market will reduce transaction costs and enhance access to bitcoin investment opportunities, and the ability to hedge in the futures market will make investing in bitcoin much more palatable to institutional investors. The presence of these new market participants will improve liquidity and dampen volatility, leading to more orderly bitcoin trading.

Read: Here’s how bitcoin can fit with your stocks and bonds

My research paper, “The Impact of Options Trading on the Market Quality of the Underlying Security: An Empirical Analysis,” published in The Journal of Finance  (1998), showed that derivative trading (i) completes the market by increasing the opportunity set for traders, (ii) increases liquidity, (iii) reduces volatility, and (iv) improves pricing efficiency. Similar improvement in bitcoin markets can be expected from bitcoin futures.

It can be argued that these same institutional investors might destabilize the bitcoin market by taking on large positions in both the bitcoin spot-market and the futures markets to take advantage of pricing discrepancies, or in the extreme might even attempt to corner the market using the futures market.

Some observers go even further. Interactive Brokers Group IBKR, +0.34%  Chairman and CEO Thomas Peterffy has warned that a sharp bitcoin price decline could cause liquidity issues for the clearinghouses that could spread across financial markets and lead to a Lehman-style collapse.

However my study, and other academic work shows that the positive impact of these new investors on the quality of the bitcoin market will likely outweigh any destabilizing concerns.  

Read: Brokerage billionaire: bitcoin futures could lead to a Lehman-style collapse

Bitcoin derivatives trading will undoubtedly attract new investors, and not surprisingly, the price of bitcoin has soaredsince the CME and CBOE announcements.

Attracting new investors is generally a positive for most investments, but the impact on bitcoin is not yet clear.

Attracting new investors is generally a positive for most investments, but the impact on bitcoin is not yet clear. Most bitcoin investors are true believers. Their view is that bitcoin will play a critical role in Web 3.0, and they plan to continue to hold bitcoin well-above the current price. Their unwillingness to sell has caused large order imbalances and could explain the sharp rise in bitcoin’s price, as well as the flash crashes that occur when sell-side supply temporarily increases.

Then there are the naysayers. Many powerful financial players — from Jamie Dimon to Nobel laureates — view bitcoin as a bubble or a fraud. Should they decide to put their money where their mouth is, bitcoin prices will face downward pressure.

Other key players are the arbitrageurs. Having a futures market may move the bitcoin price toward the cost of mining bitcoin. If the cost of mining bitcoin is lower than the price at which bitcoin can be sold in the futures market, it will be possible for arbitrageurs to earn a riskless profit.

Read: Bitcoin’s surge past $12,000 makes it bigger than all but 16 S&P 500 components

Given the time delay between investing in mining equipment and when bitcoin is earned, today, in the absence of a futures market, one assumes risk. Miners gamble that by the time their bitcoin is mined, the price of bitcoin will still exceed its mining cost. A futures contract will allow investors to lock in the selling price before investing in the mining infrastructure. If the futures price is higher than the cost of mining, it will lead to guaranteed arbitrage profits, which will necessarily drive down the price of bitcoin.

For example, one of the most sophisticated bitcoin mining rigs is currently available for about $3,700 on Amazon.com, and it claims it will mine one bitcoin per year. Even if the electricity cost is around $1,500 annually, the total cost of mining bitcoin is less than $5,000 (assuming some salvage value for the miner after its first use). That cost is less than half of where bitcoin traded after CME announced that it received regulatory approval to list the bitcoin future on its exchange.

Finally, there is a real concern that increased participation in the bitcoin market facilitated by bitcoin futures will bring increased scrutiny from regulators, who appear generally uncertain about bitcoin’s viability. Commenting on the provision of the CME future, CFTC Chairman J. Christopher Giancarlo warned market participants that these markets remain generally unregulated and outside of the CFTC’s purview, and warned about the “price volatility and trading practices” of bitcoin investors. However, a robust futures market may make the SEC more comfortable with bitcoin-linked products, such as exchange-traded funds, that it has previously denied.  

The listing of bitcoin on a futures market with option trading to follow soon is great news for the quality of the market — broader investor participation, higher liquidity, and lower volatility is likely. It may also pave the way for other bitcoin products, like ETFs, which will complete the market further.

We will also likely see a more efficient market in which the price properly reflects the views of all market participants, not just the bitcoin believers. So if bitcoin in fact is the Dutch tulip mania of the millennials — much in the same way tulip prices crashed soon after cash-settled tulip futures were introduced, this may be the beginning of the end.

Atulya Sarin is a professor of finance at Santa Clara University. He is the co-author of “Foundations of Multinational Financial Management” (Sixth Edition)(Wiley) and has worked extensively as a valuation expert. 

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