The Problem with Having Bitcoin Futures
Bitcoin futures have been introduced on the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) from December 10, 2017. Although it is being claimed that these future contracts will be used for hedging and mitigating risks, the reality is that they are being used for speculative purposes. Bitcoin has become a highly speculative underlying asset. This has prompted the Fed chairman Janet Yellen to warn people about the volatile nature of Bitcoin. The fact that the trading of the futures contract on Bitcoin had to be halted twice since the price rose so high within the first few hours of trading speaks volumes about the speculative nature of Bitcoin.
In this article, we will understand some of the fundamental problems with the Bitcoin futures.
Settled in Cash
These futures contracts in Chicago are denominated in terms of Bitcoin. However, they need to be settled in cash. This may not appear to be a big problem prima facie. However, it is significant. When the price of the underlying asset rises significant people rush to buy it causing a scarcity. However, in this case, Bitcoin will not have to be delivered to settle the contracts. Hence, the market will not be able to exert upward or downward pressure on the price of Bitcoin. The price of Bitcoin will be independent of the activities of the futures market. This looks eerily similar to the contracts that were introduced in Amsterdam during the Tulip Mania. Those contracts could also be settled only in cash and not with the underlying asset, i.e. tulip bulbs.
Surrogate Way to Buy Bitcoin
With the massive rally in Bitcoin prices, governments all over the world are tightening the noose on Bitcoin trading. The exchanges and the traders are being brought under the ambit of taxation. To avoid the government regulation, many investors are willing to pay a premium. This is why they buy the Bitcoin contracts instead of the actual Bitcoin. In case they wish to go long on their investment, they simply open another contract when the current one expires. If they wish to unwind their positions, they simply do not roll over their contracts!
Dependency on Bitcoin Exchanges
There is no liquid market for determining the price of Bitcoin at any point in time. The contracts being sold in Chicago are heavily dependent on certain Bitcoin exchanges. The price that is used by CBOE is determined based on the price quoted by Gemini which is a small Bitcoin exchange. Similarly, the price quoted by CME is the average of 4 small sized Bitcoin exchanges. The fact that these exchanges are relatively small in size makes them vulnerable to financial and cybersecurity hazards. There is no standardized price being followed for Bitcoin futures. The prices quotes received from different exchanges could vary by as much as 25%! This is what adds to the volatility and the instability of the market.
Usually, brokers require about 10% to 15% of the asset price as security. This is in the case of assets like shares and bonds. This margin money prevents the brokers from losing money because of the client. As the price starts to fall, brokers issue a call for increased margin money. If the call is met by the investor, the contract stays in force. However, if the investor is not able to put up the margin money, the contract is sold in the market and the losses are booked on account of the investor.
Since Bitcoin rallies are so sudden and volatile, brokers currently need more than 35% of the price of the contract as margin money. In a way, it is good for the market. Higher margin money lowers the leverage that brokers can provide to their clients. This limits the amount of money speculators can borrow and invest, keeping a check on the prices. The Chicago Mercantile Exchange is charging as much as 47% of the contract price as margin money! Even though returns from Bitcoin may be high, a bigger security amount limits the profits that can be made from the trade.
Risk to Brokerages
The brokerage firms are also at high risk. Many have started offering Bitcoin contracts to meet the needs of clients. However, there is a huge solvency risk given the extreme volatility in Bitcoin prices. If these brokerage firms sell a large number of future contracts and if there is a price rally, brokers stand to lose a lot of money. This is because for every investor who is going long there is another one who is going short. If the brokers are not able to recover the money from the investor going short, they will still have to pay the one going long. This threatens the solvency of the brokers and even the entire exchange. Most brokers are beginning to create separate legal entities for Bitcoin trading. This is to ensure that even if there is a bankruptcy in the Bitcoin business, it does not affect the other lines of business that the brokerage is working in.
To sum it up, the whole Bitcoin rally is starting to look a lot like the Tulip Mania. The introduction of the Tulip futures was the last straw by which the market was hanging. Within a few months after the futures contracts came into existence, the tulip bubble burst. It seems like a similar fate awaits the Bitcoin economy!
|❮ Previous Article||Next Article ❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Introduction to Forex Markets
- History of the Forex Market
- Bretton Woods Agreement and Smithsonian Agreement
- Currency Pegs
- Common Terminologies Used in Forex Markets
- Forex Trading vs. Regular Trading
- Understanding the Trading Cycles in Forex Market
- How Are Exchange Rates Determined ?
- Types of Quotations in Forex Market
- Types of Orders in the Forex Market
- Advantages and Disadvantages of Forex Market
- The Importance of Forex Education
- Major Currency Pairs
- Types of Market Participants
- Types of Intervention by Central Banks
- Dollar Yuan Peg
- Forex and Labor Arbitrage
- Carry Trade and Rollovers
- Special Drawing Rights (SDRs)
- Interest Rates and Forex Market
- Exorbitant Privilege: US Dollar
- Freely Floating Exchange Rates
- Argentina Financial Collapse
- Asian Financial Crisis of 1997
- Currency Wars
- Freely Falling Currencies
- Black Wednesday of 1992: The Day the Pound Sterling Came Under Attack
- Russian Ruble Crisis of 1998
- The Mexican Currency Crisis (Tequila Crisis) of 1994
- The South Sea Bubble
- Tulip Mania of the 17th Century
- Spanish Property Bubble of 2008
- Poseidon Bubble in the Australian Stock Market
- Bernie Madoff Scandal
- The Dot Com Bubble of 2001
- The Harshad Mehta Scam in India (1992)
- The Ketan Parekh Scam
- Savings and Loan Crisis in the United States (1980s)
- The Failure of Long Term Capital Management (LTCM)
- The Albanian Revolution and Pyramid Schemes
- Puerto Rico: The Greece within America
- Israel Economic Crisis: 1983
- The Nordic Crisis of 1992
- The Historic Iceland Crisis of 2009
- The Latvian Crisis: A Short History
- John Law and the Mississippi Bubble
- Brexit after Effects: British Economy Beats Slowdown Fears
- The End of the Dollar Hegemony
- Why Devaluing the Currency is a Bad Idea ?
- What is Causing the Bitcoin Boom?
- The Big Fat Bitcoin Bubble
- Gold vs. Bitcoin
- The Problem with Having Bitcoin Futures
- The Problem with Venezuelan Cryptocurrency
- Traditional Bonds vs. Islamic Bonds Called Sukuk
- How Decisions Made By Central Banks Affect the Stock Market?
- How to Leave the Euro?
- Are We In A Stock Market Bubble?
- Why Does the Stock Market Crash?
- Hard Brexit vs. Soft Brexit
- What is Blockchain, Why is it so Popular, and Benefits and Challenges of Using it
- Cryptocurrencies and Taxation
- Is this the Longest Bull Market in History?
- Investing in Unlisted Companies
- Why Is Short Selling A Dangerous Financial Strategy?
- Development Impact Bonds
- How Credit Enhancement Works?
- How Ultra Long Term Bonds Work?
- How to Identify an Overvalued Market?
- How do Companies Choose which Exchange to List on?
- The FAANG Sell-off
- Why are Investors Getting Spooked by an Inverted Yield Curve?
- Catastrophe Bonds
- The NSE Co-Location Fraud
- The Economics of Blue Bonds
- How the GameStop Saga Proves That Shoe is on the Other Foot for the Investors