What exactly is a Bitcoin future, and what will they mean for crypto?

17 Jan, 2019 | Updated: 17 Jan, 2019
by Arthur Sillers
Analysis
What exactly is a Bitcoin future, and what will they mean for crypto?

Bakkt, the upcoming Bitcoin futures exchange, is a contender for launching Bitcoin, and by extension cryptocurrency, into a new level of legitimacy as something that can be bought sold and traded by professional investors and traders. More recently, the exchange Coinfloor has put their hat in the futures ring by announcing the upcoming launch of their futures market called CoinFLEX. What is a futures contract, and what is the significance of Bitcoin having a futures market?

The Wall Street Journal has hinted that Bakkt is almost ready for deployment, though rumors have been circulating that in fact another postponement has struck the projects. Bakkt is a crypto endeavor put forth by the Intercontinental Exchange (ICE), the same entity which heads the New York Stock Exchange (NYSE). This fact in itself lends a level of mainstream credence to the crypto exchange, but why exactly is crypto so obsessed for Bakkt's impending release?

How do futures markets work, and what does a futures market mean for cryptocurrency?

Cryptocurrency is at a unique intersection of technology and finance, and there are a lot of people who are interested in crypto because they're a technology buff, they think taxation is theft and hope Bitcoin will topple the IRS, or because they're friend told them they could make a fortune by a little BTC buying in at the beginning- which means all told that a huge swath of people involved in crypto have basically no idea how higher finance works.

In truth, Bitcoin will be most revolutionary for those who understand and have access to the instruments of finance- and one of the most important of these tools is futures trading. Futures markets are a pretty central part of the Wall Street ecosystem, and are in fact one of the most common ways that financial bigwigs use their money to make more money.

Read moreWhat happens to Bitcoin if the stock market crashes?

Futures markets are what most people think of when they picture Wall Street traders in movies, shouting out orders to brokers, holding up pieces of paper while stock tickers print out up-to-the-minute prices. The classic example is a commodity market, where traders buy and sell contracts based on the value of goods, although a more analogous example for cryptocurrency in particular is the Forex market, which is a futures market based on the value of the different currencies of countries around the world.

On a futures market, traders buy and sell futures contracts, called derivates (because their value is 'derived' from the change in underlying value over time) which obligate the seller to provide the buyer some amount of the asset at a particular point in the future (although another common type called ‘options’ represents the option to buy an asset at an agreed upon time in the future).

Read more: Bakkt will buy part of futures commission merchant RCG

A futures contract is basically an arrangement where a trader agrees to buy a certain amount of an asset at a certain price at a specified point in the future. For example if a trader buys a February frozen orange juice concentrate future contract at $100 dollars, they are agreeing to purchase a certain quantity of frozen orange concentrate (say, a barrel) in February. Whatever the market price of frozen orange juice concentrate is in February, the buyer has agreed to purchase one barrel for $100, the price of the futures contract.

Why trade futures?

There are a number of reasons that traders use futures contracts.

Two of the most common reasons are hedging and speculating. Hedging is an attempt to minimize risk. If a grocery chain knows that they will need a certain amount of frozen orange juice concentrate to stock their shelves, they can purchase futures contracts in order to know exactly how much they will be paying in the future, and therefore be able to know more reliably what they will be paying for their inventory, even if suddenly a global orange juice fad makes frozen orange juice concentrate incredibly valuable.

A common type of hedgers are those which produce the underlying asset. An orange farm might buy a certain amount of frozen orange juice concentrate in order to lock in their revenue, in order to make sure that they will remain profitable, even in the event of everyone deciding they no longer like orange juice. The other main type of futures traders are speculators, who essentially gamble on the price of commodities.

Read more: Will Bitcoin replace fiat money?

Speculators are individual investors and portfolio managers who buy and sell futures based on what they think will happen to the price of those commodities. A speculator tries to buy a futures contract at a higher price than the current market value (called the spot price) if they think the price will go up (the long position), and tries to buy a futures contract at a lower price than the spot price if they believe that the value of the asset will go down (called shorting the market, or the short position). Speculators are a necessary part of a functioning futures market, because they allow hedgers to buy and sell contracts, and they are a common way for investment managers to build the money in their portfolios for investors.

Physical delivery versus cash-settlement

Bakkt is actually not the first Bitcoin futures market, it is simply the first Bitcoin futures market that is 'physically settled', that is, involving only the trading of Bitcoin and not settled in cash.

There is an important distinction about the new crop of markets being proposed. There already exist Bitcoin markets whose futures contracts are settled in the equivalent amount of cash. This also is likely a large part of the reason that Bakkt is having trouble launching- the fact that Bitcoin futures will be physically delivered makes it much more challenging to clear the exchange with the SEC. 

Cash settlement is a common feature of futures markets. Many traders aren't interested in physical possession of their assets. For example, even a trader representing a grocery chain has no interest in physically possessing any frozen orange juice concentrate, only in trading on the basis of its rise or fall in value.

Financial actors, for the most part, are divorced almost entirely from production and distribution of products, but this is not the case with Bitcoin, which is relatively easy to transfer and store, being a currency and not a commodity.

Read more: Why hasn't the SEC approved a Bitcoin ETF yet?

Bitcoin and other cryptocurrencies of course, are a different matter altogether, and though they present legal barriers, they are a much simpler thing to physically deliver in principle than material goods- simply needing an infrastructure to transfer the BTC from one wallet to another at the expiry of the contract.

This is yet another reason that Forex is a better model for what a Bitcoin futures market will look life for cryptocurrency, because Forex markets by and large are physically settled (after all, why would you use cash to settle a contract about cash?). This means that physically delivery of Bitcoin futures will likely be much more useful and significant for the cryptocurrency market than the current cash-settled.

What will this mean for crypto?

A futures market for Bitcoin, and other cryptocurrencies in the future, will bring a huge amount of institutional interest into cryptocurrency. Futures traders, and especially Forex traders, will easily be able to use the same software, techniques, and knowledge which they are already using to trade crypto. Not only will this bring a huge influx of capital into crypto, and especially Bitcoin, but it will also dramatically stabilize the market, and most significantly, introduce a huge amount of liquidity- which until now has been a huge barrier for institutional traders.



Because buyers and sellers will be competing with each other for the price of Bitcoin both in the short term and in the long term through futures, it will be easier to cash out Bitcoin at various prices. Liquidity is one of the limiting factors for traders interest in Bitcoin, which is notably difficult to transfer to other forms of capital. For this reason, a Bitcoin futures market will be a huge incentive for institutions and traditional financial traders to get involved with Bitcoin.

Read more: 23rd Richest man in the world shows interest in Bakkt

If you read this entire article, it’s unlikely you have a futures contract portfolio you are hoping to diversify into crypto, but if you have read this entire article, it’s also likely that you may hold some Bitcoin in your wallet. While you may not want to jump headfirst into derivatives and options as soon as Bakkt launches, there is good reason to think that a Bitcoin futures market will pull the price up sharply as institutions pour money into the market through futures trading, pulling up the rest of the crypto market with it.

On the other hand, a futures market for cryptocurrency will certainly bring it more into the purview of regulatory bodies. Expect that as a futures market legitimizes crypto as an asset, the government will become more and more involved.

Read more: 9 Bitcoin price predictions for 2019 by crypto experts

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Read more about: Bitcoin (BTC) Bakkt

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