How Bitcoin Futures Trading Could Burst The Cryptocurrency’s Bubble

A new wave was added to the never-ending Bitcoin mania when the Chicago Board of Exchange (CBOE) became the first major derivative exchange to launch Bitcoin futures on December 10. Such was the euphoria among early investors that trading was halted twice due to CBOE speed breakers, which slow or pause trading when price movements are excessive.

The launch of Bitcoin futures at CBOE is set to be followed by its cross-town rival, the Chicago Mercantile Exchange (CME) Group, which plans to launch its own version of Bitcoin futures trading on December 18. And Nasdaq is preparing for a similar launch in the second-half of 2018.

Bitcoin futures allows traders to speculate on what the Bitcoin price will be at a later date. For instance, at the time of writing this article, the January contract for Bitcoin was trading around US$18,300, up from an opening price of US$15,000. Traders bet on this and profit accordingly.

Such was the excitement at the launch of futures that the Bitcoin price touched an all-time high of US$17,382.64 after one day of CBOE trading. This might sound good for Bitcoin lovers, but it could yet spell doom for the cryptocurrency in the long run.

Trading Frenzy — Trading frenzy. Joseph Sohm / Shutterstock.com

Bitcoin futures could actually end up reducing the price of Bitcoin. Futures trading gives new investors the choice to bet against Bitcoin and also allows them to settle contracts in dollars, boosting their liquidity. Plus, Bitcoin futures allows investors to trade off the cryptocurrency without actually owning it. This protects them from any volatility in the real-time spot market. This could reduce the demand for Bitcoin, pushing down prices.

Futures Lessons

Even though crypto futures are new to the market, futures contract trading dates back to ancient times. In 1750BC in Mesopotamia the Babylonian king, Hammurabi, introduced a legal code, which included stipulations for trading goods at a future date for an agreed-upon price.

A futures contract, in its simplest form, is an agreement to buy or sell an asset at a future date at an agreed-upon price. One party to the contract agrees to buy a given quantity of securities (such as stocks or bonds) or commodities (oil, gold, Bitcoin), and take the delivery on a future date while the other party agrees to deliver the asset.

Futures markets involve hedgers and speculators. Hedgers are concerned with protecting themselves from future price drops. Hedgers will buy or sell their commodity to lock in a price against future risks of it dropping in value. Speculators assume the risk, often borrowing a substantial amount of money to buy contracts that they hope will go up in the future. If the market moves against them, they will lose more than they invested.

Spcies — Futures trading is nearly as old as normal trading. shutterstock.com

One key requirement of futures contracts is that they must be traded on standardised exchanges such as the CBOE or CME. The arrival of Bitcoin futures at an established and well-regulated derivative exchange will encourage more investors to trade in digital currency, giving Bitcoin a place among mainstream finance. Even household names including Goldman Sachs have said they plan to clear Bitcoin futures on behalf of some clients.

This will fuel the cryptocurrency’s price rise, as crypto traders and dealers can hedge their positions based on the future market. For example Bitcoin miners will benefit from futures contracts as they can use them to hedge against their mining cost, getting money in advance from speculators hoping to make a future profit.

On the flip side, the launch of Bitcoin futures will attract greater scrutiny from the regulators which will cast a shadow on the fate of the Bitcoin in the long run. In this regard, the trade association for the futures markets, the Futures Industry Association warned the US regulator that not enough risk evaluation has been done on Bitcoin and the risks it poses to financial stability.

The launch of Bitcoin futures has aggravated other regulators, with scrutiny beginning to encircle the cryptocurrency. Hong Kong’s regulator issued a warning that only licensed firms can offer such products within Hong Kong. In Korea, the Financial Services Commission financial regulator issued a directive that bans securities firms from taking part in Bitcoin futures transactions.

Perhaps more worryingly, the levels of futures trading has not been as high as the initial flurry of excitement may suggest. The volume of trading since bitcoin’s launch on CBOE has been relatively low, especially compared with more established currencies futures.

So, although Bitcoin has the added legitimacy of being traded on futures exchanges, the relatively low levels of interest from big institutional investors is indicative. If history is anything to go by, the tulip bubble burst in February 1637 – not long after the Dutch created a futures market for buying bulbs in 1636 at the peak of tulip mania. The advent of futures trading may well further inflate the “Bitcoin bubble” and push it to its bursting point.

Nafis Alam Associate Professor, University of Reading

This article was originally published in The Conversation. Read the original article