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What the buyers of Bitcoin futures seem to have missed

  • Risk

I have made no secret of my general disinterest in cryptocurrencies. At best, they seem to serve as a surrogate arbitrage between electricity rates across distance insofar as they are “mined” using a fairly linear power consumption calculation. That said, the focus of this article is about why the CBOE Bitcoin futures contract has effectively ruined Bitcoin and underscored the fundamental lack of understanding of both cryptocurrencies and futures contracts.

The Value of Bitcoin

The value of Bitcoins are best described as being derived based upon the scarcity of Bitcoins insofar as they are created through mining (like Gold) at a self-stabilizing rate using the computational power of computers to solve specific math problems, which become more complex (and thus require more power) the more Bitcoins are mined. Moreover, and potentially more significantly, Bitcoins value are said to be derived based upon the fact that there can only ever be 21 Million (less 3 bitcoin cents) mined and thus there is a scarcity factor that creates value – like a currency that is not subject to a central monetary authority printing additional fiat.

The Structure of the Commodity Contract

The XBT-Cboe or the USD denominated Bitcoin futures contract is a futures contract that was created by the Chicago Board Options Exchange (CBOE) for the purpose allowing speculation and hedging on the future price of a Bitcoin at certain dates in the future. The CBOE are the wonderful people who brought us the ability to trade futures contracts on things like the S&P 500 and the VIX (the volatility index). Futures and to some degree options have been around since time immemorial as they allow asset holders to hedge their risk of a future price change and create an opportunity for speculators to take the other side of a hedge and earn substantially move (via leverage) than of they bought or sold the asset itself.

The problem with the XBT-Cboe Structure

The Bitcoin futures contract has one major and fatal flaw: it is a cash settled contract. This may not seem like a problem given that the CBOE options are generally cash settled. The value of the index is derived from the Gemini (a Bitcoin exchange company owned by the Winklevoss Twins) reported auction price in USD.  By being cash settled, this means that the contracts can be created with cash (as opposed to having to actually deliver a Bitcoin) which means that you can trade them without the hassle of ever having to go find one.

Without the risk of having to locate a Bitcoin, it would be almost impossible to short squeeze a Bitcoin futures contract as you can keep shorting it (with more and more cash) until the market gets tired soaking up the supply of additional (synthetic) Bitcoins created by shorting the Bitcoin futures contract.

Shorting a Bitcoin future basically creates more Bitcoins

Yes. Every time you short a contract, you are borrowing the contract from someone and selling it. When you close out of the position, you have to settle out the contract; which traditionally meant delivering one of the thing you previously sold. Without the requirement of ever having to go find a Bitcoin, market participants can continue to create additional Bitcoins through short contracts without ever having to decrease the supply by delivering them. As such, every short side of a Bitcoin futures contract takes away a would-be buyer of an actual Bitcoin because they own a futures contract tied to a Bitcoin and therefore do not need to duplicate their position with a Bitcoin.

How Bitcoins are different from Gold, S&P contracts and US Dollars

A Bitcoin enthusiast might see this and think that such an argument would equally apply to futures contracts in Gold or the S&P or the trading of any currency such as the US Dollar. The problem is that for all of these Futures contracts there are fundamentally extrinsic reasons why investors purchase them.

For example, Gold is used in things such as jewelry and electronics and therefore if the price of Gold were to get too cheap, given that Gold futures require physical delivery of the Gold, end users of Gold would continue to purchase them until the price returned to its otherwise equilibrium price as they are consuming Gold (by using it and taking it out of circulation in the markets). There is a finite amount of Gold and so the creation of synthetic speculation in Gold will incent the users of Gold to buy up any irrationally excess inventory, which will force the short-sellers to ultimately have to deliver the Gold in the contracts, thus necessitating that they buy actual Gold to cover their positions – bringing everything full circle.

S&P contracts are cash settled because they can be constructed and deconstructed from the actual basket of 500 companies for which there are extrinsic buyers (those interested in the shares of the underlying companies).

If the price of the S&P futures contracts were to drive imbalanced short interest versus the actual value of the underlying shares of the companies, equity investors would simply take the other side of the contract and at settlement receive the equivalent price of the companies as their rate is established based upon the individual share prices, which themselves are derived by assets and profits.

Bitcoin will never have the delivery problem because the nature of a Bitcoin itself is synthetic. The owner of a Futures contract (created through a short seller betting against the future price of Bitcoin) derives the same utility from owning the Futures contract as they do from owning the actual Bitcoin itself.

The reason for this is that there is nothing you can really do with a Bitcoin in and of itself. You cannot eat it, use it in jewelry, burn it for energy, deconstruct it into a basket of other assets, or in any way benefit from it as a method of exchange.

Finally, fans of Bitcoin resort to the argument that Bitcoin is not really like a commodity or an index of equities it is more like a currency as a means of stored value like the US Dollar or the Euro. Again the problem here is that currencies are created by governments which are also known as taxing authorities. Taxes have the interesting effect of creating a level of extrinsic demand in the currencies insofar as the citizens subject to taxation are required to deliver (think physical settlement) the currency to the government, which is the issuer of the currency, thus effectively removing it from market circulation.

The penalty for failure to deliver here is frequently jail. As Bitcoin is not the creation of a taxing authority who can compel its citizens to physically deliver (which would create a short squeeze) there is a structural and unbalanced short bias against the Bitcoin future.

What kind of asset is a Bitcoin?

Bitcoins, if not commodities, indexes or currencies is actually much more like a Baseball card. Baseball cards have their value in excess of the cost of printing by virtue of the fact that there are people who want to own them and have some form of attachment to them (see “think they are cool”) and others who based upon historic trends buy them on the blind assumption that they will be worth more in the future because they have gone up so much in the past (see “irrational stupid investors).

Take the case of a Mickey Mantle baseball card. Mickey Mantle was a top notch baseball player who was (and still is) beloved by countless baseball fans. There are people who buy Mickey Mantle baseball cards on the basis of their love for Mickey Mantle and their belief that more people in the future will love him even more. Right now, a quick search on eBay shows Mickey Mantle baseball cards selling for about $250.

Except in this universe of Bitcoin, when you buy it on eBay you never actually get mailed the card. You are told the card exists in a safety deposit box somewhere and you are never allowed to visit it. You receive a picture of Mickey Mantle that you can tell all of your friends about and get a certificate saying that you’re entitled to one Mickey Mantle baseball card provided that you agree to never take it out of the safety deposit box and never go visit it.

You are free to resell it in the future but since nobody can ever go visit it there are an infinite number of other sellers on eBay who are selling the right to borrow their certificate to claim that you own one of these super cool baseball cards at some point in the future. Since the right to borrow the certificate looks and feels identical to the actual right to claim you own one of the certificates, many would-be buyers are just buying those and thus more futures contracts continue to be created and suck buyers out of a finite pool of people who love Mickey Mantle.

When the craze of Mickey Mantle buyers has its run because people all the sudden decide that actually Lou Gehrig is much cooler to be a fan of (true story I actually own a Lou Gehrig baseball card because the man was a legend), then all of the speculators rush to get their money out of the Mickey Mantle cards crushing the price of both the actual certificates and the right to get the certificates in the future (from short sellers repurchasing those rights and locking in their profit).

Mortimer, We’re Back.

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