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Equity valuation focuses on estimating what the likelihood of the company being a successful enterprise in the future is. Now, it is difficult to construct any model which can predict the success of any enterprise. For example, consider the fact that new age companies like Google and Facebook share almost none of the characteristics that […]
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.
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.
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!
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.
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!
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