Bitcoin Futures are Not the Future of Bitcoin

Bitcoin Futures are Not the Future of Bitcoin

Patrick Tan 20/12/2018 5

If you were a rice farmer in Japan before the 17th century, your life was one of constant toil, uncertainty and suffering. Although the costs of rice farming were more or less fixed, seeds, fertilizer, water and manpower, the ultimate price that you’d get at the market was like a game of Pachinko (a Japanese recreational arcade game that is typically used for gambling). During periods of bumper harvests, price of rice would fall and farmers would sometimes be left with less than the cost of their production (there is only so much sushi you can eat) and at other times, during poor harvests, rice prices would soar and farmers would get rich (provided they had survived the previous good harvest).

During the early 17th century, farmers, merchants and traders had decided that enough was enough and formed the world’s first modern, organized, futures exchange in 1710 — the Dojima Rice Exchange in Osaka, Japan, formed for the express purpose to trade rice futures based on standardized contracts, hence the term “futures contract.” In theory, the concept of a standardized rice futures contract was elegant and was meant to provide stability to a key staple of the Japanese diet — rice farmers could lock in the future price of their product, assuring them of a price that they knew they could produce rice at, while speculators or traders could take the opposite end of the contract and profit from any subsequent changes in the price of rice at the time of delivery of these contracts. But what happened in the first half of the 17th century upended these assumptions.

In the first years of the 1730s, poor rice harvests resulted not in rising rice prices, but plummeting ones. And with the Japanese economy still largely dependent on rice as a medium of exchange, Samurai, who received their incomes in rice (one can only imagine how they fished for change), panicked as the value of their bags of rice plummeted against the coinage that was issued. In the midst of the inverse relationship between the rice harvest and the price of rice, speculators and alleged conspirators swooped in to make some serious coin by gaming the rice futures market, stockpiling large stores of rice to manipulate prices, leading to widespread starvation. Far from providing for a stable, accessible and transparent rice market, the early Japanese experience with the futures market was disastrous. What happened over the subsequent decades was a foray into understanding the mechanics of managing a futures market to ensure a minimum price for rice as well as a maximum, government sponsorship, regulation and ultimately organization with strategic stores to ensure that the early missteps of the rice futures market were not repeated.

So What has this all do do with Cryptocurrency?

Some observers have noted that as recently as November 20, Bakkt, brought to you by the same people who run the New York Stock Exchange (NYSE), postponed its December 20 launch of the first fully-regulated Bitcoin futures contract to January 24, 2019. The announcement in cryptocurrency markets already bereft of good news, sent an already embattled Bitcoin price even further downwards, before picking up again. 


Thanksgiving Parade took on a different look this year.

That the markets overreacted is debatable at best — that traders view Bakkt as a silver bullet to solve the malaise in cryptocurrency values on the other hand seems somewhat overly optimistic and if nothing else, will only facilitate further speculation in an allegedly highly manipulated market.

1. Bitcoin is Not Yet a Strategic Asset

As much as I would hope for Bitcoin to one day become a strategic asset in the same vein as rice or even frozen orange juice — it isn’t yet. Whether as a medium of exchange or a store of value, Bitcoin has many years to prove itself. It is barely accepted by merchants, eyed suspiciously by institutional investors and neither has the formal structures or strictures to be considered a major player on the global scene either as a store of value or a medium of exchange.

Unlike rice, we don’t as yet need Bitcoin to survive — it’s far from a strategic asset. Compound that with the fact that there are almost myriad alternatives to Bitcoin. Beyond the thousand-plus other cryptocurrencies available, there are still precious metals, fiat currencies, artwork, property and other collectibles. We may be able to go without Bitcoin, but for the average Japanese person, they can only go without rice for so long.

2. Who’s Buying These Bitcoin Futures Contracts?

And because the cost of Bitcoin mining varies greatly depending on where the Bitcoin is being mined, the block difficulty and the cost of electricity, a global minimum price for Bitcoin on a futures market would drive miners to those locations where the futures price would assure them of a minimum profit — but that also means that by locking in a future Bitcoin price, more miners could get involved at the locations where the mining is profitable, increasing the hash rate and eroding any profits from mining itself. Unlike traditional farming, the response to the supply-side equation of Bitcoin mining is almost instantaneous and Bitcoin hash rates are transparent and can be monitored. Unlike a rice farmer, who can’t uproot his rice farm to another location, Bitcoin miners can, whether physically or through various mining pools. And unlike a farm, a Bitcoin miner can simply switch off their mining equipment, but a farmer can’t be expected to stop farming rice midway through the planting season.

Bitcoin mining also has variable costs, meaning that even if a Bitcoin miner were to purchase a future contract to lock in an above cost of production for mining Bitcoin, given that the cost varies over time, there’s no guarantee that that future price is sufficient to cover cost.

The other major difference is that a rice farmer can’t swap out their crops in the middle of the planting season. A flooded rice padi can’t suddenly be swapped to grow wheat or potatoes — but a Bitcoin miner can. Mining rigs can be reconfigured to mine whatever cryptocurrencies are most profitable at that moment in time based on prices and cost — something which cryptocurrency miners are already doing at this point.

 

Toby wouldn’t clean his room no matter how many times his mother asked him to. Fire insurance premiums at the Smith household went up dramatically.

Far from providing certainty and stability, a Bitcoin futures contract to deliver a set amount of Bitcoin at a future date would undermine the very flexibility that so many commercial cryptocurrency miners already enjoy. Why would a cryptocurrency miner want to commit to a Bitcoin future delivery, when they can switch to another cryptocurrency as and when needed?

So if miners aren’t necessarily the key buyers of Bitcoin futures contracts, who is?

Just like in the early 18th century in Japan — traders and speculators are likely to be the key drivers in a Bitcoin futures market, which will only lead to huge peaks of euphoria, characterized by irrational exuberance and periods of extreme pessimism — much like where the Bitcoin market is today. Far from a harbinger of stability, a fully-regulated Bitcoin futures market will exacerbate much of the extreme volatility that Bitcoin and other cryptocurrencies are already so famous for and undermine its role as a medium of exchange and a store of value. Far from increasing adoption, a Bitcoin futures market would just add to the speculation and alleged manipulation of the already dwindling market capitalization of Bitcoin and its imitators.

3. Bitcoin Futures Have Been Around for Sometime Already

During the dizzying heights of the cryptocurrency craze, both the Chicago Board of Exchange (CBOE) and the Chicago Mercantile Exchange (CME) released their own Bitcoin futures contracts to much fanfare. Traders were expecting tens of thousands of contracts per day, but the market just wasn’t ready for that to happen. With doubtful custody solutions and institutional investors sitting on the sidelines, the volume just didn’t come.

Combined, CBOE and CME traded about 9,000 contracts a day in the third quarter of 2018 and with institutional money still very much on the sidelines, this volume is not likely to go up anytime soon. By way of comparison, CME alone traded 18 million contracts daily in the second quarter of 2018 on products tied to everything from oil and gold to interest rates and the S&P500. Basically if there was something that people would bet on, you can bet that the CME and CBOE would put out a contract on it.

 

Intern got the lunch order wrong again. “I told him specifically to hold the mayo!”

To make matters worse, leverage, which allows traders to control huge amounts of commodities with very little skin in the game does not apply to Bitcoin. Whereas a trader would only need to put up 4% of collateral for a trade on an S&P500 contract, that same trader would have to dish out 10 times the amount or 40% for a Bitcoin trade. That means stashing more than US$4,000 in a clearinghouse for a US$10,000 trade — hardly what one would characterize as an efficient allocation of resources. But given the volatility of Bitcoin, it’s ultimately unsurprising that the CBOE and CME would require those high levels to stomach the counterparty risk involved in trading Bitcoin futures.

And with large institutions making up the bulk of volume in futures markets, their noticeable absence from Bitcoin markets means that volume is likely to remain low for Bitcoin futures. There isn’t really a need for hedging and no major commercial or institutional use for Bitcoin futures other than for speculation. And while the natural client for Bitcoin futures might emerge one day, that day simply hasn’t arrived yet. At least with wheat and rice futures, big farmers and agricultural producers, as well as users of agricultural products have a need for futures contracts to hedge their risk — on top of speculators — but because Bitcoin is hardly a feed stock for other products, it’s difficult at this point at least to see who would need to hedge fluctuation in Bitcoin prices outside of miners — who as mentioned earlier, can simply swap to mine other cryptocurrencies.

Conclusion

The cryptocurrency markets are undeniably depressed right now, but instead of trying to clutch onto straws in the hopes of one more cryptocurrency pump to “cash out,” what the industry ought to be looking for is building out the infrastructure that will lay the foundation for more widespread adoption, ease of access and use cases. Whilst it is far beyond me to decypher (misspelling intentional) what Satoshi Nakamoto’s ultimate vision for Bitcoin was, I would think that its use as a tool for speculation and gambling on a regulated futures exchange is far from his Utopian aim.

To be sure, a Bitcoin futures contract, especially one with the backing of Microsoft (now once again the world’s most valuable company by market cap), Starbucks (because who can code for the blockchain without a Starbucks?) and the NYSE will help to bring a whole new demographic to awareness and interest into a cryptocurrency market already in the doldrums. And while the cryptosphere may need the public attention to renew interest in cryptocurrencies and the blockchain technology which underpins them, cryptocurrencies do not need more speculation — they need more adoption.

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  • Ben Davies

    Market please go down! I want to buy more! I'm not happy the market is going up.

  • Ryan Corbett

    Wait until the sell off last days of December

  • Matt Ellis

    Amazing article !

  • Kady Miller

    I think it's a good news the UK government are talking about crypto tax in a sensible way.

  • Daniel Mandiuc

    Great info, thx !

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Patrick Tan

Crypto Expert

Patrick is an innovative entrepreneur and a lawyer passionate about cryptocurrencies and the business world. He is the CEO of Novum Global Technologies, a cryptocurrency quantitative trading firm. He understands the business concerns of founders and business people helping them to utilise the legal framework to structure their companies to take advantage of emerging technologies such as the blockchain in order to reach greater heights. His passion for travel, marketing and brand building has led him across careers and continents. He read law at the National University of Singapore and graduated with Honors in the Upper Division and joined one of Singapore’s top law firms, Allen & Gledhill where he was called to the Singapore Bar as an Advocate & Solicitor in 2005. He created Purer Skin, a skincare and inner beauty company which melds the traditional wisdom of ancient Asian ingredients such as Bird's Nest with modern technology. In 2010, his partner and himself successfully raised $589,000 from the National Research Foundation of Singapore under the Prime Minister’s Office. He has played a key role in the growth of Purer Skin from 11 retail points in Singapore to over 755 retail points in Singapore and 2 overseas in less than a year. He taught himself graphic design, coding, website design and video editing to create the Purer Skin brand and finished his training at a leading Digital Media Company. 

 

   
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