In the months following Bitcoin’s first regulated future trade, a healthy discourse has emerged around how best to think about the corresponding futures curve. Bulls and bears alike are working to gauge the relationship between the current spot price and the projected spot price implied by a futures contract.
A foundational understanding of the way in which derivative products affect the supply/demand equation will allow a market participant to develop truly accurate abstractions for the price and volatility of this nascent asset class. It will allow a market participant to intelligently predict and speculate on trends, just as it’s done with more mature asset classes.
In order to create abstractions and predict trends using Bitcoin futures, it’s paramount to first understand the many characteristics of Bitcoin’s futures curve.
The core of the curve
At its core, Bitcoin’s futures curve consists of a series of forward prices of varying expiration dates plotted together on one surface. The result is an illustration of where the market believes the Bitcoin price will be at some specific date in the future. The slope of this curve gives us a glimpse into these beliefs. And just like in other commodity markets, these beliefs can manifest in contango or backwardation:
Contango is an upward sloping curve. This occurs when the futures price is above the expected future spot price. Put simply, contango results when people are willing to pay more for the commodity at some point in the future rather than buying it today and incurring the cost of storing it.
Backwardation is a downward sloping curve and happens when the relationship described above is reversed. In other words, when the expected spot price is trading higher than the futures price, backwardation results.
As to be expected, whether the curve is in a state of contango or backwardation is determined by a variety of elements. Some key components include price sentiment, storage costs and insurance costs; along with ‘force majeure’ factors like weather conditions or geopolitical events.
Holding Bitcoin: risk and reward
Not surprisingly, holding Bitcoin poses a risk. The biggest risk, of course, is the risk of being hacked. This perceived risk impacts the curve. Another similar threat includes misplacing private keys, which therefore results in the loss of the asset. Some argue that these risks can be defined as costs of storage.
So when it comes to the futures curve, a risk-averse investor may put a premium on a product that provides Bitcoin exposure yet alleviates this cost. This results in a premium for the futures price. And this is what can create a contango in the futures curve.
Other traders, like miners or larger institutional investors, may look at Bitcoin futures as a hedging mechanism. They have no directional view of where Bitcoin price might be in the short term and aren’t necessarily looking to arbitrage. Rather, they're interested in protecting the downside.
This may make them willing to sell contracts at the current spot price, or even slightly below it, in order to earn downside protection. This dynamic can create what may be perceived as backwardation. As of the end of Q1, the latter dynamic appeared to hold more credence.
How the future looks for the futures curve
In order to even attempt to predict the future, it’s critical to understand the past. In a recent report written by Element Group, the team analyzed the progression of Bitcoin’s futures curve from Bitcoin’s first regulated futures trade in December 2017 through the end of Q1. They found that the Bitcoin futures curve started out in contango but by early 2018, moved into backwardation. The curve has since teetered between being in this state and being effectively flat for most of Q1. The team determines that the downward curve implies that as of March 2018, there was little to no conviction in the Bitcoin futures marketplace.
While it’s too soon to make any large-scale generalizations regarding the Bitcoin futures market, assessing data and analyzing trends and what causes them will pave the way for determining how various factors influence Bitcoin pricing and what “normal” patterns look like for this emerging and volatile sector.
A topic of discussion right now is the shift of institutional investors into cryptocurrencies. An environment where traditional stock market portfolio returns are lackluster may foster an appetite to add risk exposure through unconventional means. The inclusion of an uncorrelated asset class with hyper growth potential could be intriguing for a portfolio manager looking for additional yield without the additional opportunity cost of capital.
However higher rates and the looming threat of a trade war has seen institutional investors rotate firmly out of equities and into fixed income on a large scale this year. Contrary to what some speculate though, economic uncertainty alone won’t cause this shift- the reality is that several structural constraints need to be overcome before the shift occurs. Much of which hinges on improvements in the service provider market as well as continued clarity from regulators on how they view cryptocurrencies as an asset class.
In conclusion, we submit that as we head into the summer, a number of possible tail winds could arise and impact the future of Bitcoin. Conferences will occur, spurring industry announcements that will serve as catalysts for market growth. Protocol main nets and dapps releases are on the horizon. These are all factors that could kick off a secular bull market in the latter half of 2018 that may mirror that of 2017.
Thejas Nalval is the Director of Portfolio at Element Group, a full-service advisory firm for the digital token capital markets.