The latest buzz in the world of Bitcoin has been the launch of Bitcoin futures. Through this financial instrument, individuals and particularly financial institutions are able to “bet” whether the price of Bitcoin will go up or down. Many believe that these futures will lead to a more stable Bitcoin price and will push the digital asset towards mainstream adoption by legitimizing it as a financial asset.
On December 11th, the first Bitcoin futures were officially tradable on the Chicago-based CBOE exchange. After the massive run-up of Bitcoin’s price during the period prior to the launch of these futures, it was expected to strongly correct downwards due to the futures. This was because investors could finally profit from a declining Bitcoin value.
This conviction did cause an approximate 20% drop in Bitcoin’s price. However, as soon as the futures launched, it turned out that most future traders speculated on an increase in Bitcoin’s price. This was seen as a very positive sign, and Bitcoin continued to push upwards.
What Are Futures?
A futures contract is an agreement to sell or buy an asset at a specific time in the future for the current price. This asset can be a variety of things, such as gold, currency, stocks, and now Bitcoin. In the contract, the current price of the asset and the period of time until the asset is sold and bought is fixed.
Taking Bitcoin as an example, this is how a future contract for the digital currency works. Say you expect the price of Bitcoin to go down significantly within the next 4 weeks. It would be quite profitable to sell your Bitcoin at its current price if it were actually to go down 50% in the next 4 weeks. This is exactly what a future contract does, as you agree with a second party to sell your Bitcoin at the current price in 4 weeks. The second party expects the price to go up over this period, so for them buying Bitcoin in a month’s time at its current price would be a steal.
These contracts are traded through a futures exchange, a system which was introduced by the Chicago Mercantile Exchange, the company which will start with offering Bitcoin futures on the 17th of December. With future contracts, exchanges are necessary to make sure both parties fulfill their contractual obligations. You can imagine that the losing party can be quite reluctant to fulfill their end of the contract. It’s quite painful to have to sell your Bitcoin for half of its current price, which is the risk of future contracts.
Why Use Futures?
Generally there are two reasons for engaging in future contracts: risk management and speculation.
Bitcoin’s price has been highly volatile, and it’s unlikely that it will calm down anytime soon. A trader’s dream, but for merchants this fluctuation has been a reason not to engage, and it stops them from accepting Bitcoin for payments. By using futures, such parties can protect themselves against these price risks. The total Bitcoin value of an agreement can be fixed in a future contract, which guarantees a specific price.
For speculators, futures are an exciting financial instrument to potentially make profits by predicting the market. If you make the right call, you can buy Bitcoin for a much cheaper price than what the market offers, or sell Bitcoin at way above the market price.
Moreover, futures have made it possible to make money on the falling price of Bitcoin by shorting it. Before the futures, you could sell if you saw a market crash coming and buy back in once a decent support appeared. This means that you can save your money from losing value by turning it back into fiat. However, it’s not possible to increase its value, which is made possible by futures.
The Future(s) of Crypto
Because futures offer a way to reduce the risks of falling prices, the introduction of future contracts is expected to bring in large financial players who have thus far been sitting on the sidelines. Institutional money simply can’t engage in investments that are this risky without any means to mitigate these risks. However, once these large institutions enter the market, they will open the Bitcoin and crypto market up to their entire clientele. At last, Bitcoin is going mainstream.
The futures are just the beginning of financial derivatives available for Bitcoin. Options, swaps, and many other financial products will likely be introduced in relation to Bitcoin in the near future. Like the futures, these trade options will attract new pools of money, which will have a positive effect on the price of Bitcoin in the long run.
But why wouldn’t these products extend to other cryptocurrencies? Cryptos such as Ethereum and Litecoin are rapidly moving to market valuations that are hard to ignore. And because risk can’t be mitigated due to the absence of derivatives such as futures, the eager but limited institutional money is not able to trade these coins.
Once the larger financial firms of the world enter the crypto space while still being able to manage the risk associated, we will see a massive increase in the total value of the crypto market. The entrance of such parties will generate a lot of public attention towards cryptocurrencies and legitimize their existence.
Even though Bitcoin and most cryptocurrencies are a means to escape the power of institutional money and Wall Street, it seems like we need them for mainstream adoption and acceptance. The introduction of futures has been the first step in this process, and we’re going to see a lot more developments in this regard.