DECEMBER 7, 2017 By: Izabella Kaminska

Over the last week or so, we’ve recounted the problems with bitcoin’s market structure and how they are likely to impact the upcoming launch of bitcoin futures (here, here and here).

In the course of explaining the structural difficulties, we’ve pointed out how the capacity of market makers and bi-directional traders to support the product is crucial if bitcoin futures are ever to become a success. Currently, this is unlikely to happen because there is no easy way to play both sides of the market without taking on huge amounts of credit, fragmentation, illiquidity and hacker risk on the physical side.

As it stands, CFD and spread-betting houses are the ones mostly attempting to provide this bridging role. Problem is, even they are struggling to process the risk — and that’s despite being much less intensively supervised than the more established players who would usually be interested in servicing futures markets.

Some sort of risk-absorbing entity, as a consequence, must appear if retail and institutional participants (who are used to fiduciary standards) are to step into the market in size.

As a result, there are only three possible scenarios from here on in:

The futures (plagued by illiquidity and non convergence with the underlying) flop.
The lack of a market-maker redistributing one-sided risk back into the market will see the risk transferred elsewhere, most likely into the clearing house (to the risk of the entire trading community).
A less established player with a greater tolerance for risk — possibly a natural long — steps into the fray.
The third option doesn’t necessarily prevent the second option from playing out, however, given such an entity would still have to be serviced by the CME/CBOE clearing systems.

Nevertheless, let’s imagine such an entity exists. What would its game plan be? And why would it think it could handle the risk?

The easy answer to the second question is that it may have spotted an arbitrage it thinks could more than compensate for the risk at hand.

As to the game plan…

If you’re gunning to be the only entity in town prepared to sell bitcoin futures, it would be in your interests to start “pre-hedging” physical bitcoin as soon as possible with a view to locking in a risk-free basis return once the ability to sell futures on a regulated venue becomes possible.

Ideally, the trade would require an average purchasing price that’s much lower than the rate bitcoin futures would eventually be sold at. To maximise this trade, as much value would have to be ploughed into the purchase (or generation) of bitcoin ahead of time, as likely buyside demand for the futures once launched.

In terms of timing, due to bitcoin’s illiquidity, a “pre-hedging” position of this size would no doubt take time to put on. From that perspective it would make sense to start purchases as soon as a futures contract looked even remotely viable. FWIW, according to Factiva, the first serious clue CME was looking into a listing came in November 2016 when it launched a pair of indexes designed to track the virtual currency’s price. The CFTC’s decision in July to allow LedgerX to run a swap execution facility for bitcoin options, meanwhile, was a likely indicator a futures contract could be approved soon as well:

Nevertheless, no matter how strategically planned, pre-hedging of this size is always bound to leave a market footprint. (Especially in a market as illiquid as bitcoin.)

With that, the sort of self-fulfilling feedback loop that usually occurs when someone attempts to corner a market probably comes into motion.

For many, sparking a feedback loop of this kind is often deemed a trading objective in and of itself. Not for a bonafide smart operator. The smart money understands a good trade is as much about executing the “out” as it is about positioning the “in”. You can start a pump, but you can’t always profitably orchestrate the dump.

Hence why the futures component of the trade cannot be under emphasized.

Without the certainty of a properly regulated marketplace defending the futures side of the equation, a payoff cannot be guaranteed. It’s why the arbitrage exists in the first place: the trade cannot be exercised elsewhere in the bitcoin ecosystem because the risk of counterparty default at the first sign of distress is far too great. You’d win the trade, but you’d probably lose the payout.

If a regulated futures market takes that risk away, however, the trade becomes a no-brainer if not a mastermind opportunity.

Which is arguably where we are now.

Indeed — if such an entity does exist — only three possible risks that threaten the trade at this point:

The futures launch is suspended unexpectedly, perhaps due to regulatory concerns or industry pushback?
The anticipated futures demand never arrives because the margin costs of holding open long positions proves to be too great and/or liquidity is so shoddy nobody can trade effectively.
The cash settled return on the futures leg, won’t necessarily be matched by the price achieved on the physical liquidation.

One way or another, we will find out soon.