Bitcoin futures make their debut on Sunday, and like everything else surrounding cryptocurrencies, they are the subject of fierce debate.
Digital currency mavens are convinced the advent of an exchange-traded product will transform bitcoin, providing a venue for professional traders and institutional investors to enter and legitimize the market. Critics, including some within the futures industry, argue that the contracts are premature and, in a worst-case scenario, present a systemic danger given the underlying volatility of the digital currency market.
Here are a few things investors need to know:
Futures basics
Let’s start with the basics.
Cboe Global Markets Inc. CBOE, +0.87% will launch its bitcoin futures contract, trading with the symbol XBT, at 6 p.m. Eastern on Sunday, while rival CME Group Inc. CME, +0.49% plans to launch its contract on Dec. 18.
A futures contract allows a trader to place a leveraged bet on whether the price of the underlying asset will move higher or lower before the contract expires. A trader who thinks the price will rise can go “long,” while a trader who expects the price to fall can go “short.” In futures, there is a short bet for every long and vice versa.
Bitcoin futures will be cash settled, meaning no bitcoins will actually change hands when a contract expires. Winning traders effectively collect their gains from the losers. As with most contracts, traders will likely have closed out positions, collecting gains or ceding losses, before expiration.
Shorting
The ability to place a short bet without having to first borrow the underlying security is one of the appeals of the futures market. Investors hope it will make for more efficient price discovery, helping to tame the extreme volatility that regularly whipsaws the bitcoin market.
It’s also likely to be welcomed by bitcoin bears, who have been frustrated by the technical difficulty inherent in shorting bitcoin.
Read: Forget missing out on bitcoin mania, and be glad you didn’t short it
That easier shorting ability could put near-term pressure on bitcoin prices, but even cryptocurrency bulls should welcome the development, said Thomas Lee, managing partner of Fundstrat Global Advisors, in a Friday note.
Shorting “creates ‘true price discovery,’ and the ability to short means hedge funds can take bitcoin more seriously. This should actually improve the long-term prospects of bitcoin as it broadens sponsorship,” he said.
Hedging
The success of the contracts may also turn on its appeal as a hedging tool for those focused on the digital mining process that creates new bitcoins. Indeed, the big players in the market, dubbed “bitcoin whales” in this Bloomberg article, may be particularly interested in the ability to hedge against the possibility of a sharp price fall via the futures markets.
And some professional futures traders “are licking their chops for the opportunity to unleash their quantitative trading systems on the bitcoin market,” said Matt Osborne, chief investment officer at Altegris, a La Jolla, Calif.-based provider of alternative investment products with around $3 billion in assets under management.
But that’s going to take time, he said, as they will need price history data on which to build systems.
Premature?
On the downside, it’s hard to ignore the reservations expressed by big banks and brokers, who have criticized the futures launch as premature. In an open letter to the Commodity Futures Trading Commission, the Futures Industry Association said the exchanges didn’t get enough feedback on margin levels and other considerations.
Read: Brokers say bitcoin futures contracts ignore risks
A number of big Wall Street banks were telling customers they won’t offer them access to bitcoin futures when the Cboe contract launches Sunday, The Wall Street Journal reported, citing people familiar with matter. Goldman Sachs Group Inc., the largest U.S. futures broker, will offer access, but only to certain customers, the report said.
Meanwhile, some futures brokers are adding to the already hefty margin requirements imposed by the exchanges in response to bitcoin’s underlying volatility.
Margin
Margin is the amount of money a trader must initially pony up as collateral when taking a futures position. For many heavily traded contracts, the margin amount is under 10% of the total value of the underlying contract. But the CME will require bitcoin traders to put up a 35% margin, while the Cboe is set to require 44% of the daily settlement price.
In the case of Cboe, that means if the contract was trading at $15,000, a trader wishing to go long or short would have to put up $6,600. He would be subject to additional margin calls if the margin account falls below a certain level.
The high margins reflect concerns about the underlying volatility of bitcoin BTCUSD, -10.24% which this week alone saw large price swings, at one point rallying around 40% in less than two days as it soared to new highs.
Price limits
Like most futures contracts, bitcoin futures will be subject to limits on how far prices can move before triggering temporary and permanent halts. In the case of the Cboe contract, trading will be halted for 2 minutes if best bid in the contract closest to expiration moves 10% above or below the previous day’s close.
If, after trade resumes, the contract moves 20% or more above or below the previous day’s settlement, trade will be halted for five minutes.
‘Tiptoe’
Institutional investors and professional traders are likely to “tiptoe” into the futures market, Osborne said. But what about retail investors who might be tempted to dip their toes in?
“Bitcoin is volatile enough as a stand-alone investment. I don’t think the retail investor needs to be adding to leverage through a futures contract on top of bitcoin,” Osborne said. “So buyer be very much beware when it comes to retail investors and futures contracts.”