What are bitcoin futures?

A futures contract is an agreement to buy or sell an asset at a set price on a future date. Once the contract is entered into, both parties are obliged to fulfil its terms regardless of the market price at the time of expiry.

With futures one can open long and short positions. In the former a trader agrees to buy the asset at a specified future price; in the latter the trader agrees to sell the underlying on the contract’s expiration date.

These derivatives are used mainly to earn speculative profits. With futures, traders can go long or short and use leverage. The latter promises higher returns, but also greater risk.

Originally, however, futures were devised to hedge price risk. Thus, they can also be used to reduce the impact of adverse price moves in various assets.

For example, the main risk for bitcoin miners is a fall in the coin’s price to a level that makes mining unprofitable, when electricity costs exceed revenue from mined coins. To protect the business, a miner can sell futures on the number of bitcoins they hold. If the price drops sharply, gains on the futures short can offset losses on the underlying asset.

Futures come in two varieties: deliverable and cash-settled. In the former, on the expiry date the buyer must buy and the seller must deliver the underlying asset in the quantity specified in the contract’s specifications.

Deliverable futures include, for instance, contracts on oil or wheat. Yet even there, in the overwhelming majority of cases trades are closed without physical delivery, i.e., they are purely speculative. Transactions with deliverable futures are also often hedges aimed at minimising price risk. As a result, most deliverable futures are closed before expiry.

Cash-settled futures do not envisage delivery of the underlying, but only a cash settlement for the difference between the contract price and the asset’s price on the execution date. Such instruments are likewise used mainly for speculation and for hedging price risk.

Futures can be written on a wide range of assets—securities, stock indices, commodities and cryptocurrencies. In general, bitcoin futures are much like other contracts: they allow bets on future rises or falls in price.

Notably, one can trade BTC futures without owning the cryptocurrency itself, merely speculating on its price. That is how trading works on such well-known exchanges as CME and CBOE, which are geared mainly towards large investors.

However, on the Bakkt trading platform, which is being readied for launch, there will be futures that provide for delivery of physical bitcoin after expiry.

It is an exchange-approved document that sets out all the terms of a futures contract, including:

• the contract name;
• its short name or ticker (eg XBT on CBOE or BTC on CME);
  a description;
• contract size (for example, 1 BTC on CBOE and 5 BTC on CME);
• type (deliverable or cash-settled);
• minimum tick size (on CBOE, five points, which in USD/XBT equals $5);
• delivery date and the contract’s trading period, and so on.

It is when a contract stops trading on the exchange. On the expiry date, obligations under the futures are settled—either by exchanging the price difference (variation margin) or by delivering the underlying asset.

The expiry date is set out in the contract’s specifications.

Initial (or deposit) margin is a refundable performance bond charged by the exchange when opening a futures position. In other words, it is the sum required to open a position. It typically amounts to 2–10% of the underlying asset’s current market value.

For bitcoin futures, however, given frequent bouts of high volatility, initial margin is much higher than for traditional financial instruments. On CME and CBOE it exceeds 40%.

Initial margin is collected from both sellers and buyers and is designed to protect the broker from the risk of default.

Maintenance margin is the minimum equity required in the account to keep a position open and avoid a margin call (forced closure of a position by a broker, which locks in the trader’s loss and sharply reduces the balance).

Access to CME and CBOE is provided by brokers (for example, TD Ameritrade and Interactive Brokers). These firms can set their own margin requirements, which may exceed the exchange’s. For instance, the US broker E-Trade set margin requirements for bitcoin futures at 80%.

There is also variation margin. This is the sum of money representing profit or loss from open or closed contracts. The final variation margin is calculated at the end of the trading session.

Before expiry the prices of a futures contract and the underlying asset usually differ. As the execution date approaches, the gap narrows.

Suppose the futures price is above the spot price before execution. This is called contango (from English “Contango”, literally “premium to price”). In this case market participants are confident the asset’s price will rise in future. Contango may occur, for example, ahead of a halving of the block reward, before a possible approval of a bitcoin ETF, or the launch of the Bakkt platform.

If the futures price is below the market value of the asset, that is backwardation (from English “Backwardation” — “lagging”). It means bearish sentiment prevails.

In addition to the tightly regulated US venues CME and CBOE, bitcoin futures are also available on platforms such as BitMEX, OKEx, Crypto Facilities and others.

Such exchanges typically have much looser KYC procedures and AML policies. They also have a far lower bar to entry, making them accessible to more than just large investors. These venues also offer higher leverage (on Crypto Facilities, for example, 50x is available).

Many experts are convinced that the emergence of bitcoin futures on traditional markets promotes mainstream acceptance and popularisation of cryptocurrencies, as mainstream investors will view them less sceptically. That, in turn, could stimulate demand and support price and market capitalisation in the long run.

The appearance of traditional financial instruments based on bitcoin effectively signifies its recognition by regulators as an investable asset. The fact that bitcoin futures are gaining traction on the world’s largest and tightly regulated US market may set an example for financial institutions in other countries. In jurisdictions where trading cryptocurrencies is banned, futures also allow speculation on the prices of the underlying digital assets.

On the other hand, large market participants have gained the ability to open short positions, big volumes of which can put pressure on bitcoin’s price. However, CME executive Tim McCourt believes that futures do not affect bitcoin’s price, since BTC contracts still account for only a small share of the market. The famed trader Peter Brandt, who is convinced that one should not underestimate the influence of the vast number of small bitcoin investors, concurs.

At the same time, deliverable futures on Bakkt may serve as an additional source of demand for bitcoin. Moreover, as this market develops, the likelihood that the SEC will finally approve exchange-traded funds (ETFs) tied to bitcoin futures increases.

There is also a view that bitcoin futures help reduce the volatility of its price.

Either way, integrating the crypto market with traditional finance could foster mass adoption of new assets—and, with it, their long-term growth.