Bitcoin’s (Con)Tango

After the successful launch on October 19 of the first U.S. Bitcoin futures ETF — ProShares Bitcoin Strategy ETF, trading as BITO — skepticism grew quickly about the scalability of these products. A reason is the Chicago Mercantile Exchange’s (CME) position limits on Bitcoin futures. Those could become self-imposed when assets under management of Bitcoin futures ETFs swell. Proshares, however, took immediate action to alleviate the concerns about limits. 

Yet, BITO may already have a problem of facing position limits after reaching $1.2 billion in assets, building up 20% of the open interest of October and November Bitcoin futures. The flows into BITO caused volumes to pick up of the two contracts that were quite illiquid. As a result, futures are trading in contango — the near contracts are trading at a discount of 1% to 2% to contracts that mature further out —  indicating that a continued rise of Bitcoin is expected. Based on the current shape of the futures curve, Bitcoin could test the US$70,000 to US$75,000 range. Those levels may prove too conservative as more ETFs are launched that drive up demand for Bitcoin futures.  

Bitcoin futures could experience an extreme form of contango because of the unique features of Bitcoin. Because of the fixed limit of total coins mined and the financing on crypto exchanges, there is what analysts call a natural demand for Bitcoin futures. The funding of Bitcoin positions on crypto exchanges is to ensure that there is not an arbitrage between futures and Bitcoin indices. The exchanges therefore use perpetual futures — a contract with terms settled in hours — to establish an equilibrium between Bitcoin futures and Bitcoin. 

Bitcoin has been more subject to short squeeze — when the shorted investment’s price rises and sellers close their position to avoid a loss — than commodity futures because shorting is an expensive proposition. The funding rates fluctuate wildly because of opacity of the size of long and short positions in Bitcoin on crypto exchanges. Bitcoin futures are playing an increasingly important role to balance Bitcoin positions in perpetual futures. 

Strategist Marko Kolanovic of JP Morgan discussed that the roll cost could become prohibitive for Bitcoin itself.  He estimated the annualized roll cost for BITO could be as high as 9% based on the history of futures prices. What could counter that point of view is that this year compared to recent years, Bitcoin has appreciated in value on much wider investor participation and that has improved its liquidity. The rally of Bitcoin’s price was accompanied by a lower roll cost for futures than, for example, in 2020 and 2019. 

As such, Bitcoin futures have a positive 1.5 percent of implied rate of return which indicates the futures market is trading on expectations of rising Bitcoin prices. 

With a next series of Bitcoin futures ETFs on deck, including one levered at 1.25 times (pending ticker BTFX ), the Bitcoin futures curve is likely to steepen — as in create an extreme contango — as purchase volumes are directed to 2022 maturity futures contracts just as the CME has doubled the position limits. 

Markets understand that a steeper contango is elevating Bitcoin as an alternative asset to gold for inflation hedging, to bonds to diversify equity risk, and even to cash as its liquidity increases because of fast money flows into Bitcoin futures ETFs. The more extreme the contango, the more likely Bitcoin will break records even easier than seen in previous periods of major rallies. Bitcoin futures may soon price Bitcoin at  US$100,000 as futures ETFs totally dominate the price of Bitcoin. For investors seeking out alternatives and ETFs providing easy access to Bitcoin, the futures market can easily reach levels far beyond where Bitcoin is trading. 

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