CME Long versus Short Positions
In every futures contract, there’s a long and a short position and an underlying asset (in this case bitcoin). The long position is taken by the trader who wishes to profit from an increase in the price of the underlying, and the short position is taken by the trader who wishes to profit from a decrease in the price of the underlying. The price of bitcoin is determined by the CME CF Bitcoin Reference Rate (BRR), a price index composed from Kraken, Itbit, GDAX, and Bitstamp.
It is very unusual for two traders to show up at the exchange at the exact same time for a trade. Instead, the counterparty in the futures contract is almost always a market maker who hedges themselves by buying or shorting the underlying in order to earn the spread of the trade. Thus, we have two scenarios:
- Trader long, market maker short
- Trader short, market maker long
Trader long, market maker short
Long: Bitcoin has a virtually uncapped upside, but a limited downside. Investors who want exposure to bitcoin can go long on the CME futures, and those who do not seek this exposure can simply avoid it. Thus, trader interest in the CME futures will mainly come from longs.
Short: For the market maker, shorting futures and buying bitcoin on the spot market is straight-forward — there are regulated bitcoin exchanges in the U.S. such as Gemini and GDAX where bitcoin can be purchased. When the price of bitcoin is higher on futures than on spot (a market situation called contango), it creates a profit opportunity for the market maker. However, the CME futures may be a bit too clunky for this maneuver to be executed effectively as the contract size is 5 XBT and the minimum price tick is $25, which limits the precision and granularity of such hedging activities. A larger obstacle is the hefty 35% margin requirement, which is totally reasonable considering the peril an asset as volatile as bitcoin poses to the clearing house. Nevertheless, it makes it very expensive for market makers to engage in this activity.
Trader short, market maker long
Short: The natural candidate for shorting the CME futures are industrial bitcoin miners such as Bitmain. The short position will allow miners to effectively sell their future bitcoins beforehand, which can be very useful for improving the cash-flow efficiencies of their mining operations. Miners do not take large risks by shorting bitcoin as they are hedged from the bitcoins they will mine, which they usually can estimate with some precision.
Other potential shorters are event-driven hedge funds who may try to outperform pure holding strategies by entering strategic short positions when they believe the market is overbought. Selling bitcoins on the spot market is usually not a viable alternative in these cases. Hedge funds are often restricted to storing their majority bitcoins in cold-storage multi-signature addresses, where bitcoins can only be moved in accordance with certain protocols designed in order to limit the chance of robbery or insider theft. At least during CME’s opening hours, shorting through the CME will be a quicker means of decreasing one’s exposure to the bitcoin price than selling.
However, since the CME does not currently accept bitcoin as collateral for margining, shorters will need to put up 35% of their short position in USD in order to be able to enter such a trade which severely limits its practicality in many cases. Shorting will therefore mostly come from traders with broader portfolios who can allocate the necessary margin from some other position temporarily, i.e. funds that trade in more assets than just bitcoin. However, those traders are less likely to be interested in shorting bitcoin in the first place as they aren’t competing against holding strategies the way that actively managed cryptocurrency hedge funds are.
There is also the possibility that the futures market will be used to manipulate the price of bitcoin. The theory is that governments and banks, concerned by the disruptive force bitcoin brings to their regime, accumulates bitcoin on the spot market over long periods of time and enters large leveraged short positions before they dump the coins on the spot market. This way, manipulators could potentially profit a great deal while simultaneously harming the market and bitcoin’s utility through volatility.
Long: There is currently no suitable venue for shorting bitcoin on the spot market. Market makers who want to enter long positions on the futures market thus have no good way of hedging. However, there is a very interesting opportunity for another group of market participants here; the bitcoin holders. Since there will be a shortage of market makers for longs, this role could instead be by served by players with large amounts of bitcoin that up until now have only been holding them in cold storage.
When the price is lower on futures than on spot (a market situation called backwardation), bitcoin holders can sell their bitcoins on the spot market and long the futures. This will give bitcoin holders a chance to earn a yield on their cold-storage bitcoins that wasn’t possible before, which actually improves the utility of bitcoin as an asset for investors. However, the same issues regarding margin requirements, contract and tick sizes apply to this group as the market maker short group above.
Comparing these groups
Traders entering long positions are likely to be investors who seek to gain exposure to bitcoin. I think we can assume that this is a substantial group. On the other side, we’ve got hedge funds looking to decrease their exposure temporarily, miners and potentially manipulators. Since there is currently no way of knowing if manipulation will take place, it is not useful to try to account for it in this comparison. As such, I believe that the market pressure on the CME futures will largely come from the long side.
On the market making side, it appears to be more practical to short than to long. This will serve to decrease volatility upwards, but increase volatility downwards relative to each other. However, market makers do not steer the market, they only provide liquidity and are therefore less interesting for this analysis. They do however tether the futures market to the spot market, which is why the CME bitcoin futures will be very important to the price of bitcoin.