There have been so many developments in the crypto currency space over recent months its becoming hard to keep track of them all. The potential forks, and fork failures in Bitcoin have been by far the most widely commented on developments. There is another recent development that that I believe holds far more importance to not only Bitcoin, but to all cryptocurrencies. This is the announcement by the Chicago Mercantile Exchange (CME) that they would begin to offer Bitcoin futures in Q4 of 2017. The Chicago Board Options Options Exchange (CBOE), has indicated that it is likely to follow suit. CBOE is the largest derivatives exchange in the world. Whilst receiving a good level of coverage on the mainstream crypto news services, I think the significance of this development has truly been underappreciated by most participants in the Bitcoin space. This article will outline why it’s so important.
Rather than reinvent the wheel and explain what futures trading entails, I will fall back on the work of Professor Jason Potts and his colleague Marie-Anne Cam of RMIT University in Australia which can be found at the following link:
To summarise the most relevant detail from what is an excellent article overall, futures trading is really important to institutional investors.
Institutional investors include banks, insurance companies, pensions, hedge funds, REITs, investment advisors, endowments, and mutual funds. In other words, any large organisation that manages a large pool of money on behalf of a group of clients. This covers everything from the large endowment funds that back US Ivy League Colleges to government backed pension schemes common in many countries such as the UK, Canada and Australia. Despite protests from the likes of Jamie Dimon, many large institutional investors have begun expressing interest in investing in in crypto currency assets. Until now however they have been prevented from doing so by two things. Volatility and liquidity.
Crypto currencies are likely to remain very volatile assets, at least for the foreseeable future. While volatility provides opportunity, it also exposes investors to risk. Institutional investors are by their nature, risk averse. This makes sense if you consider their role. They invest other people’s money, not their own, and they invest for very specific purposes, such as providing retirement incomes for government employees. Loss of capital is not conducive to achieving these aims. I can attest to this from personal experience. I am a professional investment advisor by occupation and I am comfortable taking a lot more risk with my own money than I am with my clients. This is both an ethical position, as I am conscious of the responsibility that my clients place in me when they entrust with their savings, but also a practical one. I’m not likely to sue myself if a take a big bet on bitcoin and it goes wrong. So excessive volatility is a significant obstacle to institutional investors taking a position in any asset.
Until now there has been no way for investors to manage volatility in crypto markets, so institutional investors have stayed away. Bitcoin futures are a game changer in this area. Futures allows investors to manage risk. Let’s examine the implications of that statement for a minute. One of the main obstacles to big intuitions taking a position in bitcoin, is the inability to manage their exposure to risk, and futures contracts are a method of managing risk. In one hit, we have eliminated one of the major obstacles to big investors investing in Bitcoin.
Coincidently and conveniently, futures also increase market liquidity. How they do this is beyond the scope of this post, but they also provide a partial solution to the second problem that big investors face. They don’t comprehensively solve this problem, in the same way they do for risk management, so their role in liquidity enhancement is less significant. That said, it still helps the overall picture.
Why is this so significant? A simple example illustrates the potential well. Please note that what follows is a very simplified calculation that serves to demonstrate the scale of the potential for this development. It is not intended as a prediction or forecast.
To illustrate I will use the example of my own country, Australia. In Australia, the principle retirement savings scheme is known as superannuation, or “Super” for short. The super system comprises all regulated retirement funds, both private and public sector. The total value of savings in the super system is estimated at approximately $1.54 trillion US Dollars (USD). The majority of these funds are managed by large institutional investors. If futures trading in Bitcoin is enabled, this opens the door for these institutions to consider adding Bitcoin to their investment portfolios. If 1 % of the current savings pool in the Australian super system is invested in Bitcoin, this would see an inflow of USD $15.4 billion. That’s approximately 8% of the total market cap of Bitcoin as I write this article. So the introduction of Bitcoin futures couple with a decision to introduce a very small amount of Bitcoin into main stream investment portfolios in one country has the potential to add almost 10% to the total market capitalisation for the coin.
Some important points to note in the above example. The figures used represent only those funds in the retirement savings system in Australia and do not include any other investments outside of this system. Australia is also a relatively small country. Most estimates of the Australian economy place it at about 2% of the global total. The American equivalent of the Australian super system was estimated in 2016 to have total assets of almost USD $22 trillion. If 1% of this asset pool was moved into bitcoin this would mean an influx of funds of USD $220 billion. This is greater than the total market capitalisation of all crypto coins as of today. And we are still only talking retirement savings.
So yes, I think Bitcoin futures are a big deal.
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