CME Futures and Dealing With Volatility

Could the tiny amount of un-faked trading volume really control Bitcoin? It’s tough to believe so. Bitcoin as of 2nd April 2019 has a market cap of $87 billion and trusted exchange volume from OMC is almost $2.1 billion. That isn’t even 3% of the total market, so how does that justify the 20% jump in price that happened?

Well, spot markets are not all that efficient for any asset. Genuine price discovery is unlocked via derivatives (futures, options, and swaps). The same can be said for Bitcoin. The real driver of Bitcoin’s price is the futures market. To be precise, it’s the CME Bitcoin Futures.

Futures Products and Their Effects

CME is the ‘Chicago Mercantile Exchange’. It is an American financial institutions that facilitates trading of derivative products. Most of the volume comes from currency and commodity futures. However, in December 2017, CME as well as CBoE (Chicago Board Options Exchange) launched futures and options for Bitcoin. It is widely believed that this is what caused such a rapid burst of the bubble that Bitcoin was in. It can be argued that these futures were simply helping with efficient price discovery. In the midst of a run of exuberance, the CME futures helped bring price down to reasonable levels.

On February 22, 2019, CME Bitcoin futures volume surged past 18,000 contracts, the highest it ever was. At the price at the time, it was roughly $360 million worth of exchanged volume. On February 23, Bitcoin surged 4.3%. On February 24, Bitcoin fell by 9.2%. This was the choppiest (extremely volatile) price action the market saw in months. But this isn’t the only incident.

CME futures for Bitcoin expire on the last Friday of the month. If you look back to Jan 2018, you’ll see the most volatile day of the month is always the day after futures expiration.

The Effects of Futures Volatility

CME futures expiration has not always had a huge effect on the market. In certain months it has, while in others it didn’t have enough volume to significantly move the market. In December, expiration was followed by a price increase of 8.4%. But in most other months, futures volume was insignificant and it didn’t lead to a major market move. The inference from this is that months with high futures volume see volatility on the day of expiration and the day after as well. Months with dismissible volume in CME futures didn’t see much or any volatility after expiration. There’s a clear link here. The CME futures do in fact push price, but we need to see if they have enough volume to push the market in the first place. The issue is that we can’t be sure if the market will go up or down because that is up to the P&L of contracts.
Another aspect of the volatility is the psychological role it plays. Volatility is an exchanges best friend. For a trader, volatility is either a sweet dream or their worst nightmare. One day of volatility can turn a trader into a millionaire; it can also destroy someone with poor risk management. Volatility can turn the most logical trader into a careless, greedy person. Most people lose money in choppy markets. It’s when price action is sustainable yet robust that the best trades occur.

For Bitcoin, most large moves in one direction are followed by a large move in the opposite direction. Cryptocurrency is much more behaviorally driven than traditional asset classes. The fear within various market participants is clearly depicted in the charts. The term ‘FOMO’ may have existed before, but was popularized because of Bitcoin. The manipulation induces fear.

Working Past Volatility and Price

Correlation between CME volume and Bitcoin’s volatility are uncanny. The months in which volume was negligible were the months Bitcoin hardly moved. For any cryptocurrency investor or trader, keeping an eye on CME volume is essential. In fact, as I earlier mentioned, the Bitcoin bubble burst just a month after CME listed Bitcoin futures. Understanding that this volatility is innate is a necessity. Bitcoin isn’t like any other asset we’ve encountered so we cannot use the market frameworks for it.

This is such an easy thing to say but so incredibly difficult to implement. The markets will continue to be volatile for quite some time. It isn’t something that will disappear overnight. In fact, we should ideally be prepared for it to never stop. This is why development of portfolio backed stablecoins like Reserve Protocol are important to the ecosystem. Gold developed its reputation as a store of value after years of proving itself to be one. Bitcoin doesn’t become a store of value just because we want it to be one.
In a society where fiat is no longer dominant, volatility would cease to exist. Rather, Bitcoin may stop being volatile as it becomes the USD (in the sense that everything else will be pegged to it). But more on that later this week.

- AB

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