In a report titled “Why is Bitcoin’s Future Curve So Steep?” JPMorgan Chase analysts examined the futures market and growing derivatives around bitcoin, providing insights on why the contango is so steep and exploring what the future holds for the financial asset as it becomes increasingly financially sound.
Here are some of the highlights of the report.
“As has often been the case in the past, the gradual growth and maturity of cryptocurrency markets has naturally sparked interest in derivatives and other leverage sources. While futures are trading against a range of pairs, it is not surprising that Bitcoin dominates this nascent market. Like the spot market, these products trade within a highly fragmented ecosystem, with nearly 30 active locations. The vast majority is also traded offshore, with less than 15% of total open interest listed in large, regulated domestic locations such as the CME (Exhibit 1). Normal future futures have also kept pace with the deepening of the cash market, suggesting that it is also benefiting from institutional inflows and improved on-the-spot liquidity provision (Exhibit 2). ”
With the launch of bitcoin CME futures contracts in late 2017, institutional investors in the United States began to access bitcoin derivatives exposure, but access to a “bitcoin spot” has been harder to come by, even as bitcoin’s market cap increases by more than 200 percent higher than the 2017 peak.
The analysts offered possible reasons why the contango has remained so large. Possible explanations provided by JPMorgan include counterparty risk and return in offshore markets, complications with obtaining BTC exposure in the legacy system and, subsequently, Grayscale Bitcoin Trust (GBTC) as the main source of BTC exposure on the street (and all of the premium / discount problems that come along with the investment vehicle).
“Why aren’t such attractive prices just arbitrated off? Perhaps someone could blame counterparty risk and return in unconnected offshore markets, but certainly not the CME. In a market with a strong bullish sentiment and heavy retail involvement, it is tempting to simply blame leverage demand. And that’s certainly true to an extent. However, there are also some more idiosyncratic but equally important aspects of how these contracts are designed in the context of Bitcoin-specific market segmentation and which are likely to explain a significant proportion of ‘ r this wealth. ”
An annual product offered through the cash trade and carrying bitcoin. Source.
JPMorgan believes that the introduction of a bitcoin exchange trading fund (ETF) will compress the product offered by the trade, as a liquid investment vehicle trading at net asset value (NAV) will give investors access to a “spot BTC ”is what they need in order to carry out the arbitration trade.
As shown in the chart below, net positions in CME’s bitcoin futures market indicate that hedge funds have continued to increase their short positions to 2021, totaling approximately $ 1.45 billion at the time of writing. Are hedge funds short bitcoin? Absolutely not, they simply carry out the cash and carry trade, and catch the big spread in the process.
CME bitcoin futures net jobs by trader category. Source.
“These basis trades are particularly attractive in the cryptocurrency market. As of this writing, the Bitcoin CME June contract offers ~ 25% annual slide compared to the spot. Future wealth is even more acute if we expand our view to include contactless swaps, where carry can be as high as 40 +% (Exhibit 4). To put this into context, very few fiat currencies, including developed and emerging markets, that offer easily quantifiable local products (eg, from FX swaps) are more than 5% (Exhibit 5). The TRY special case of course, but with local consumer price inflation at around 10% or higher, compared to the specific deflationary monetary policy and Bitcoin cross-border transferability, this hardly seems a credible substitute. ”
It is quite bullish for JPMorgan to compare bitcoin with foreign fiat currency, and not only highlight the huge opportunity offered by the steep futures curve, but also highlight the asset’s sterile monetary policy, transferability and global liquidity throughout the report. The analysts also highlighted the global aspect of bitcoin liquidity and market penetration, showcasing the product offered on the future of CME as well as other offshore markets.
The report also highlighted the introduction of bitcoin ETFs as a key step for future liquidity of assets and trading volumes.
“This means that launching the Bitcoin ETF in the US is, in our view, the key to normalizing the pricing of Bitcoin’s future. As has been widely discussed, it could reduce many barriers to entry, bringing new potential demand to the asset class. A risk factor worth considering, however, is that it would also make basis trading much more efficient and attractive at current prices, especially if those ETFs can be bought on margin. We would expect this to bring more underlying demand to futures markets, particularly the CME but also possibly other onshore exchanges. To the extent that contango normalizes for those contracts, we would expect some transition to pricing on unattached exchanges as well, as there is probably some arbitration activity between the two. ”
In a big, but expected development, the big banks appear to be eyeing the bitcoin market in a significant way. JPMorgan is certainly not the only legacy organization eyeing the advances in the ecosystem, and it’s only a matter of time before it starts to get its own exposure, possibly through the cash and carry trade .
The key question for investors is, what happens if the contango does not normalize as the bitcoin and derivatives market continues to grow exponentially?
What happens when finite financial asset markets and fiat currency are fractionally held with centrally controlled discount rates colliding?
Maybe, just maybe, the true “risk-free rate” is bitcoin …