The first US-based Bitcoin ETF (exchange traded fund) was launched last week. Well, sort of.
Amid the fanfare and talk of bringing Bitcoin mainstream, a lot of commentators appeared to miss a crucial point – that the newly launched ProShares Bitcoin Strategy ETF ($BITO) was futures-based, and not based on the price of Bitcoin itself.
In this article, we’ll outline what futures are, what purpose they serve and how they work. We’ll then dive a little into the so-called “Contango” trade and how this all relates to Bitcoin.
What are futures contracts in the context of financial markets? Simply put, they are agreements traded on an exchange between two parties to buy or sell a specific quantity of a specific asset or commodity (such as corn, shares, gold or Bitcoin) at a stipulated price on a specific date in the future, known as the delivery/expiry date. Investors in future contracts can usually hold until the expiry date or trade them in the interim on an exchange.
A clearing house acts as an intermediary to mitigate any counter-party risk by guaranteeing the performance of the contract. This requires that both the seller and the buyer deposit with the clearing house an “initial margin”, usually around 10% of the contract price.
A “maintenance margin” linked to the value of the contract is also set whereby parties will be called upon to deposit additional funds if the value of the contract drops to a specific level. This is because future contracts are marked to market on a daily basis, and gains and losses are posted and realised on a daily basis to the margin accounts of each party in the futures contract.
On a high-level, future contracts are used for both hedging and speculative purposes and normally settled by physical delivery of the underlying asset, although sometimes it is done by cash adjustment.
Originally, futures were designed to enable farmers to reduce price risk by selling future crops at a fixed price at a stipulated date in the future. For example, imagine you’re a farmer who expects to produce 10 units of corn in 6 months’ time. Today, the price per unit is $10 and you’re worried that external factors may drive it down to $5. To eliminate that risk, you enter into a futures contract agreeing to sell 10 units of corn for $10. In 6 months’ time, if the price of corn per unit is trading at $13, you would have made a loss on your contract of $3 per unit of corn. Alternatively, if the price had fallen to $5, you would have made a profit of $5 per unit of corn on your contract. By agreeing to a fixed price in the future, you won’t enjoy the benefit of any growth in the price per unit of corn, but you won’t also suffer the losses if its price declines.
What then is a futures-based ETF?
Unlike traditional ETFs which typically track the price of an underlying asset, a futures-based ETF tracks the price of underlying futures contracts.
Using Bitcoin as an example, the Bitcoin ETFs approved thus far provide exposure to Bitcoin through CME (Chicago Mercantile Exchange) listed futures which are cash settled and designed to track the CME Bitcoin Reference Rate (BRR).
The BRR is an aggregated price index of the average of trade executions across several spot Bitcoin exchanges.
Unlike say a WTI oil futures contract where crude oil is physically exchanged on the expiration date, cash settled futures don’t exchange any physical assets.
In the case of Bitcoin futures, these are settled in cash in the sense that no on-chain Bitcoin transfers take place. Instead, the buyer will pay the seller the fiat equivalent based on the BRR.
This brings us to Contango, which refers to the phenomenon whereby the futures price of a commodity trades higher than the spot price.
The premium above the current spot price for a particular expiration date is usually associated with the cost of carry, although in the context of Bitcoin, it is due to market expectations of continued bullish action.
Bitcoin futures contracts have 6-month expiries and have been in Contango for some time now.
Generally, as a futures contract draws closer towards its expiration date, the closer the convergence between the spot and futures price.
Let’s go back now to Bitcoin ETFs – in the case of Proshares ETF ($BITO), the prospectus stated that the fund “seeks to invest in cash-settled front-month Bitcoin futures”.
Currently, the front month is the October contract which last settled around $62,075.
On around the 29th of October, the fund will “roll” its exposure from the October contract into the November contract. Assuming zero change in the spot price (BRR), this “roll” will negatively affect returns as it requires selling October for $62,100 and buying November at $62,600.
So as long there is a Contango you have what is known as the “Contango Bleed”.
The estimated cost of the Bitcoin Contango Bleed is difficult to quantify at this early stage of the ETF’s life.
Some suggest that the futures-based ETF could underperform spot by 8.5% while others have said it could be as high as 17%!
Either way, a futures-based ETF is best conceived as a trading vehicle.
Even if there was a spot Bitcoin ETF, Bitcoiners would still say that it makes far more sense to buy and hold Bitcoin yourself – “not your keys, not your coins”.