Bitcoin: To infinity or to reality?

It is hard to be in the business of futures execution and resist commenting on the Bitcoin phenomenon, so we wanted to share some thoughts on the recent introduction of Bitcoin futures on the CBOE and CME.

As a leading provider of agency execution algorithms for Futures instruments, QB can provide execution in just about any sufficiently liquid market. We service our clients in everything from Australian Dollar to WTI futures. In all these markets they are a 1 delta listed derivatives contract on something tangible. The intangible nature of an asset that is a digital, cryptocurrency is hard to get one’s head around. Bitcoin has been compared to gold, it’s just that it’s gold without the yellow metal – a value storage and transportation mechanism, unregulated and without government backing. And for most people, an exchange and wallet provider is needed to convert between Bitcoin and real, fiat currency which adds it own set of risks and complexity. The basis risk also appears to be considerable as it is not clear to us how arbitrage can efficiently and effectively work between the futures and the underlying as is typical in other futures markets. Conversion costs are high, fraud/theft risks in digital wallets are significant, and the lending market of the underlying Bitcoin doesn’t appear to be of institutional scale. We can’t even refer to the underlying as Bitcoin “cash” as “Bitcoin cash” is the name for a rival Bitcoin (a Bitcoin “hard fork” created in August 2017) and not the underlying asset for the CBOE and CME futures. Perhaps we should just refer to it as “Bitcoin spot”.

There is clearly a lot of hype about the new CBOE and CME futures driven by media sensation and the ever growing popularity of Bitcoin spot. We will provide our services on Bitcoin futures when institutional demand materializes. So far we haven’t seen much interest from the buy-side and believe the small volume is primarily driven by retail. The current dynamics of this market also present significant challenges for any provider of algorithms: 1) Forecasting volumes, volatility and quote sizes – virtually impossible to do in a reliable fashion, 2) Extreme volatility* – rapid price moves are hard for an execution algorithm to adapt to or attempt to get ahead of, 3) Trading halts – interruptions which are hard to plan for, 4) wide bid/offer spreads. Whether these two new futures instruments will mature into smooth, liquid, continuous trading like other well established futures markets remains to be seen. But we welcome the growing interest we are hearing from the professional trading community whose participation is a key ingredient in maturing a market and establishing its purpose.

* The 11,159 to 15,795 range that we’ve seen while writing this only underscores this.

The closest similarity to Bitcoin in QB’s existing product universe is VIX futures. When you think about it, this does make some sense. VIX is an index which is calculated from the implied volatility of a basket of S&P 500 index options. VIX futures are essentially a derivative of a volatility indication from prices of a basket of listed derivatives. It is not feasible to trade an exact underlying but market exposure to the phenomena tracked by VIX is enormous.  As a result, the VIX index is closely followed and the VIX futures are very actively traded. So this comparison does at least give some perspective to the Bitcoin non-believers that intangibility itself is not necessarily an obstacle to this being a functioning market. What is probably a greater risk to the success of these futures is that futures markets function so well, perhaps too well to be related to an underlying asset that still has a lot to prove. The basis trade may be too challenging which could lead to a detachment between the future and the underlying. There is also the potential for market manipulation, especially around the settlement price which is calculated using an auction price of Bitcoin spot as determined by 1 exchange (Gemini – CBOE) or several exchanges (Crypto Facilities Ltd – CME).

We do not know if bitcoin will ever be relevant to our buy-side institutional clients, but if they, or more likely the members of the professional trading community from whom we have been hearing, demand algorithmic execution, QB will be ready to help reduce implicit trading costs. Until then we have plenty to offer our clients in all the other, more tangible markets we cover.

We wish you very happy holidays and all the best for 2018.

Quantitative Brokers
New York
December 22, 2017