How Cryptocurrency Futures are Impacting the Global Financial Ecosystem

There are many reasons to be excited about recent trends in cryptocurrency — from user uptake, to banking integration, even increased regulation. Currently, Coinbase, the most popular global exchange and wallet provider, is available in 32 countries and has over 13 million users, implying a global population of at least 20 million cryptocurrency users worldwide, up from fewer than 1 million users in 2016.

Financial institutions, many early critics of cryptocurrency, are now adding crypto-trading capabilities, making significant venture investments in the technology and rolling out cryptoproducts including micro-loans and asset tokenization. The level of integration between crypto and fiat is increasing with banks offering crypto-debit cards and facilitating crypto-fiat money transfers. Investment banks and brokerages are increasingly seeking ways to capitalize on growing consumer demand for this rapidly evolving new asset class.

Even regulatory authorities are now moving beyond alarm about cryptocurrency towards assimilation with a more nuanced, accommodating perspective that takes the highly variable nature of digital assets into account. Specifically, regulators are taking steps to establish a clear separation between tokens that provide a specific platform utility and those that function as securities. Beyond, securities laws, regulators are tackling price manipulation, money laundering and taxes — complex issues that have plagued issuers of all forms of currency for centuries.

These evolutions represent progress, maturity, the sort of foundational elements that imply cryptocurrency is here for the long-haul. But, perhaps the most positive development in the category this year has been the introduction of futures markets.

To almost everyone other than cryptographers and computer scientists, Bitcoin remained a novelty from its inception in 2009 until early 2017 when growing curiosity about the benchmark cryptocurrency evolved into full-on speculative mania as the BTC price cleared $1,000.

In the second half of 2017, on the back of increased press attention, the price of Bitcoin climbed dramatically to nearly $20,000, followed by a rapid decline starting in mid-December.

To many, this signaled the popping of the bubble, the end of the ride. But, there was something else going on here. The peak price coincided with the introduction of Bitcoin futures trading on the Chicago Mercantile Exchange (CME). The rapid run-up and subsequent fall in the price after the introduction of futures does not appear to be a coincidence. Rather, it is consistent with trading behavior that typically accompanies the introduction of futures markets for an asset.

A Federal Reserve Bank of San Francisco Letter from May 2018, argues that these price dynamics are consistent with the rise and collapse of the home financing market in the 2000s. They suggested that the mortgage boom was driven by financial innovations in securitization and groupings of bonds that attracted optimistic investors; the subsequent bust was driven by the creation of instruments that allowed pessimistic investors to bet against the housing market.

Similarly, the advent of blockchain introduced a new financial instrument, Bitcoin, which optimistic investors bid up unabated, until the launch of Bitcoin futures allowed pessimists to enter the market, which contributed to the reversal of the Bitcoin price dynamics.

A futures contract is a contract that stipulates that an individual will buy or sell a particular asset for a set price on a specific date in the future. In the commodities markets, farmers deal in futures as a hedge against the risk of falling prices in the commodity they produce (say, corn) while, on the other side of the equation, companies like airline operators deal in futures to hedge against the risk of an increase in the price of fuel for their aircraft.

The ability to buy and sell futures contracts means that money can be made on both sides of the market. Before the CME introduced Bitcoin futures, it was virtually impossible to bet against the rise in the price of Bitcoin. This meant that the vast majority of market participants are incentivized to push the market price of Bitcoin one direction, higher.

Once there is an active futures market for Bitcoin, however, there is an incentive on the short side of the equation as well as on the long side. This means that there is also potential for large gains to be made as the price falls.

So why is the futures-led decline in the price of Bitcoin a good thing for cryptocurrency?

Because one directional markets are not markets at all. The more untethered the price of Bitcoin becomes to its intrinsic value as a payment mechanism or a store of value, the less likely banks and commercial enterprises are to make investments in its future…and the more skeptical governments and regulators will become about the benefits of cryptocurrency to society and to the economy.

The futures market has brought some rationality to the price of Bitcoin. Six months later, the price of Bitcoin remains well off its December 2017 highs, but the past six months have also seen a broadening of consumer and retail support for the cryptocurrency and a level of institutional investment that implies cryptocurrency will be an increasingly important part of the financial ecosystem.

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