Bitcoin trades with Contango. But what does that mean?
“Contango is a situation in which the futures price of a commodity is higher than the spot price.” -Investopedia
Now what is a futures contract?
“A futures contract is a legal agreement to buy or sell a specified commodity or security at a specified price at a specified time in the future.” -Investopedia
The spot price (market price for Bitcoin on exchanges) is currently trading lower than the forward prices. The spread for the June futures contract on most major exchanges is more than 25 percent on an annual basis.
This means that anyone can buy bitcoin and use that bitcoin as collateral to sell the June futures contract. This trade generates a risk-free return of 6 percent on USD (more than 25 percent on an annual basis) regardless of where the Bitcoin price is in the following months.
The only risk is custody of the exchange (loss of coins due to poor management or hacks).
Why is there this “free” money?
The contango is due to the profitability of long bitcoin’s leverage (and the amount of capital that is ready to take advantage of long leverage versus leverage leverage).
Almost everyone uses Bitcoin for a long time in two ways:
- Long perpetual swaps
- Long Forward Futures Contracts
There are currently $ 22 billion open positions in perpetual swaps and futures]so there is a significant amount of capital and liquidity.
If you take the perpetual swap for a long time, you will be charged a funding rate every eight hours. This refinancing rate is set by the market to ensure that perpetual futures price stays near the index spot price. In a way, it’s basically a futures contract with a term of just eight hours that is always renewed.
Last month, the average perpetual swap every eight hours averaged 0.03 percent, or 0.09 percent daily, or 32.9 percent annually. This funding rate is the longs that the shorts pay (because more capital will of course be long Bitcoin, especially if the price goes up).
So if you want long leverage over an extended period of time and the perpetual swap funding rate is high, it is much better to leverage a futures contract that may only be trading at an annualized premium of 23 percent.
But just like the swap market, not many investors want to use short-forward futures contracts here either. Much of the capital, which is short bitcoin, is likely to go into basic arbitrage trading.
What are the effects?
It is possible that Bitcoin’s contango created a supermassive black hole.
The ever-growing bitcoin black hole:
- Bitcoin is the world’s best financial commodity that should grow forever
- Market participants buy and the price rises
- Price rise attracts more buyers (with leverage)
- Leverage buyers drive up the contango spread
- USD arbitrageurs try to get the risk-free return
- To get the spread, they buy bitcoin and sell futures
- By buying Bitcoin, the price continues to rise
- The rise in price increases the contango spread and attracts more arbitrageurs
- Investors realize that this feedback loop exists and simply buy Bitcoin from HODL
- Do you repeat this for all market participants up to hyperbitcoinization?
Why wasn’t this misled?
Bitcoin contango base trading is adding gas to the fire. As more and more capital recognizes this opportunity, the price of Bitcoin will continue to rise.
There are a few possible explanations as to why this proliferation hasn’t gotten out of hand. Because a really “efficient” market would probably gobble up all the “risk-free” 20 percent return opportunities.
One possibility is that the only people in the bitcoin industry who have both a good understanding and the capital to move markets realize that billions of dollars worth of bitcoin must be bought in order for the spread to potentially close . If there is an incentive to buy billions of dollars in Bitcoin and you know Bitcoin is the hardest money in the world, you probably won’t accept the “risk-free” product more than 20 percent, knowing that Bitcoin is so from last year will outperform in the long run.
The second possibility is simply that the excess capital invested in bonds, stocks and real estate of more than $ 100 trillion is held by investors who do not know or are uncomfortable about arbitrage trading in futures, To employ capital in this space.
The final option is for the risk-free spread to be a truly market-based, “risk-free” rate of return. With bond yields rigged lower and lower over the past few decades, this could be more than 20 percent of the market to expect stocks, real estate, and other assets to perform in line with it, plus a small risk premium. This high expected nominal return could be possible due to the endless budget spending of governments financed by the cautious monetary policy of the central banks.
What could break the contango?
Bitcoin is only rising well on paper, but what could eliminate the futures contango?
Since futures contango is driven by more money wanting to leverage long than short leverage, that dynamic would have to reverse, meaning that more capital would need to be short leverage than long leverage for Bitcoin to switch from contango to backwardation .
Given the backdrop of macro money printing, limited bitcoin supply, and a growing number of bitcoin income and credit products, there is little reason to believe that this will at least happen soon.
Even so, there are a few possible scenarios where Bitcoin’s contango breaks and turns into backwardation.
First, old HODLers might start selling in size. This may not be due to a growing number of financial products making Bitcoin easy to use without selling it.
Second, people might read too deeply into @ 100Trillion’s S2F and S2FX models. If Bitcoin’s price exceeds the models, some may consider selling to buy back lower. While this would be very risky, especially in the current macro environment, if enough market participants do this it could be self-fulfilling.
Finally, a drastic change in monetary / fiscal policy could temporarily break the contango. For example, during the March 2020 crash when the money printer wasn’t running fast enough, Bitcoin went into backwardation.
Is that hyperbitcoinization?
We are not sure. Would we be comfortable selling a significant amount of Bitcoin at any price?
This is a guest post from Mimesis Capital. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.