Yes, Virginia, the Bitcoin contango is a mystery

Lots of people are saying that massive contango in the Bitcoin futures is no surprise, because the contracts are cash settled.

For example:

“If you’re doing a cash-settled future, it’s just a bet,” said Aaron Brown, a former managing director at quant hedge fund AQR Capital Management who invests in the cryptocurrency and writes for Bloomberg Prophets. “If that’s not related to any underlying physical transaction, the only people who want to do it are gamblers.”

Or N. N. Taleb:

I think they are wrong.

Let me start with some background since my readers (if I have any) are not all finance types. A futures contract is conceptually very simple. Example: You and I agree right now that at noon four weeks from today you will give me $6000, and I will give you 100 barrels of oil. That is the contract. Our trade four weeks from now is the settlement of the contract, and my delivery of the barrels is called physical settlement. Physically settled contracts are useful for hedging; e.g. if you are a transportation firm that actually needs the oil in four weeks but wants to price some tickets for sale today. Physical settlement is also open to arbitrage: If oil today is much cheaper than$60/barrel, I can sell you those futures, purchase 100 barrels of oil, then simply hold them for four weeks until I deliver them to you. Of course, during those four weeks I have to store the barrels and forego any interest on the cash I paid for them; these represent the “cost of carry” and give rise to the contango.

Now, it is very possible that you do not really want the oil, but merely want to speculate that oil will cost more than $60/barrel four weeks from today. In that case, you might agree that instead of giving you barrels, I can give you the cash equivalent based on the price of oil at that time. Or for simplicity, one of us will give the other the difference between that amount and$6000. This is called cash settlement, and most (all?) futures either allow or require it.

An important detail is defining “the price of oil at that time”. I am sure you can imagine ways based on some recent bid, offer, or transaction in some market. And I am sure you can also imagine someone with a large futures position badly wanting to manipulate that bid, offer, or transaction.

Even absent such manipulation, cash settled futures are less useful for hedging and less open to arbitrage, because they depend on that future market price.

When I wrote my prior post, I wrongly assumed the CBOE Bitcoin futures were physically settled; i.e. that they required delivery of actual Bitcoins (which are not exactly “physical” but never mind).

In fact, those futures are cash settled. But to understand the implications, you have to look at how the settlement price is determined:

The Final Settlement Value of an expiring XBT futures contract shall be the official auction price for bitcoin in U.S. dollars determined at 4:00 p.m. Eastern Time on the Final Settlement Date by the Gemini Exchange (the “Gemini Exchange Auction”)

The Gemini Exchange is a Bitcoin trading platform owned by the Twinkletoes Twins.

Gemini describes its auctions like so:

The final auction price for every auction is established as the price that executes the greatest aggregate quantity across both the auction and continuous order book. A desirable property of this auction design is that it approximates the results of the Walrasian tâtonnement process used in standard economics textbooks to describe how the forces of supply and demand determine prices and market clearing quantities. Within this auction design, the market is open to accepting bids and offers until the time the auction algorithm runs. This auction mechanism is similar to the auction mechanisms used by NYSE Arca, Nasdaq, Bats, and other large stock exchanges throughout Europe and Asia.

Lots of fancy terms, but the bottom line is that this is a double auction where anyone can participate and everyone pays/gets the same price. So the arbitrage goes like this:

1. I sell you the overpriced futures
2. I buy Bitcoins at spot
3. I participate later in the actual auction determining the settlement price, entering a limit sell order for all of those Bitcoins at \$0
4. I use the proceeds to settle the contract in cash

Note that in step (3), the amount I receive for my Bitcoins is exactly what I need to settle with you in cash, by the definition of the settlement price. It does not matter what anybody’s “sentiment” is. It does not matter if you also participate to “push the price higher”. Since I can participate myself and sell all of my Bitcoins at the settlement price, this is a perfect arbitrage (less the Twinkletoes’ cut).

Perhaps I am not Gapishing something, but my guess is that the futures premium will collapse as bigger players get this arbitrage machinery spun up. Also January 17 might be an interesting day for Bitcoin.

Update: Ta-da!