BitOoda Afternoon Report, 2/6/20: Analysis of the BTC Forward Curve

Today we would like to focus on challenges presented to BTC traders and investors by the structure of the forward curve. We will focus on CME futures as the most liquid derivative instrument available to US institutional investors seeking to trade on a regulated platform. The contango market is defined by longer-dated futures trading above shorter-dated futures and spot/cash prices. The backwardated market is the opposite.

In traditional financial assets (such as interest rates, FX, precious metals, equities) the abundance of well-capitalized sophisticated market participants makes the structure of the forward curve stable and predictable. The “no arbitrage” condition implies the forward curve described by the difference between the yield (risk free interest rate) in the pricing currency (say USD) and the yield of the asset (assuming negligible storage costs). If an asset yields less than the currency in which it is priced, the curve is in contango; if it yields more, it is in backwardation. Deviations from the exact shape produce arbitrage opportunities for high credit rated participants that can borrow near the risk-free rate.

In commodities, due to shortages or nontrivial storage costs, the arbitrage is not directly available to participants. Some cannot afford to delay consumption (in backwardated markets), and some do not have access to cheap storage assets (in contango). Prolonged contango or backwardation creates unique challenges for market participants. For example, prolonged contango is great for hedgers, as they are able to sell their future production consistently above spot prices (thus collecting extra yield or revenue). For ETF’s and passive funds, the problem is reversed as they are “rolling” the long position at ever-increasing futures prices, thus paying the yield to the marketplace just to hold the position. The opposite is true in a backwardated market. When the curve flips (as the crude oil curve did due to expected demand drop because of coronavirus), previously profitable “rolling” strategies disappear. Yesterday’s Wall Street Journal article on this subject can be found here:

BTC is neither a consumption commodity, nor a mature financial asset. It has no direct consumption use or any storage costs. However, at this point the forward curve is not heavily arbitraged by well-capitalized players. The curve is currently upward sloping (contango) at the rate of approximately 12% annualized. This could not have persisted in a mature market. There are no storage costs to BTC owners (unless they forget their wallet passwords and addresses at the rate of almost 12% a year). Interest rates to large institutions are 1.52% and not 12%. BTC does not “yield” a negative return (not confiscated, at least not yet).

We believe it is due to one or more of the following reasons:

· Current market is dominated by participants whose cost of capital is closer to 10% than 1.5%.

· CME futures long position is dominated by players who do not or cannot own the actual coin (for any number of reasons including regulatory).

· Passive investors buying deferred futures to avoid the pain of the short-dated roll where the contango is the widest.

The current contango is great for hedgers and shorts and arbitragers, but is eating into capital and returns of long-only participants who must contend with expensive roll every month.

The contango widens on rallies and shrinks on selloffs (the opposite of how a commodity market behaves). We believe the behavior is dominated by overzealous longs establishing and exiting leveraged positions.

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