
The smartest Bitcoin trade in town? - leot
https://ftalphaville.ft.com/2017/12/07/2196554/the-smartest-bitcoin-trade-in-town/
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leot
DECEMBER 7, 2017 By: Izabella Kaminska

Over the last week or so, we’ve recounted the problems with bitcoin’s market
structure and how they are likely to impact the upcoming launch of bitcoin
futures (here, here and here).

In the course of explaining the structural difficulties, we’ve pointed out how
the capacity of market makers and bi-directional traders to support the
product is crucial if bitcoin futures are ever to become a success. Currently,
this is unlikely to happen because there is no easy way to play both sides of
the market without taking on huge amounts of credit, fragmentation,
illiquidity and hacker risk on the physical side.

As it stands, CFD and spread-betting houses are the ones mostly attempting to
provide this bridging role. Problem is, even they are struggling to process
the risk — and that’s despite being much less intensively supervised than the
more established players who would usually be interested in servicing futures
markets.

Some sort of risk-absorbing entity, as a consequence, must appear if retail
and institutional participants (who are used to fiduciary standards) are to
step into the market in size.

As a result, there are only three possible scenarios from here on in:

The futures (plagued by illiquidity and non convergence with the underlying)
flop. The lack of a market-maker redistributing one-sided risk back into the
market will see the risk transferred elsewhere, most likely into the clearing
house (to the risk of the entire trading community). A less established player
with a greater tolerance for risk — possibly a natural long — steps into the
fray. The third option doesn’t necessarily prevent the second option from
playing out, however, given such an entity would still have to be serviced by
the CME/CBOE clearing systems.

Nevertheless, let’s imagine such an entity exists. What would its game plan
be? And why would it think it could handle the risk?

The easy answer to the second question is that it may have spotted an
arbitrage it thinks could more than compensate for the risk at hand.

As to the game plan…

If you’re gunning to be the only entity in town prepared to sell bitcoin
futures, it would be in your interests to start “pre-hedging” physical bitcoin
as soon as possible with a view to locking in a risk-free basis return once
the ability to sell futures on a regulated venue becomes possible.

Ideally, the trade would require an average purchasing price that’s much lower
than the rate bitcoin futures would eventually be sold at. To maximise this
trade, as much value would have to be ploughed into the purchase (or
generation) of bitcoin ahead of time, as likely buyside demand for the futures
once launched.

In terms of timing, due to bitcoin’s illiquidity, a “pre-hedging” position of
this size would no doubt take time to put on. From that perspective it would
make sense to start purchases as soon as a futures contract looked even
remotely viable. FWIW, according to Factiva, the first serious clue CME was
looking into a listing came in November 2016 when it launched a pair of
indexes designed to track the virtual currency’s price. The CFTC’s decision in
July to allow LedgerX to run a swap execution facility for bitcoin options,
meanwhile, was a likely indicator a futures contract could be approved soon as
well:

Nevertheless, no matter how strategically planned, pre-hedging of this size is
always bound to leave a market footprint. (Especially in a market as illiquid
as bitcoin.)

With that, the sort of self-fulfilling feedback loop that usually occurs when
someone attempts to corner a market probably comes into motion.

For many, sparking a feedback loop of this kind is often deemed a trading
objective in and of itself. Not for a bonafide smart operator. The smart money
understands a good trade is as much about executing the “out” as it is about
positioning the “in”. You can start a pump, but you can’t always profitably
orchestrate the dump.

Hence why the futures component of the trade cannot be under emphasized.

Without the certainty of a properly regulated marketplace defending the
futures side of the equation, a payoff cannot be guaranteed. It’s why the
arbitrage exists in the first place: the trade cannot be exercised elsewhere
in the bitcoin ecosystem because the risk of counterparty default at the first
sign of distress is far too great. You’d win the trade, but you’d probably
lose the payout.

If a regulated futures market takes that risk away, however, the trade becomes
a no-brainer if not a mastermind opportunity.

Which is arguably where we are now.

Indeed — if such an entity does exist — only three possible risks that
threaten the trade at this point:

The futures launch is suspended unexpectedly, perhaps due to regulatory
concerns or industry pushback? The anticipated futures demand never arrives
because the margin costs of holding open long positions proves to be too great
and/or liquidity is so shoddy nobody can trade effectively. The cash settled
return on the futures leg, won’t necessarily be matched by the price achieved
on the physical liquidation.

One way or another, we will find out soon.

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reacharavindh
Paywalled.

