Is Investing & Trading with Bitcoin Futures ETFs a Bad Idea?

Is investing and trading with Bitcoin futures ETFs a bad idea? Though Bitcoin futures have gained in popularity and volume over the past couple of years, there are several crypto experts who think that it is a very bad idea for the retail investors to buy them, especially the Bitcoin futures ETFs.

This, however, is a matter of debate, given the fact that it provides a lot of opportunities to make some profit with minimal risks.

Therefore, before you jump into it or out of it simply by believing what others have to say about Bitcoin futures, you should know a few facts about them in particular.

Fortunately, this is the right place to be in to know the facts that are necessary to determine whether investing in Bitcoin futures, especially in the ETFs or Exchange Traded Funds is a bad idea.

In this article, you will come to know about how the people responded to the Bitcoin futures, which helped the Bitcoin price to surge past $60,000, and the proposed Bitcoin futures ETFs.

Therefore, through this article you will find all the necessary help to understand the details before buying any such futures based Bitcoin ETFs.

The crypto experts are very skeptical about the decisions of the SEC or The Securities and Exchange Commission on the Bitcoin futures ETFs.

They feel that it will not help the retail investors in particular since there are too many outlets out there from where people can buy Bitcoin directly.

Moreover, these are highly complicated and therefore the retail investors should abstain from investing in them, especially by those average retail investors who have very little or no understanding of futures or ETFs.

Why? It is because it needs much more than derivatives to carry over. 

Is Investing and Trading with Bitcoin Futures ETFs a Bad Idea 

Investing and Trading with Bitcoin Futures ETFs

The futures-based Exchange Traded Funds for Bitcoin has got the nod from The Securities and Exchange Commission.

It is considered to be a boon to the crypto holders and the price of Bitcoin has reached astronomical heights due to them.

However, how much good these ETFs will do to the retail investors is to be seen as time passes.

Experts believe that the fund itself is a ‘horrible idea’ due to the contango effect, a common phenomenon in the futures markets, which is sure to hit.

The costs involved are much too high in terms of the returns it promises to pay.

These returns are dramatically low in comparison to a direct investment made in Bitcoin.

The losses incurred by the retail investors will be so high that it will make the concerns of the SEC regarding the inconsistent referral price points of the spot market as well as the volatility of Bitcoin look so trivial.

Therefore, before you even think of investing in the Bitcoin futures ETFs, you should know what you are getting into, and especially, what you are buying.

The most important thing that you need to understand is that you are paying for something that will not be yours.

This means that you are not buying actual Bitcoin. In fact, you are actually buying a contract through the Bitcoin futures ETFs.

This contract will track the future price of the digital asset itself that you have speculated instead of its spot price or current price.

This also means that there is a very little or no chance of your speculated price of Bitcoin ETF and actual Bitcoin to match down the road.

Therefore, there is a high chance that you will be trading at a premium in a bull market condition or at a discount in a bear market on the basis of your futures-based Bitcoin ETF.

The only thing that is good about it is that you will get an exposure to the Bitcoin futures market through the ETFs but there will be a lot of complications and intricacies involved in the process.

One thing that bothers the crypto experts the most is the phenomenon of the futures market.

This is where the manager will need to roll out an expiring Bitcoin futures contract as well as a current contract, maybe at the same time.

This will eventually have a significant impact on the ability of the fund to track the actual price of Bitcoin effectively.

This will not only enhance the chances of incurring losses but will also increase the trading costs of the ETFs significantly.

That is why the experts suggest that the retail and average investors who are interested in the futures market should understand the obtuse nature of it.

They must research a lot to know what these futures contracts really are and understand how these operate in the market before they buy any of them.

The crypto experts also believe that, as a regulator, the SEC chose the easiest route and cleared the road for Bitcoin futures to an ETF instead of approving a fund based on the spot market.

This is said because the underlying contracts of the Bitcoin futures are themselves regulated by the CFTC or The Commodity Futures Trading Commission.

If they approved a spot market-based ETF proposal they would have also needed to agree to the prices quoted by the exchanges that deal with Bitcoin listings which are typically not regulated by the CFTC or the SEC themselves.

Instead, they backed the futures solution because they could not look over and above the unregulated and global world of Bitcoin exchanges and the prices produced by them.

It seems that the SEC typically could not believe or rely on the more refined and trustworthy indexes for Bitcoin that had all the abilities to play the role absolutely well.

That is why the crypto experts are so skeptical about their decision of favoring contango based losses over the spot market.

They think that it will do the small investors more harm than good.

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It will not be able to protect them, as it is supposed to, from incurring losses that will be significantly higher than they would have incurred by trading Bitcoin directly in the spot market in spite of whatever uncertainties the market might bring to it.

Hedge Funds Perspective 

Looking at the Bitcoin futures and futures based ETFs from the perspective of the more seasoned investors such as hedge funds the profit made may be more.

These funds will be good for the Bitcoin and crypto market overall.

This is because the crypto experts believe that these funds will drive the institutions more and more of their money will start flowing into the market.

This will help the liquidity of the market and the seasoned investors will make a lot of money.

This will eventually help the hedge funds and the providers especially when ETFs are traded in the bull markets at a premium because there is a high chance that people will buy these products without having adequate knowledge about them.

A lot of financial experts and those in the crypto community agree to it though some argue the presence of intermediaries and their involvements in a potential investment in ETFs.

Safety Aspect 

When it comes to the Bitcoin futures contract based ETFs, the common concept of Exchange Traded Funds that it is a much safer investment because it is an ETF does not apply.

It still comes with a significant amount of risks in spite of the fact that you will not be investing directly in the coin through a futures-based Bitcoin ETF.

Once again, it is due to the exposure you would have in the Bitcoin market which is extremely volatile as well as the intricacies that are associated with the futures contracts.

These risks are significantly higher for the new investors, as pointed out by the crypto and financial experts.

This is because they have been anxiously waiting until now to gain exposure in the crypto market without understanding the risks involved in it.

The investors think that this will keep them safe and they will make a lot of money through it.

Therefore, they will jump into it without doing their due diligence which is the main concern.

The experts feel that they will forget the most important principle of investing in crypto which is – do not invest more than you can afford to lose.

Understanding Contango Effects and Challenges 

There will be some significant challenges posed by the Bitcoin futures ETFs due to the contango effect.

This is a particular situation wherein the prices of those futures contracts with longer expiration dates are higher in comparison to those futures contracts that are for shorter periods.

This involves the various types of costs involved in managing and operating the ETFs by the manager. This includes and is not limited to:

  • The cost of rolling out the contract every month
  • Selling off those lower-priced contracts
  • Buying the higher priced contracts of next month
  • Expiring the contracts of the current month and more.

A futures strategy will underperform more notably when the contango effect is higher.

The futures contracts will not be able to track the price of the underlying asset, Bitcoin in this case, as it is intended to track.

The crypto experts therefore believe that this strategy is therefore lethally flawed and is a costly phenomenon as well for the Bitcoin ETFs.

They also say that the negative yield of Bitcoin futures every month on an average has been quite notable which is primarily due to the cumulative costs associated with it in comparison to the spot market.

The most noteworthy challenge that this contango effect poses is the significant rise in the prices of the futures contracts that are longer-dated, making them quite expensive eventually.

This results in lowering the average yield roll.

Research shows that the average negative yield per month for the Bitcoin futures is much higher than the average contango costs associated with crude oil futures and gold futures and is slightly lower than the contango cost of unleaded gas.

Another significant aspect to consider at this point is the storage factor, which is not required much in the case of crypto.

Therefore, its tendency toward contango is minimal which is further explained by the future price expectations in a purely hyper-bullish market.

However, with it comes another significant problem in managing the Bitcoin futures, which, arguably is quite different, if not a very difficult proposition.

Since there is no cost of storage involved, the long term effect simply does not happen in this case as it declines in the case of other commodities.

The entire thing reflects the higher spot price speculated for the future.

There are no back-end contracts to put into play in this case to your benefit. It is straight up and there is no place to hide.

Another significant challenge posed by the Bitcoin futures ETFs with relation to the contango effect is that the managers of the funds need to have a large amount of cash in their hands in order to cover the roll expenses over time.

These funds are never exposed to Bitcoin gains and therefore it results in an opportunity cost.

This is not the case with the spot market backed ETFs since the majority of the funds is invested.

The Price Links 

The price of the Bitcoin futures has a direct link with the spot price, as said earlier.

Therefore, the exchanges need to self-certify that the contracts are not readily at risk of manipulation.

However, a lot of crypto market critics and observers are cynical about it.

They think on the contrary because they believe that Bitcoin is not liquid and the market is extremely volatile which may result in large swings in the price of Bitcoin, especially in large trades.

This is because manipulators can move the price of the Bitcoin futures in their favor by placing a large trade in the spot market.

Since the price of Bitcoin futures depends entirely on the price of Bitcoin it is easy to bring in this so-called banging-the-settlement effect.

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However, this will happen only when the futures contract is settled in cash, which is typically the case with Bitcoin futures.

Bitcoin Reference Price 

The probability of price manipulation has forced the exchanges to focus on the Bitcoin Reference Rate or BRR.

They think that the prices of futures contracts cannot be manipulated unless the reference rate is manipulated.

Different exchanges follow Bitcoin Reference Rates and price their Bitcoin futures contracts at a specific period of time every day.

They hold an exchange auction to determine the price of Bitcoin by matching the cumulative buy and sell demands.

In this process, all the participants can submit their orders the day before at or within a specific time period.

This helps the exchange to determine the ‘cross price’ based on the largest demand that needs to be filled.

This means that, the more orders are placed every day in the auction, the harder it will be to manipulate the price.

That is why several exchanges even incentivize people to have maximum involvement in the auction.

These incentives may come in any form such as reduced fees for executing trades at the auction or by offering instant settlement for trades.

However, there is an issue with this process especially if the exchange is not big enough in terms of accounting and trading volumes.

The chance of manipulation still remains due to the low trading volume in these exchanges.

This, however, does not mean that exchanges that have large trading volumes are not susceptible to manipulations.

This can be achieved when a lot of brokers place large trades in collusion within the auction period to move the price in their favor.

In order to prevent such things from happening, several exchanges may also develop their own reference rate to price the Bitcoin futures contracts.

These happen to be much more advanced and complicated reference rates that are created for the sole purpose of reducing the chances of price manipulation.

In this process the Bitcoin Reference Rate is calculated on the basis of all transactions made on a few specific exchanges at a specific time period.

The steps followed to create the BRR include:

  • Adding all relevant transactions to a joint list
  • Recording the size and price of each trade
  • Partitioning the list into a specific number of time intervals of equal size and
  • Calculating the volume-weighted average trade price for each part.

The properties of such a Bitcoin Reference Rate make it quite impossible to manipulate the price because the manipulators will first need to manipulate the prices of the different exchanges for a long period of time.

Apart from that, the median factor lessens the brunt of the outlier prices and since these are volume-weighted, it filters the high numbers out of the small trades.

Therefore, there is no chance of these to dominate the non volume-weighted average price.

Still, this too is not foolproof. The primary reason behind it is that Bitcoin is usually not traded in large volumes.

This is the basic problem of it which cannot prevent the potential and unwavering manipulators from placing a number of trades eventually making it large enough to move the price of Bitcoin in the direction they want.

Price Manipulation 

The price manipulation factor is one of the most significant ones that the regulators are more concerned about.

This is why the SEC was so apprehensive and was reluctant to approve the proposed Bitcoin ETFs earlier.

They said in their ruling that Bitcoin markets are volatile and unregulated and therefore the exchanges will not be able to address the risks of potential frauds and manipulations. It is impossible to develop a proper surveillance-sharing contract for that matter.

As far as the self-certification aspect is considered, the SEC showed their concerns over the comparatively nascent and continuously developing and unregulated crypto market in which the CFTC has very restricted legislative authority.

Once again, the SEC is concerned about the price volatility of Bitcoin and potential unfair trading practices that may be followed by the participants.

Things will become worse with the Bitcoin futures contracts and futures based ETFs, the regulators opine. 

Cybersecurity Risks 

There is also a risk of cyber security at the Bitcoin exchanges that cannot be overlooked completely.

Market observers and crypto experts believe that it is not an easy task for the exchanges to broaden scheduled maintenance of their sites within a short notice.

It involves a lot of cost and effort to build a proper and foolproof technical infrastructure.

In such a situation, the customers may not be able to access their Bitcoin for a major part of the day since the exchanges will not be able to respond to the requests due to ‘504 Gateway Time Out.

Such kind of service outages can last for several hours at a stretch till the issues are resolved.

The exchanges will have to make excuses to retain their customers saying that their server is down for maintenance, there is heavy traffic or significant volume or volatility, but deny cyber attacks.

However, this will result in inconvenience to the users who will not be able to buy or sell their assets within the set period resulting in losses simply because the exchange was nonoperational.

Systemic Risks 

Typically, the crypto market is considered to be comparatively insulated and therefore is more stable as compared to the conventional financial system.

However, with the introduction of the Bitcoin futures contracts ETFs, even this is exposed to risks of Bitcoin due to the erosion of the barrier.

This is because these ETFs are subject to compulsory central clearing.

The exchanges now act as central clearinghouses or as the counterparty to the buyers and the sellers.

The terms of the trades are guaranteed by them even if one party of the contract defaults, in accordance with the Dodd-Frank requirement.

This actually eliminates the risks involved with bilateral trading of derivatives.

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But the problem is that all these risks are now concentrated in these clearinghouses.

This is where the market participants and the regulators have shown their concerns.

They think that the increased risks on the clearinghouses now will threaten financial stability.

They also say that this will result in less liquid assets to trade with much lesser transparency.

Moreover, there is a significant risk posed by the broker-dealers who are the members of the clearinghouses that are typically sparsely capitalized.

The clearinghouses have to rely on these members to guarantee fund contributions and promise to meet any shortfalls that may arise due to counterparty defaults.

Now, the broker-dealers say that it is not fair because there is a risk in this kind of a deal.

They will be compelled to cover a loss due to default by one party to Bitcoin futures even if they themselves do not deal with Bitcoin futures.

The Futures Industry Association argues that the necessity of providing a separate guarantee fund for Bitcoin futures ETFs by them or whether the exchanges should put up additional capital for it should have been discussed publicly.

However, The CFTC disagrees with them saying that the decision has been taken on the basis of the feedback received from a significantly large number of market participants.

However, they added that it is not their authority to decide who will create such a separate guarantee fund or whether at all it is necessary. It depends solely on the clearinghouses.

Therefore, the systemic risk is a worthy concern now that it has become a ‘pass the buck’ game.

The only way the clearinghouses may respond, if at all they have to, is by raising the initial margin requirements by a few percentage points.

This will once again make the Bitcoin futures and the ETFs more expensive than it already is.

And, with such changes made on the margin requirements on a regular basis by the exchanges, there is a high risk that the counterparties may not be able to keep up with it, given the fact that Bitcoin as such is extremely volatile.

Future Outlook 

Considering the performance of the Bitcoin futures ETFs in the past few months the trading price of these contracts is found to be quite high in keeping with the price of Bitcoin.

This, however, is against the no-arbitrage principle.

This principle states that a riskless profit should not be made by combining the positions of the futures contracts with the positions related to other assets.

According to this process, you borrow some amount to buy one Bitcoin at a specific price and then sell off a Bitcoin futures contract at a higher price to pay off the borrowed amount along with its costs. This will therefore allow you to make a risk-free profit.

This type of cash-and-carry arbitrage openings seldom exist in a traditional financial market.

This is because the investors or arbitrageurs participating in these markets react very quickly to typically exploit them.

In the process they do away with the arbitrage opening.

The reason that there is a constant arbitrage opportunity existing in the Bitcoin futures market can be many and varied such as:

  • Most investors are willing to own Bitcoin futures contracts even at a premium because they do not want to possess actual Bitcoin and
  • Investors also do not want to go through the stress of holding the assets in a wallet being worried about hacking and stealing of funds.

Another significant reason for people favoring futures contracts is the difference between the futures price and spot price.

This causes a friction in the market which is arbitraged away.

However, in the case of Bitcoin, the price of it on one exchange is the same on the other exchange and on the next and so on.

This is in accordance with the law of one price.

After all, if it was not, then you may buy Bitcoin on one crypto exchange that is offering it at a lower price and sell it immediately on another exchange that is offering a higher price and thereby make immediate profits on your trades.

Of the record, there can still be some variances in the prices of Bitcoin across exchanges.

This is not due to the failure of the law of one price but mainly due to the variance in the trading fees, changes in price due to delays in executing a trade, or counterparty risks due to fraud or system failure.

This however will reduce the profits made due to arbitrage.

Therefore, to make the most out of the difference between the futures price and spot price of Bitcoin, an investor should have a large amount in the account of the exchange.

This is quite a risky move given the fact that the price of Bitcoin can change dramatically due to its extremely volatile nature.

However, even after all the downsides of Bitcoin futures contracts and futures based ETFs, the market seems to develop quite significantly.

It is now a matter of time when the exchanges will improve their infrastructure in order to reduce the frictions and allow the users to make more arbitrage profits. 

Without these developments made, it is quite impossible at the moment to predict the future of this particular Bitcoin product. 

Conclusion

The crypto exchanges are keen to offer Bitcoin futures contracts to keep up with its rising demand among the investors. But, whether the investors can really make profits or is it a bad investment is a topic of debate due to the risks related to it.