The fact that bitcoin is traded in contango presents a notable investment opportunity and suggests hyperbitcoinization. But what is this?
What is Contango?
“Contango is the phenomenon that occurs when the price of futures contracts is higher than the price of the underlying asset (spot price or spot price).” – Investopedia
Now, what is a future contract?
“A futures contract is a legal agreement to buy or sell a particular commodity or security asset at a predetermined price at a specific time in the future.” –Investopedia
Currently, the spot price (market price of bitcoin on exchanges) is traded below future prices. The spread for the June futures contract is more than 25% annualized on most major exchanges.
This means that anyone can buy bitcoin and use it as collateral to sell the June futures contract. This trade guarantees a risk-free return of 6 percent in dollars (more than 25 percent annualized), regardless of where the price of bitcoin is in the following months.
The only risk is the custody of the exchange (losing coins due to mismanagement or hacks).
Why does this “free” money exist?
The contango exists due to how profitable it is to leverage the bitcoin bought (and the amount of capital willing to go for the leverage bought versus the leverage sold).
Almost everyone uses bitcoin in two ways:
- Perpetual long exchanges
- Long-term futures contracts
Currently, there are US $ 22 billion in open interest contracts for perpetual and futures swaps, therefore, there is a significant amount of capital and liquidity.
If you trade long-term swap, you will be charged a financing fee every eight hours. This financing rate is defined by the market to ensure that the perpetual future price is close to the spot price of the index. In a way, it is basically a futures contract that is only eight hours long.
In the last month, perpetual change averaged 0.03 percent every eight hours, or 0.09 percent daily or 32.9 percent per year. That funding rate is those bought by paying those sold (because more capital will naturally result in a long bitcoin, especially when the price is going up).
So, if you want to leverage for a long period of time, and the perpetual swap financing rate is high, then it is much better to leverage bought in a futures contract that may be trading only with an annualized premium of 23%.
But again, just like the swap market, few investors want to leverage short-term futures contracts. A large part of the capital that is short on bitcoin is probably doing base arbitrage trading.
What are the implications?
It is possible that the bitcoin contango created a supermassive black hole.
Bitcoin’s ever-growing black hole:
- Bitcoin is the best monetary asset in the world designed to grow forever
- Market participants buy and the price goes up
- The price increase attracts more buyers (with leverage)
- Leveraging buyers increases the spread of contango
- USD arbitrators try to capture risk-free return
- To capture the spread, they buy bitcoin and sell futures
- Buying bitcoin causes the price to rise further
- The high price increases the spread of contango
- The investor recognizes that this feedback loop exists and just buy bitcoin for HODL
- Repeat for all market participants until hyperbitcoinization?
Why was this not regulated?
Bitcoin-based trading contango is adding gas to the fire. As more and more capital begins to recognize this opportunity, the price of bitcoin will continue to rise.
There are some possible explanations for why this spread was not arbitrated. Since a truly “efficient” market would likely consume any 20% “risk-free” income opportunity.
One possibility is that the only people in the bitcoin market who have a good understanding and capital to move markets recognize that, for the spread to be potentially closed, there must be billions of dollars in bitcoins purchased. If there is an incentive to buy billions of dollars of bitcoin and you know that bitcoin is the most difficult monetary asset in the world, you probably will not accept “risk-free” by more than 20 percent because you know that bitcoin will perform better than the long run.
The second possibility is simply that the more than $ 100 trillion of excess capital invested in bonds, stocks and real estate is held by investors who are unaware that futures trading exists or are not comfortable using capital in space. still.
The last possibility is that this maneuver may represent a “risk-free” rate of return truly based on the market. Since bond yields have been manipulated more and more downward in previous decades, that more than 20% may be the market’s way of saying that it expects stocks, real estate and other assets to perform in line with that, in addition small risk premium. This expected high nominal return could be possible due to the government’s endless fiscal spending financed by central bank monetary policies.
What can stop contango?
Bitcoin just rising looks great on paper, but what could stop the contango?
Since contango is driven by more money wanting to leverage bought than leveraged sold, that dynamic would need to change, meaning that more capital would need to be leveraged sold than bought for bitcoin to change from contango to backwardation.
With the scenario of macro cash printing, finite bitcoin supply and an increasing number of bitcoin loan and yield products, there is little reason to expect this to happen, at least soon.
That said, there are some potential scenarios where the bitcoin contango breaks down and turns backwards.
Um, old HODLers could start selling large quantities. This may not be due to an increasing number of financial products that make using bitcoin easier without selling it.
Two, people could read very deeply in the models S2F and S2FX from @ 100Trillion. If the price of bitcoin exceeds the models, some may consider selling to buy back cheaper. While this is very risky, especially in today’s macro environment, if enough market participants do this, it can become self-fulfilling.
Finally, a drastic change in monetary / fiscal policy could temporarily break the gap. For example, during the March 2020 crisis, when the money printer was not working fast enough, bitcoin went down.
Is this hyperbitcoinization?
We are not sure. Would we feel comfortable selling a significant amount of bitcoin at any price?