Bitcoin is trading in contango. But what does this mean?
Now, what’s a futures contract?
Currently, the spot price (market price for bitcoin on exchanges) trades lower than futures prices. The spread for the June futures contract is more than 25 percent annualized on most major exchanges.
This means that anyone can buy bitcoin and use that bitcoin as collateral to sell the June futures contract. This trade locks in a risk-free 6 percent USD-denominated return (more than 25 percent annualized) no matter where the price of bitcoin goes over the following months.
The only risk is exchange custody (losing coins due to poor management or hacks).
Why Does This “Free” Money Exist?
The contango exists due to how profitable it is to leverage long bitcoin (and the amount of capital willing to go leverage long versus leverage short).
Almost everyone goes leverage long on bitcoin in two ways:
- Long perpetual swaps
- Long forward futures contracts
Currently, there is $22 billion in open interest on perpetual swaps and futures], so there is a significant amount of capital and liquidity.
If you go long on the perpetual swap, you are charged a funding rate every eight hours. This funding rate is set by the market to ensure the perpetual futures price stays near the index spot price. In a way, it is basically a futures contract that is only eight hours in duration and it always rolls over.
Over the last month, the perpetual swap has been averaging around 0.03 percent every eight hours, or 0.09 percent daily or 32.9 percent annually. This funding rate is the longs paying the shorts (because more capital is naturally going to be long bitcoin, especially when the price is going up).
So, if you want to go leverage long for an extended amount of time, and the perpetual swap funding rate is high, then you’re much better off going leverage long on a futures contract that may only be trading at a 23 percent annualized premium.
But again, just like the swap market, not many investors want to leverage short-forward futures contracts. A large portion of the capital that is short bitcoin is likely doing the basis arbitrage trade.
What Are The Implications?
It’s possible that bitcoin’s contango has created a super massive black hole.
The Ever-Growing Bitcoin Black Hole:
- Bitcoin is the world’s best monetary good designed to go up forever
- Market participants buy and the price goes up
- Price going up attracts more buyers (with leverage)
- Leverage buyers drive up the contango spread
- USD arbitrageurs attempt to capture the risk-free return
- To capture the spread, they buy bitcoin and sell futures
- Buying bitcoin causes the price to go up further
- Price going up increases the contango spread, attracting more…
Read more:A Deep Dive Into Bitcoin’s Contango