Do futures contracts affect the price of the underlying asset?
They did with bitcoin, according to a recent report from the Federal Reserve Bank of San Francisco’s FRBSF Economic Report entitled, “How Futures Trading Changed Bitcoin Prices.”
The report makes the compelling argument that before futures, there was no way to bet against bitcoin. Therefore the price grew exponentially as more people got involved, effectively betting for the cryptocurrency’s price rise. Without the ability to bet against it, price pressure was completely one-sided and grew under the support of optimists while pessimists were unable to cast their downward vote.
The authors, Galina Hale, Arvind Krishnamurthy, Marianna Kudlyak, and Patrick Shultz, point out that the peak price coincides with the launch of bitcoin futures trading on the Chicago Mercantile Exchange and they cite a study by Fostel and Geanakoplos (2012) that finds the same pattern with mortgage backed securities.
In exploring the question of bitcoin’s price, the authors separate speculative value from transactional value. Speculative value comes in the form of people buying and holding bitcoin in hopes of its price increasing over time. Transactional value is seen in the quantity of bitcoin necessary to facilitate all the transactions.
The FRBSF report’s conclusion about bitcoin’s potential value is that, “…what will eventually determine the “fundamental” price of bitcoin is transactional demand relative to supply.”
There will never be more than 21 million bitcoin. With fixed supply, theory says that the price should rise with demand.
Evidence suggests that worldwide transactional demand is currently so strong, it is overwhelming technology’s ability to facilitate it. Solutions to this bottleneck are in development and a few have already been deployed.
The company Blockstream has created a Bitcoin Satellite network that beams the bitcoin blockchain onto almost all landmasses on Earth. The Lightning Network sidechain enables micropayments that allow bitcoin to facilitate everyday transactions and even micropayments, which are not possible with conventional payment methods.
Worldwide consumers are not the only source of demand for bitcoin. Early in 2019, Intercontinental Exchange (ICE) will work with Bakkt, to facilitate bitcoin futures contracts, with one fundamental difference from the existing bitcoin futures market. Bakkt will back all contracts with actual bitcoin and settle at the end of each day with bitcoin.
This will increase the number of transactions and increase the demand for the limited amount of bitcoin, effectively tightening supply. Whether or not that will affect bitcoin’s exchange rate (price) remains to be seen.