Over the last couple of weeks, the concept of “contango” — the situation where a futures price of a commodity is higher than the spot price, made popular among Bitcoiners by Preston Pysh and Plan B — has been discussed (and meme’d) throughout the Bitcoin community, particularly on Twitter. But what actually is contango? Why is it important? And how does it affect the price of bitcoin?
The goal of this piece is to provide you with the answers to these questions, in layman’s terms, in addition to explaining how contango accelerates the supply suffocation that is already naturally taking place due to Bitcoin’s programmatic, four-year supply halving.
(In the chart below, note the sharper-than-normal slope downward in the number of bitcoin of exchanges. In addition to better education/institutional custody of coins, contango is likely playing a part in this.)
What Is Causing Bitcoin Contango?
Before getting into what contango is, I would like to illustrate the macro backdrop of why this phenomenon is able to take place. It is first important to understand that asset prices are inversely correlated to risk-free yields, higher yields equal lower equity valuations (and vice versa). As risk-free, fixed-income instruments (U.S. Treasury bonds) sell-off, yields rise; as they are bought, yields are driven down. In a free and open market, this effect reaches equilibrium as yields rise/lower in correspondence to what the free market agrees upon.
However, this is not the case any longer with U.S. Treasury bonds. Due to decades of poor monetary policy decision making, particularly since 2008, the entire financial system is extremely fragile. The U.S. Federal Reserve is now manipulating fixed-income yields directly by buying its own treasury bonds. By buying treasuries, thus pinning the yields used in financial valuations down, this creates manipulated growth in legacy asset markets, such as the stock market. Following the decoupling of the U.S. dollar from gold in 1971, the Fed began to use the tool of manipulating yields to create the illusion of growth.
(This can be illustrated in the chart below, showing the 10-Year treasury bond in particular.)
If the Federal Reserve were to stop buying treasuries and pinning their yields down, the free market would blow them out, thus causing the collapse of asset prices. Therefore, the Fed has no other choice but to continue buying treasuries to keep the system afloat. Similar to a spring, at this point, the whole system has been coiled so tightly that the unpinning of risk-free yields would cause havoc in markets.
The New Bitcoin “Risk-Free” Yield
In the bitcoin market, futures are trading at a substantial premium to spot market price. Why these futures are trading at a premium is currently unknown, as there is no storage cost; which is the reason commodity futures traditionally trade at a premium. There are two likely explanations for the premium: the ease of access to leverage through futures markets, or that certain entities are unable to get exposure to bitcoin price appreciation via spots, so they have to buy at a premium through futures markets. I suspect that the premium is more likely caused by the former. Although the exact reason behind why these spreads exist isn’t fully understood, they do exist and are there to be captured.
(The chart below illustrates the dramatic increase in futures open interest.)
To arbitrage and capture the difference between spot and futures prices, a financial entity can simultaneously go long/short, giving them a yield that is essentially risk- ree. For example, an August CME futures contract is priced at $54,105, while the current spot price on Coinbase is $50,905. By simultaneously buying spot for $50,905 and going short via futures, a financial entity can pocket the $3,205, or 6 percent return, over five months, given they hold these positions until the August expiry. On an annualized basis, this is a 14.4 percent yield, nearly risk-free; dramatically higher than the current one-year U.S. Treasury bond, which yields .08 percent. In addition, as the bitcoin price appreciates and becomes more volatile, there will be even fatter spreads to arbitrage through this method.
We have discussed the method by which one could arbitrage the spreads in bitcoin spots/futures, but now I’d like to illustrate how the increasing popularity of this trade will accelerate the supply suffocation already naturally occurring via Bitcoin’s…