Trading and investments in cryptocurrencies have gained significant momentum during the last couple of years. Cryptocurrency investors are largely exposed to extreme price volatility in the spot market. Prior to the introduction of cryptocurrency futures, traders and investors had limited means to short sell the cryptocurrency for hedging against sudden decrease in prices.
The introduction of bitcoin futures on global exchanges such as the Chicago Mercantile Exchange (CME) and more recently The Intercontinental Exchange (ICE) (through Bakkt) has changed the dynamics of the global cryptocurrency markets. Individual traders and investors including large financial institutions are increasingly hedging to mitigate price risk effectively and efficiently using crypto currency futures on global exchanges. Price risk management and hedging are some of the core requirements under Islamic finance principles.
Review of 2019
Trading volume of futures and options (F&O) contracts on international exchanges increased from 14.9 billion contracts in the first half of 2018 to 16.5 billion contracts in the first six months of 2019 – an increase of over 11%. On the other hand, trading volume on CME bitcoin futures has increased by a whopping 93.6% from 710,000 contracts (January–October 2018) to 1.4 million contracts (January–October 2019). The average daily volume (ADV) has also increased during the same period from 3,400 contracts to 6,583 contracts per day. This clearly indicates increasing acceptance of the CME bitcoin futures by market participants as a hedging instrument.
Increasing global demand for bitcoin resulted in its price increasing from US$964 on the 1st January 2017 to peak at US$19,783 on the 18th December 2017 – an increase of over 20 times in a short span of 12 months. As of the 5th November 2019, bitcoin prices are trading at US$9,400. Daily bitcoin prices have changed by more than 10% on 23 trading days during calendar year 2017 as compared to 19 times in 2018 and only 11 times in the January-October 2019 period.
This highlights the potential for futures to decrease volatility in the underlying asset’s spot prices. Futures trading has been instrumental in building the future price curve and streamlining the volatility in the underlying asset prices thus fulfilling an important requirement from Islamic finance perspective.
Hedgers can greatly benefit by adopting a stack and roll hedge mechanism whereby the positions in the near-month futures is rolled over as the contract maturity date approaches. Basis risk (difference between the spot and futures prices) is largely decreased by the unique methodology adopted for determine the daily bitcoin reference rate at 4 PM London time, which is also the final settlement price for the CME bitcoin futures. The remarkable success of the CME bitcoin futures has resulted in a substantial increase in the maximum permissible open position limit from 1,000 lots to 2,000 lots (net position).
Preview of 2020
CME has already announced the launch of options contract on bitcoin futures in the year 2020. This shall further benefit market participants who would be able to better manage their bitcoin risk exposure. ICE’s Bakkt has also announced the launch of options on bitcoin futures in December 2019. An investor in bitcoin in the spot market can buy put options to mitigate risk of decreasing bitcoin prices. Blockchain technology is being increasingly adopted by Middle Eastern and Asian companies – this would herald a technology revolution in the years ahead. This can enable financial institutions to develop Shariah compliant products offering price risk management and enabling traceability and asset ownership on real-time basis,
Bitcoin futures provide traders and investors an opportunity to effectively and efficiently mitigate price risk with a globally renowned exchanges such as CME or ICE. The price drivers of cryptocurrencies are unlike that of a typical free-float currency whose volatility is largely driven by macroeconomic factors, interest rates, trade balance, demand and supply for the currency from importers and exporters, foreign currency remittance, foreign investments entering and exiting the country, capital account convertibility, central bank regulations, etc.
Price volatility of cryptocurrencies is extremely high due to its unique set of price drivers that include its technology framework on which it has been designed, blockchain mining process (which involves validating blockchain transactions to earn cryptocurrency using processing power of computers on global network), regulatory restrictions by central bankers on trading and investments in cryptocurrencies, security of cryptocurrency exchange vaults, demand for cryptocurrency as an asset class for both trading and investment among others.
The global cryptocurrency markets are in a relatively nascent stage of development. Nevertheless, the blockchain technology framework provides significant benefits for the overall global financial ecosystem and its stakeholders. Transactions are executed seamlessly across national borders without the inherent intermediate costs charged by financial institutions in the global currency market transactions. This is the right time for Islamic financial institutions to get involved in this asset class and underlying blockchain technology. It offers immense benefits and customers seeking Shariah compliant solutions should not be left out from its purview.