Cointango: Are Institutional Investors Missing Risk-Free Opportunities?

Cointango Bitcoin Futures

Copper‘s latest in-depth report, Cointango: Are institutional investors missing risk-free opportunities?, explains that it is entirely possible for traders to play this contango arbitrage without getting exposed to counterparty risk, thanks to the availability of new solutions that address such concerns.

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Cointango: Are Institutional Investors Missing Risk-Free Opportunities?

The shortest path between two points is a straight line. Unfortunately, it’s unlikely that the Greek mathematician Archimedes, who is credited with this quote, had accounted for modern financial markets. Today, traders are measuring the Alpha and the Omega on the vast amounts of trading strategies and products available to them on global markets. Limited only by capital, traders have found ingenious mathematical ways to build out their outlook employing Technical Analysis and forging fundamentals in order to eke out the best return.

Cryptocurrency markets, now on the cusp of becoming mainstream as exchanges begin to float, have only added to the opportunity around the clock. But there seems to be a disconnect between the very premise of decentralised digital assets, and cryptocurrency markets on institutional-geared trading venues.

Central to the appeal of Bitcoin is its fully open-source and decentralised nature. By holding an asset that is censorshipresistant and that can only be controlled by the investor, the counterparty risk factors drop down to near zero. Today, however, cash-settled futures and Exchange Traded Products are taking priority by institutional investors trading at massive premiums. This is primarily due gross overestimation of storage and insurance costs. These premiums have rippled into futures prices leaving the door open for investors to take advantage of price discreptancies by holding ‘physical’ Bitcoin. Copper assess a traditional risk-free arbitrage trade.

Bitcoin market participants have long favoured being bulls. Evidenced by the fact that the majority of liquidations across cryptocurrency markets happen on Long positions (see chart 1). This is the preferred option by traders for multiple reasons, not limited by the fact Bitcoin is a disinflationary asset which helps traders supply/demand analysis. The ability to use leverage also means unlimited upside, unlike a short position.

Cointango Bitcoin Futures

Overleveraged positions by traders is most likely the case too. So far in 2021 alone, ‘Long’ positions have accounted for a massive 62% of liquidations. The irony is not lost on anyone that such mass liquidations have happened during a bull market.

Regardless, this permanent ‘Long’ bias has trickled down into Bitcoin’s characteristics as a financial asset on global markets, and can be seen in the pricing of forward dated futures.


Bitcoin Futures Prices Are Trading Above The Spot Price

Much like gold, Bitcoin has taken on the same expectations on commodity futures markets. Due to the prevalent belief among Bitcoin investors that the cryptoasset’s scarcity and increasing demand over time will drive further price appreciation, forward dated futures trade in Contango. This means that the futures prices are trading above the spot price. Traders and markets generally attribute this price difference to storage fees, insurance and transportation costs (see table). While some of this might apply to Bitcoin, it is in fact a negligible cost. Copper calculates the total life-cycle costs of a trade (from fiat-to-fiat) for institutions including banking, OTC, trade, delivery and custody fees to be around 1.25%.

The costs of holding and trading physical Bitcoin seems to have been overly exaggerated by institutional markets. Up until recently, Grayscale’s Bitcoin Investment Trust (OTC:GBTC) traded at a 40% premium to its Net-Asset-Value (NAV). However, since Bitcoin began to rally and supply constraints began to further grow across global exchanges, the premium unwittingly went into the negative. But is that the best exposure to Bitcoin? Grayscale’s negative premium might seem like an opportunity. Until it reverts back into high premiums, prompting risk-averse money managers to avoid the asset class in its entirety.

But traders, as mentioned at the start of this report, have figured it all out already. A classic trade that money managers used to employ regularly was the ‘Cash-and-Carry’ Trade. Such a trade would allow investors to quickly take advantage of the premiums or discounts found on spot prices against futures. However, the return and opportunity of this has been fairly small on institutional venues trading traditional assets. Especially in recent times where stock markets and hard assets are making outstanding returns.

Ironically however, the maths, as we will show, points to the fact that the world’s most volatile asset (see chart) can also serve as the risk-free trade of the decade with zero sensitivity to Bitcoin’s radical price swings.

Read the full report here by Copper


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