Historically, derivatives have acted as both a boon and a bane for financial markets. It allows for robust price discovery i.e. the price market participants value an asset at, but it also fuels leverage-enabled products like mortgage-backed securities that have crashed the global economy. Bitcoin price discovery is currently very opaque, but the introduction of institutional derivatives is sure to have a profound effect on the market.
At the end of the day, most derivative products are actually looking to tackle the same set of problems. These products are designed to enable price discovery on assets by gauging market sentiment and future outlook.
There are two types of price action in the futures market: contango and backwardation. The former is when the monthly expiry price is forecasted to increase month after month, while the latter is when the monthly expiry is at a lower rate with each consecutive month. At the heart of it, this is how basic sentiment is gauged in traditional markets as it indicates where institutions think prices are heading.
When it comes to Bitcoin, the equation seems a lot more complex. In reality, it is actually much easier to comprehend. Bitcoin is purely a price-enabled asset with no cash flows. The method of valuing its future price is completely based on the forecasted future utility of holding it.
The Bitcoin price in the derivatives market is usually at least a few pips off from the spot market. This is because spot order books are relatively easier to manipulate.
Now that the Bitcoin market has both cash and physically settled futures, it will be a lot easier to determine the fair market value of the asset. Of course, quantifying Bitcoin’s value is an incredibly difficult process, completely independent of the Bitcoin price. However, this quantifiable figure of value set by the market is, at the very least, a psychological standpoint for what people are willing to pay for one Bitcoin.
You might be reading this and thinking “why does the market need price discovery”? For starters, as previously established, it allows us to understand what people are willing to pay for a single coin.
It also helps spot undervalued and overvalued markets to take advantage of said situation through relatively simple derivative strategies.
Institutions and merchants that are using Bitcoin as a payment processor are receiving and sending money with Bitcoin. For them, price discovery is incredibly important for assessing their hedging strategy. In some cases, the costs of a hedge may not be worth undertaking if Bitcoin is received at a fair market value.
There are many bouts of manipulation and wash trading that occur across exchanges in the entire ecosystem. Physically settled futures are relatively difficult to manipulate and hence lead to price discovery on these markets being favoured over the rest.
In the end, the Bitcoin price is a function of underlying utility, just as we can see in gold markets. Price discovery is important to determine the going rate, and will continue to be. Bakkt is a net positive for Bitcoin.