CME Bitcoin futures are trading at a discount, but is that a good thing or a bad thing?

CME Bitcoin futures are trading at a discount, but is that a good thing or a bad thing?

Chicago Mercantile Exchange (CME) Bitcoin (BTC) futures have been trading below Bitcoin’s spot price on regular exchanges since November 9, a situation technically referred to as backwardation. Although it points to a bearish market structure, there are several factors that can cause momentary distortions.

Typically, these CME holiday month contracts trade at a slight premium, indicating that sellers are asking for more money to hold off settlement for longer. As a result, futures should trade at a premium of 0.5% to 2% in healthy markets, a situation known as contango.

However, a prominent futures contract seller will cause a short-term distortion in the futures premium. Unlike perpetual contracts, these fixed-calendar futures do not have a financing rate, so the price can deviate widely from spot exchanges.

Aggressive sellers caused a 5% discount on BTC futures

When there is aggressive activity from shorts (sellers), the two-month futures contract will trade at a discount of 2% or higher.

CME Bitcoin 1-Month Futures Premium vs. BTC Index. Source: TradingView

Note how 1-month CME futures had traded close to fair value, either at a 0.5% discount or a 0.5% premium versus spot exchanges. But during the November 9 Bitcoin price crash, aggressive futures contract sellers caused CME futures to trade 5% below the regular market price.

The current discount of 1.5% remains atypical, but it can be explained by the contagion risk caused by FTX and the Alameda Research bankruptcy. The group was supposedly one of the biggest market makers in cryptocurrencies, so their demise was bound to send shockwaves through all crypto-related markets.

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The bankruptcy has severely affected prominent over-the-counter desks, investment funds and lending services, including Genesis, BlockFi and Galois Capital. As a result, traders should expect less arbitrage activity between CME futures and the remaining spot market exchanges.

The lack of market players worsened the negative effect

As market participants try to reduce exposure and assess counterparty risk, any excessive demand for longs and shorts at the CME will naturally lead to distortions in the futures premium indicator.

The reversal in contracts is the primary indicator of a dysfunctional and bearish derivatives market. Such a movement can occur during liquidation orders or when large players decide to short the market using derivatives. This is especially true when open interest increases because new positions are created under these unusual circumstances.

On the other hand, an excessive discount will create an arbitrage opportunity because one can buy the futures contract at the same time as selling the same amount in spot (or margin) markets. This is a neutral market strategy, often known as ‘reverse cash and carry’.

Institutional investors’ interest in CME futures remains stable

Curiously, the CME Bitcoin futures open interest hit a four-month high on November 10. This data measures the aggregate size of buyers and sellers using CME’s derivatives contracts.

CME Bitcoin futures open rate, USD. Source: Coinglass

Note that the record high of $5.45 billion happened on October 26, 2021, but Bitcoin’s price was close to $60,000 then. Accordingly, CME futures open interest of $1.67 billion on November 10, 2022 remains relevant in the number of contracts.

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Traders often use open interest as an indicator to confirm trends or at least the appetite of institutional investors. For example, an increasing number of outstanding futures contracts is usually interpreted as new money entering the market, regardless of the bias.

While this data cannot be considered bullish on a stand-alone basis, it signals that professional investors’ interest in Bitcoin is not waning.

As further evidence, note that the open interest chart above shows that savvy investors did not reduce their positions using Bitcoin derivatives, regardless of what critics have said about cryptocurrencies.

Given the uncertainty surrounding cryptocurrency markets, traders should not assume that a 1.5% discount on CME futures indicates long-term bearishness.

There is undoubtedly a demand for shorts, but the lack of appetite from market makers is the primary factor leading to the current distortion.