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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?

Bitcoin (BTC) futures on the Chicago Mercantile Exchange (CME) have been trading below the spot price of bitcoin on regular exchanges since Nov. 9, a situation technically called backwardation. While this indicates a bearish market structure, there are many factors that can cause instantaneous distortions.

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

However, a large seller of futures contracts will cause a short-term distortion in the futures premium. Unlike perpetual contracts, these fixed calendar futures do not have a funding rate, so their price can vary greatly from spot exchanges.

Aggressive sellers triggered a 5% discount on BTC futures

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

CME Bitcoin 1-month futures premium against the BTC index. Source: Trading View

Note how monthly CME futures trade near fair value, offering a 0.5% discount or 0.5% premium over spot exchanges. However, during the November 9 Bitcoin price crash, aggressive sellers of futures contracts forced CME futures to trade 5% below the normal market price.

The current 1.5% rebate remains atypical, but can be explained by contagion risks caused by the bankruptcies of FTX and Alameda Research. The group was supposedly one of the largest market makers of cryptocurrencies, so their fall should have caused a shock in all crypto-related markets.

The bankruptcy severely impacted well-known OTC offices, 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 rest of the spot market exchanges.

The absence of market makers exacerbated the negative impact

As market makers attempt to mitigate their exposure and assess counterparty risk, the potential for excessive demand for long and short positions on the CME will naturally cause distortions in the futures premium indicator.

Backwarding in contracts is a major indicator of a dysfunctional and bearish derivatives market. Such a move 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, as it is possible to buy a futures contract and simultaneously sell the same amount in the spot (or margin) markets. This is a neutral market strategy commonly known as “flip the money and carry”.

Interest of institutional investors in CME futures remains stable

Curiously, on November 10, open interest in CME Bitcoin futures reached its highest level in four months. This data measures the combined size of buyers and sellers using CME derivatives contracts.

Open interest in CME Bitcoin futures, USD. Source: Coinglass

Note that the all-time high of $5.45 billion occurred on October 26, 2021, but at that time the price of Bitcoin was around $60,000. Therefore, open interest in CME futures as of November 10, 2022 of $1.67 billion remains relevant for the number of contracts.

Connected: U.S. Cryptocurrency Exchanges Lead Massive Bitcoin Outflows With Over $1.5B In BTC Withdrawn In A Week

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 pending futures contracts is usually interpreted as new money entering the market, regardless of bias.

While this data cannot be considered optimistic on its own, it does signal that the interest of professional investors in bitcoin is not fading away.

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

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

There is certainly demand for shorts, but market makers’ lack of appetite is the main factor leading to the current distortion.