// #Economics
The Hell Money Podcast had a great ep on financial instruments and how they intersect with bitcoin. Specifically, futures, which is something I have managed to not learn about for a long time. I did a quick refresh on debt-based instruments, which generally make more sense to me since it is clearly a “win win” scenario for both parties. A borrower with high time preference gets money now, a lender with low time preference gets some interest to part with their funds for a bit. Temporal arbitrage.
For some reason, off-the-cuff, a futures market feels a little more degenerate gambling-y than a loan. And while both a loan and a futures contract involve a promise from a party to pay in the future, futures feel sketchier. Like, what if they lose big and decide to just not pay?
But taking a look at the basics of a futures contract, it is another “win win”. The standard use case is a producer and a consumer. The producer produces some commodity which the consumer consumes to create a product which they sell. In this scenario, the consumer’s profit largely depends on the price of the commodity. If the commodity’s price is fluctuating wildly, they could be making bank or going bankrupt since they want to hold the price of their product relatively stable. So rather than worrying about this market which they have no control over, they enter into a contract with the producer to pay a set price in a year for the commodity. If the commodity’s price goes down, they technically lose money, but it is worth it to them to spend energy else where. If the commodity’s price goes up, they are protected and the producer loses money since they would have made more selling at the market’s spot price.
It ain’t all bad for the producer though. They too are protected from the volatile market. They are willing to enter the futures contract to ensure they will make at least some money from their harvest, even if the commodity’s price plummets in a year. If the commodity’s price shoots up, they lose out on what they would have made on the spot price, but worth it to ensure a next year.
For some terminology, the agree’d upon price the commodity will be sold at in a futures contract is called the forward price (vs. the spot price of the market at that time). The producer shorts the contract and the consumer goes long. Those words will make more sense in a second.
So this sounds very little like gambling and much more about long term stability. A way for both sides to hedge their costs. But so far, the contract involves a commodity which both parties are interested in. This is not a requirement to participate in a futures market.
If you think the price of a commodity is going to go down in a year, you could enter a futures contract in the short position. You think the future spot price will be lower than the forward price. When the contract expires, if the spot price is under the forward price, you win! You can buy the commodity on the market and then sell it to the futures contract counterparty at the forward price. But if the spot price is over the forward price, you lose! You are forced to “buy high, sell low” and lose the difference.
Futures don’t have to actually move the amount of the commodity, they can be cash settled. So you don’t have to touch the commodity to speculate on the future price. Taking it further, broker’s might allow you to take on a futures contract with just putting down a small fraction of the contract’s value, a margin. So you can become highly leveraged which opens the door to being totally wiped out if things go south. For example, you enter multiple futures contracts in the short position and only put small margins in on each, highly leveraging your wealth. The contracts expire, the spot price is way over the forward price, and you owe a lot of money.
For a short there is theoretically no worst case, the spot price can just keep going up and you will have to pay the difference between the spot and the forward price. If you take the long position, you think the price is going to go up. When the contract expires you buy at the forward price and can turn around and sell at the spot price. At least there is a worst case in this scenario, the spot price goes to 0 and you are left with some commodity to deal with.
This is sounding a little more gamble-y. A short position has gone from “at least I make this much money no matter what” to “there is a chance I lose everything”. However, it does create a forward price market which is a signal to others in the market. The futures contract is a derivative since its value is derived from its underlying commodity, but not 100% tied to it.
So how does bitcoin get involved? Bitcoin miners are kinda the perfect example. They are essentially a “producer” of bitcoin, but their operating costs are probably in dollars (e.g. energy costs, infrastructure upkeep). They might be willing to short bitcoin in order to lock in a sell price in the future. And this might give miners more confidence to invest more into the business.
An interesting point is made in the Hell Money ep, bitcoin might actually create a more stable and transparent market because bitcoin can actually settle almost instantly. Where other markets can easily become highly leveraged since its a pain to settle, which leads to possibly massive consequences if things unwind, the bad bitcoin-based bets are flushed in smaller increments more frequently.
