In the next couple of weeks we’ll start sharing some live trades on the Twoquants website, i.e., trades which we have put onto our own book (broker statements will be shown to provide evidence). Those trades will be shown in a separate Twoquants report, and they’ll either be:

  1. systematic in nature and thus the result of an automated trading system;
  2. options-based, with a view of gaining long convexity exposure (most of the time at least); or
  3. otherwise grounded in the use of derivatives where we believe interesting, high risk-reward trading opportunities exist.

We want to take the opportunity of the upcoming Crypo Gathering at “the Netflix of Finance” Real Vision, to give you an idea of how we personally like to handle this volatile asset class (in addition to #hodling) by constructing a Bitcoin cash & carry trade that belongs to the third category mentioned above. Some cryptocurrencies are very similar to the wild west: rough, unregulated or similar to good old snakeoil. Some of them however, like Bitcoin, have made their way into regulated financial markets and present an interesting opportunity for traders and investors alike.

Comments and feedback are welcome as always! So, here is the trade that I have put on.

I’ve put on the trade using my own money on 22 June 2020 at 11:45 CET. Here’s what the market looked like at that point in time:

  • BTC spot price on Bitstamp: $9411
  • Jul 2020 CME Bitcoin futures (BTCN0, Expiry 31 July 2020): B $9515 / A $9525
  • Jul 2020 ICE BAKKT Bitcoin futures (BTEN0, Expiry 15 July 2020): B $9472.5 / A $9482.5

The above information allows us to compute the funding rate that’s implied in both futures contracts.

Implied Funding Rates

a) Jul 2020 CME Bitcoin futures

  • Bid futures premium to spot = $9515 / $9411 – 1 = 1.11%
  • Days to expiry = 39
  • Annualized funding rate = (1 + 1.11%) ^ (365/39) – 1 = 10.88%

b) Jul 2020 ICE BAKKT Bitcoin futures

  • Bid futures premium to spot = $9472.5 / $9411 – 1 = 0.65%
  • Days to expiry = 23
  • Annualized funding rate = (1 + 0.65%) ^ (365/23) – 1 = 10.83%

Observation #1: There’s only a small difference in implied funding rates between the two contracts (5bppa). This is good news, i.e., both contracts seem to be priced at arbitrage (at this exact point in time at least).

Observation #2: The implied funding rates are both greater than 10%! In today’s world of super-low, zero, or even negative interest rates, this is a high level – higher than the rate paid on most junk bonds. I’ll get to the possible reasons for that high interest rate in a little bid, but one thing is clear: Bitcoin is a free and decentralized market. It trades 24/7 and there’s no central bank or government interfering with (or dictating) what the level of interest should be. Thus, the implied funding rate is determined liberally among market participants.

Cash & Carry Trade

The Bitcoin cash & carry trade has two legs:

  • Leg 1: Buy spot Bitcoin (that’s the “cash” part of the trade, because we must come up with the money to buy Bitcoin).
  • Leg 2: Sell futures against the spot Bitcoin position, sized such that it hedges 100% of the spot market exposure (delta). That’s the “carry” part of the trade.

We now need to decide which futures contract we want to sell and how large we want to size the trade. The CME contract is more liquid than the ICE contract and it also offers a slightly better implied funding rate (5ppa more). However, the ICE contract allows for more granular sizing because its contract size is 1/5th of the CME contract. Note also that the CME contract is financially settled whereas the ICE contract allows for physical settlement in the BAKKT warehouse.

I decided to use the ICE contract. My decision has to do with better risk control (more on that later), the advantages of which outweigh the extra 5bppa offered by the CME contract.

Here are the details of my live trade:

  • Sell 2 lots of the Jul 2020 ICE BAKKT Bitcoin futures contract at $9482.5
  • But 2 Bitcoin on Bitstamp at $9415.35

This trade implies a gross annualized funding rate of 11.94%, which is about 1% higher than the market rates observed at 11:45 CET (see above). Why the better rate? (a) I placed a limit sell order at mid for the Jul 2020 ICE BAKKT futures and got filled, saving half of the B/O spread; (b) I got lucky with the execution on Bitstamp, where I placed an instant order (market order) right after I got filled on the futures contract. The time difference between my futures and spot transaction (a few seconds) has worked in my favor, i.e., the price of spot Bitcoin on Bitstamp dropped a bit.

Bitcoin Exchange & Futures Broker

I used Bitstamp because I have an account there since many years. Bitstamp charges 0.25% of the transaction value as a one-off fee (which is really a lot), so this is a cost that we’ll need to deduct from our trade (more on that later). You may want to use a different exchange, e.g., one with lower transaction fees, and/or custody insurance of hot wallet holdings, etc. What you’ll need though is an exchange that accepts FIAT money, since otherwise you cannot enter the trade. I tend to keep my Bitcoin holdings off exchange in a cold wallet, which is what I did in the context of this trade, too.

The carry part of my trade was done through Interactive Brokers (IB). I don’t use IB much, especially not for my futures trading, but the two FCMs which I normally use only support the CME contract and not the one listed on ICE. So, IB it was, despite the high initial margin requirements and funding spreads that IB tends to charge.

Futures Margin

The initial margin requirements for Bitcoin futures are generally high. Bitcoin is volatile and the high margin requirements are a key reason for the high implied funding rate. Margin requirements differ between FCMs and there are some that charge between 50-70% of the notional contract value, both for long and short positions, while others, IB being one of them, charge around 50-60% for a long position, but about 400% for a short position. Bitcoin may drop to zero, but it may also jump to greater than $40K. The possibility of an upside gap of that magnitude is what’s reflected by the short margin requirement. For comparison, the initial margin requirements on S&P e-minis is less than 10% of the notional contract value, both for the long and short side.

The higher the initial margin requirement we need to fund, the lower the expected PL of our cash & carry trade. In that sense the “carry” part becomes almost another “cash” part.

IB’s short initial margin requirement for 1 lot of the ICE Bitcoin contract is $40K and the maintenance margin requirement is $32K. The equity in my IB account allowed me to fund the initial margin.

The margin requirement blocks about four times more capital than the spot transaction. The spread that we are charged on that high margin requirement adversely affects our PL. A professional investor (say, a family office) will have options to mitigate this, e.g., by taking out a loan (at low FIAT interest rates) and using it to pay for the margin. There may also ways to net the margin requirement against the long spot position. In any case, I think this is a highly attractive trade for anyone with excess cash and liquidity.

Financials

Below is a quick overview of the basic trade financials:

Date
 
Fut 
ticker
 
Expiry
 
Days 
to expiry
 
Fut PX 
$
 
Spot PX 
$
 
Spread 
$
 
Spread 
%
 
Spread 
% p.a.
 
Gross PL 
until expiry $
 
Fut 
comm $
 
Margin 
req $
 
Margin funding 
spread
 
Funding charge 
to expiry $
 
Net PL  
until expiry $
 
22-Jun-20
 
BTEN0 Curncy
 
15-Jul-20
 
23
 
9,482.50
 
9,415.35
 
67.15
 
0.71%
 
11.94%
 
67.15
 
4
 
40,000
 
0.75%
 
18.90
 
44.25

If we only did this single trade, it would be a net losing trade. That’s because the 0.25% transaction fee charged by Bitstamp amounts to $117.69, which is greater than both the gross and net PL expectation. However, if we can continue with this trade at about the same implied funding rate, this one-off cost starts to become an increasingly smaller drag on our PL. Continuing will cause monthly rollover costs for the futures contract though (commission and B/O), which I estimate to be in the $110-160 range for a full year (12 rollovers).

Based on the above, a professional investor may therefore expect a net % PL in the 9-10% range, assuming cash efficient funding and/or netting of margin. My personal PL expectation is in the 5% range. I didn’t mortgage the house to improve the financials of this trade.

That said, there is no guarantee that the implied funding rate will stay where it currently is. We’ll do the trade for as long as it’s attractively priced, but we’ll stop when this is no longer the case. In fact, when the CME launched its Bitcoin futures contract in December 2017, it immediately traded in contango and implied an attractive funding rate. Subsequently, this picture changed and the curve was rather priced flat. It changed again about one year ago and since then the Bitcoin futures market is priced in an attractive contango for cash & carry trades.

Why the Contango?

The below is probably not a complete list, but the contango is likely caused by:

  • Demand for Bitcoin futures from the long side (e.g., from institutional investors who are either afraid of, or not permitted to, being long spot Bitcoin).
  • The high margin requirements for futures translate into high balance sheet costs for brokers. Those costs are reflected, in aggregate, in the forward price.
  • Not enough market participants able, or willing to, engage in cash & carry trades.

Note that the funding rate, which we see implied in forward contracts trading on Bitcoin exchanges (e.g. Deribit) is lower than those for futures. It’s around 5%. A great overview is offered by www.skew.com. Those forward contracts tend to be settled in Bitcoin rather than FIAT money (enabling margin netting on the same exchange), and the investor spectrum is presumably much less institutional than for the futures (i.e., less pressure on the long side).

Risk Considerations

Let’s start with the obvious: You need to take care of your spot Bitcoin position. If you lose your coins, leg #1 of the trade is gone, leaving you short Bitcoin futures.

The futures position will produce variation margin on each trading day. If the price of Bitcoin falls, the PL on your futures statement will be positive. On the other side, if Bitcoin rises, you’ll need to cover the variation margin to maintain the trade. This is liquidity-intensive because you either need to pre-fund your account with cash or keep liquidity on the sidelines in case your broker issues a margin call. It’s liquidity-intensive because the price of Bitcoin may indeed gap up substantially, and you need to be able to stomach such jump to stay in the trade. Selling a part of your spot Bitcoins into a rally to raise cash is likely to take too much time, i.e., your broker’s margin call will have aged and there’s a risk of your futures position getting liquidated. Selling spot Bitcoin and converting into FIAT will also result in additional costs, and you will need to sell an amount that still allows for a complete hedge via futures after the sale (needs to match).

If the price of Bitcoin rises and you continue with the trade, the notional value of your trade will become larger, as will your $ PL expectancy. Appropriate trade-sizing is important – it always is. At Twoquants we’re showing trades for an exemplary portfolio size, but traded with real money, and this is the reason why I chose the ICE contract over the CME contract. It allowed me to size the trade at two Bitcoins rather than five. Imagine Bitcoin opens at $50K tomorrow morning… The CME Bitcoin future would call you for about $40K*5 = $200K variation margin right away (assuming Bitcoin spot trades at $10K, for the sake of an easier calculation). In addition, your initial and maintenance margin requirements would increase substantially. If it’s still 4x after such a move, the requirement would jump from $200K for one short lot of CME Bitcoin futures to $1M. So, in total you’ll have to have $1.2M. That’s a real risk, so think carefully about the right position size.

That upside gap risk could be mitigated by buying OTM call options on Bitcoin, using a strike price that matches your ability to come up with short-term liquidity. Doing this will reduce the PL of this cash & carry trade though.

Finally, there’s the risk of the clearing house. But that’s a risk we take all the time, each time we trade a futures contract.

Thanks for reading and #happytrading!

PS — We’ll show how the live PL of that trade develops over time in our upcoming Twoquants reports. Meanwhile, I am looking forward to Real Vision’s Crypto Gathering which starts tomorrow, June 29.

Note that this is only an idea, not advice of any kind as pointed out in our Disclaimer.