By Keith Black, PhD, CFA, CAIA, FDP, Managing Director of Content Strategy, CAIA Association In February 2020, IPE asked whether the $200 billion cryptocurrency market was of interest to institutional investors. While the premise was tempting, few institutions made the allocation, due to challenges and uncertainty in custody while questioning whether Bitcoin is a currency, an asset, a commodity, a store of value, or something of highly uncertain value. Investors also seem spooked by the idea of zero-yielding assets, especially because Bitcoin may be compared to commodities but has no tangible form easily accessed from a trusted, centralized institution. Fast forward to March of 2021, Bitcoin is trading at over $53,000 and the cryptocurrency market cap exceeds $1.6 trillion. While there is ample evidence that corporate treasuries and institutional investors are initiating holdings in cryptocurrencies, a JPMorgan survey notes that 78% of institutional investors are still not planning to allocate to the sector. Futures and options contracts, as well as a potential ETF vehicle, may offer the structural changes that accelerate institutional participation in the market. In May 2020, Bitwise made “The Case for Crypto in an Institutional Portfolio.” While the volatility of Bitcoin is legendary, Bitwise demonstrated how that volatility works for investors. Since 2014, those who added 2.5% Bitcoin to a 60/40 portfolio and rebalanced quarterly earned an additional 2.3% annual return while increasing standard deviation by just 0.2% and maximum drawdown by less than 1%. Of course, Bitwise notes the March 30, 2020 price of Bitcoin as $6,479. While some investors are just getting their heads around how Bitcoin works, up comes Ethereum and the rest of the decentralized finance (DeFi) world. DeFi projects have moved from $1 billion invested in June 2020 to over $41 billion invested today, known as the total value locked. While cryptocurrencies previously did not earn a yield, investors can now earn annual payment-in-kind interest rates of 1.9% to 7.4% while continuing to hold positions in cryptocurrencies. These yields are paid by borrowers who take loans in US dollars or another fiat currency collateralized by their holdings in cryptocurrencies. While some are taking cryptocurrency-backed loans to leverage their holdings in the space, others may be seeking to defer the substantial capital gains tax that will be owed when the massive gains of the last three years are realized. Many of the new crypto projects are financed with the profits, either realized or borrowed, earned by investors in the exponentially increasing prices of BTC and ETH in recent years. For the many institutional investors who may be uncomfortable with crypto hardware wallets and decentralized exchanges, their first steps into the asset class are likely to be with a centralized counterparty, such as Fidelity Digital Assets or the CME Group. The CME Group listed futures on Bitcoin in December 2017, options on Bitcoin in November 2019, and futures on Ethereum in February 2021. Who are the likely buyers and sellers of crypto derivatives at the CME Group? Futures and options can be used in a variety of ways, including hedging, speculation, and a start of a long-term investment program. Natural sellers of futures and call options or buyers of put options include market participants who naturally have long positions in cryptocurrencies. An extraordinarily popular trade saw the Grayscale Bitcoin Trust (GBTC) increase AUM by over $17 billion in 2020, as investors were able to buy nontrading shares of the trust at NAV in the hopes of selling them as trading shares six to twelve months later at a premium to NAV. While GBTC is currently trading at a discount to the market price of the trust’s BTC holdings, a premium of 10% to 40% persisted through most of 2020. Investors who owned the nontraded shares of GBTC with a lockup period of six to twelve months could have sold CME BTC futures to hedge the BTC price risk while hoping to lock in the NAV premium they hoped to earn. Other natural sellers of cryptocurrency price risk are miners who deploy large-scale server farms to solve cryptographic puzzles to manage the BTC network and earn rewards of BTC for their services. This brings us to the natural buyers of BTC and ETH futures at CME. Those would be institutional investors, our friends and CAIA members who invest on behalf of pensions, endowments, foundations, and sovereign wealth funds. One potential barrier to institutional investment may be a lack of knowledge or comfort with topics required for direct investment in cryptocurrency, such as hardware wallets, decentralized exchanges, and private keys. However, knowledge of direct investing in crypto is not required for investors to make an allocation to long positions in BTC and ETH futures to participate in the growth of the crypto asset class. Many of these investors already have accounts at CME to trade interest rate, commodity, and fixed income derivatives products, so cash settled futures contracts on cryptocurrency are simply an additional asset class to be added to their derivatives portfolio with preexisting accounts and relationships. One BTC futures contract at CME is denominated as 5 BTC with a current underlying value of $250,000 and a margin of around $100,000. This compares to the S&P 500 E-mini contract with an underlying value of $200,000 (50 SPX) and a margin of $11,000. Note that the margins imply that BTC volatility is expected to be much larger than that of the S&P 500. Options add even more strategies, as investors can buy puts to ensure against declines in the value of their crypto holdings or sell calls to enhance their yield. Those who worry about the downside risk in crypto may be hesitant to buy futures but may access returns of cryptocurrencies through the purchase of call options where the maximum loss is the premium paid for the options. While many market participants would like to have access to a Bitcoin ETF, the SEC has denied all previous applications of physical Bitcoin-based ETFs due to concerns over custody issues and potential manipulation in the underlying decentralized Bitcoin market. However, there is a precedent for futures-based ETFs, such as the 73 listed here, many of which use CME or Cboe-listed commodity and volatility futures as their underlying. Using the CME Bitcoin futures as the underlying, the NYDIG Bitcoin Strategy fund is the latest to seek SEC approval for a Bitcoin ETF. Perhaps the SEC will approve ETFs based on Bitcoin futures, as products traded on the CFTC-regulated CME Group may alleviate concerns about custody and market manipulation issues. Life moves pretty quickly in the land of crypto and DeFi. In just the last year, the value of the asset class has increased by 8x and corporations like MicroStrategy and Tesla added BTC to their corporate treasury. In addition, investors can now earn yield on their currencies through DeFi and have worry-free custody or synthetic exposure through centralized counterparties like Gemini, Coinbase, Fidelity, and CME.
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