Contango Deep Dive
We hope everyone’s weekend went well. On this pleasant Sunday evening let’s have light session of Contango before we head into the week. 💃
To understand any system we need to understand inputs and outputs. For example, if we want to understand how a car moves forward by the engine (the output), then we need to understand how gasoline, the combustion engine, axels, and wheels work (the inputs). Similarly, if we want to understand the the price of bitcoin (the output) then we need to understand what entities like miners, retail, high net worth individuals, family offices, corporations, investment banks, sovereign wealth funds, and nation states doing as it relates to is buying, selling, and hodling the supply of bitcoin (the outputs).
As a simplistic example, if for some reason miners decided to flood the market with their 1M bitcoin tonight (the input) then this would dramatically lower the price of bitcoin (the output). Or, if a top 5 GDP nation state decided to purchase $1T of bitcoin over the next 3 months to put into their treasury (the input) this would dramatically increase the price of bitcoin (the output).
Today, we’re going focus the behavior and incentives for two of the major inputs to bitcoin price - investment banks and hedge funds. These investment firms collectively control tens of trillions of dollars worldwide. So, with bitcoin only being worth $1T both of these entities have a lot of power to move the price of bitcoin.
Now, let’s talk Contango 💃.
What caught our eye this week was a conversation happening with a few bitcoin legends: Willy Woo, PlanB, and Preston Pysh. They discussed that investment firms are beginning to take bitcoin off the market (via purchasing) so that they can sell futures contracts for a higher price than the price today (spot price). Upon completion buying bitcoin and selling a contract, the firms pick up an immediate 10-20% "risk free” return for the premium to sell the contract. After completing this 10-20% gain that they lock in immediately, the firms will then go buy more bitcoin to complete more trades. Plan B noted that he can do this whenever he wants at his current trading desk. (The Bitcoin futures market is in “contango”. YouTube has resources to explain this word in greater depth if feeling inclined.)
TLDR: Firms with trillions of dollars are accelerating their participation in the futures market. Specifically, they lock up bitcoin, sell a futures contract, get 10-20% instant annualized return, rinse and repeat (as fast as they can).
Why is this important?
Investment firms are incentivized to get yield. Due to low global interest rates, yield is very difficult to come by. For example, most government bonds, corporate bonds, and corporate dividends are at historical lows. For example, most government bonds are 0 or even negative. So the normal games that investment firms do to get interest rates through bonds and corporate dividends are currently on pause. Meanwhile, these firms have cash in the trillions sitting on the sidelines is getting inflated away as governments print trillions of dollars to prop up global economies.
So, what’s next? They look over at the bitcoin futures market and see 10-20% annualized yields that can be captured instantly through buying bitcoin and selling futures contracts. The money sitting on the sidelines is then funneled into purchasing bitcoin, taking it off the market, shocking supply, and sending the price of bitcoin up. See beautiful graphs below.
Step 1 - Look to see 10-20% returns exist in the Bitcoin Futures Market
Above we can see that they yield for buying bitcoin and trading a futures contract is 10-20%
Step 2 - Buy bitcoin and move it off an exchange in order to sell the futures
Hedge funds (others) are taking coins off of the exchanges.
Step 3 - Sell the futures
Open interest in the futures market rises parabolically.