The bitcoin futures on the Chicago-based CME exchange dropped for several days into “backwardation,” a condition that arises in the commodities markets. In this scenario, the prices on near-month contracts surpass those for the further-out delivery dates.
This backwardation seems to have started in the past week and continued up to early Tuesday. At the time, this strange condition might have been seen as an indication that instant demand for the crypto was outstripping supply. Nonetheless, crypto analysts are not sure whether that interpretation holds for bitcoin.
Nathan Cox, CIO at Two Prime Digital Assets, said:
“BTC’s backwardation does not necessarily imply tighter supply conditions.”
Bitcoin’s CME-based futures backwardation on this occasion was short-lived as is normally the case. The May contract is trading at a discount to the June contract in a structure that is known as contango.
Backwardation is the downward sloping futures curve in a market scenario where front-month contracts trade at higher prices compared to the far-maturity contracts. For instance, BTC’s May expiry futures contract traded at a premium of up to $15 to the June contract early May 17, according to TradingView. At some point, the June contract drew a premium of around $55 over the July futures.
Backwardation in Oil Versus Bitcoin
“Backwardation arises from higher demand for an asset currently than the contracts maturing in the coming months through the futures market.”
Nevertheless, this definition is applicable in the oil market.in this commodity market, demand is a function of economic growth. The market mainly encounters tighter supply conditions as a result of production cuts or an abrupt increase in economic activity.
Analysts and market experts at times attribute the opposite condition, contango, to the cost incurred when storing commodities for long periods. A good point of reference is the futures market for West Texas Intermediate (WTI) crude. WTI is the primary benchmark for US oil prices.
That market was seen to plunge into backwardation in November last year, representing a supply shortage at the time, after the Organization of Petroleum Exporting Countries (OPEC) sustained production cuts. WTI prices surged from $44 in November to reach highs of $68 in March 2021. Cox said:
“Oil spot and futures markets have very different inputs into the calculation, and the oil demand outlook can be quantified much more explicitly than digital assets, which tend to be an indication of pure price expectation versus actual usage or demand.”
WTI futures that are currently listed on the New York Mercantile Exchange (NYMEX) are settled physically. Reuters noted in 2021:
“When the WTI contract expires, a quantity of the oil that previously existed only on paper is converted into physical barrels that need to be used or else stored at a major U.S. storage site.”
Nevertheless, the bitcoin futures listed on the Chicago Mercantile Exchange (CME) are cash-settled. It means that a credit or debit is issued which marks either a loss or a profit in the trading account. In that context, the buyer does not receive the real delivery of coins. This characteristic makes the CME futures more of a speculative instrument in the crypto market.
A crypto economist at Jarvis Labs, Ben Lilly, told reporters in a Telegram chat:
“Bitcoin is different than oil in that it’s mainly speculative. What we find is backwardation tends to be more predictive of a reversal or buying opportunity, especially in a bull market.”
Is Bitcoin Backwardation Bearish?
Up to now, the bullish sentiment allegedly conveyed by the recent futures backwardation has failed to translate into higher prices. Bitcoin is struggling to recover the $40,000 level after imploding to reach lows of nearly $32,000 on May 19. Cox mentioned:
“It points to the fact that future price expectations for BTC are actually lower than spot.”
Based on a statement by Gamma Point Managing Partner Rahul Rai, the backwardation in the bitcoin market is rarely a bullish sign. This condition might represent a bearish sentiment among institutions. Rai said:
“CME is a venue for them to get short BTC exposure at scale.”
The Carry Trade
Rai believes that backwardation cannot be the result of an instant supply squeeze. However, it is fueled by institutional arbitrage flow, cash and carry trades (basis trades), looking for profits from the spread that arises between the futures and spot market prices. Rai explained:
“CME is where institutions execute the short futures leg of the basis arbitrage trade, and hence there is constant selling pressure coming from funds running the cash and carry trade at scale.”
A cash and carry method features selling a futures contract against a long position in the spot market. In that manner, fund houses pocket a constant return, as the premium decays over time and then converges to meet with the spot price on the set expiry date.
Carry traders mainly execute the short futures leg in far-month contracts, providing investors with higher premiums than near ones. In that context, they end up pushing the premium on far-month contracts lower.
Another component that is known to make the CME futures vulnerable to the backwardation process is the low retail participation. Despite the huge lot size, this exchange gives significantly low leverage compared to its unregulated peers, like Binance. Rai concluded:
“As CME futures have a minimum trade size of five contracts, i.e., 5 BTC, (micro futures only just launched) retail leverage seeking flow, that typically bids up futures over the spot and widens the basis, has primarily been on centralized exchanges rather than CME.”
On his part, Cox had this to say:
“Bitcoin markets statistically spend less than 10% of their time in backwardation.”