The Basis Trade in Bitcoin

The basis trade in crypto isn’t all it’s cracked up to be on paper, according to David Mercer, CEO, LMAX Group.

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David Mercer, CEO, LMAX Group

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key takeaways

  • The basis trade involves buying a commodity at spot (taking a long position) and simultaneously establishing a short position through derivatives like options or futures contracts
  • In mature, liquid markets, practically every single trader, hedge fund, and associated high frequency trading algorithm constantly searches for basis trade opportunities and capitalizes on them

Crypto markets have come a long way. Back in the days of Mt. Gox being the biggest exchange, few with significant capital to put to work would ever have dared to dream of risking a single penny in bitcoin. And that’s assuming they even knew it existed.

Needless to say, things have changed quite a bit. The epic rise of bitcoin in 2017 – 2018 and the ICO mania that accompanied that rally brought crypto into the general public awareness for the first time.

The ensuing bear market or “crypto winter” then resulted in many losing all interest. It was a fun ride, but the party had ended. Crypto was a cool fad that had run its course.

A few keen market observers saw the potential this new asset class had, however. Some of them founded companies or built out new divisions of existing companies to serve market needs that would soon come to fruition.

In the first half of 2021, bitcoin and crypto markets find themselves at a crucial inflection point. With a market cap and liquidity that may have seemed unbelievable just a few years ago, crypto still pales in comparison to major capital markets. Liquidity is thin for big institutions, who also lack market access and often must expose themselves to significant credit risk just to dip their toes in the market.

Still, many are interested and some are already participating. Not only because of the appeal of the asset class itself, but due to trading opportunities that don’t exist elsewhere. Some have risk/reward ratios that are too attractive to ignore. Perhaps the most significant of these is what’s referred to as the basis trade in bitcoin.

The basis trade explained

The basis trade involves buying a commodity at spot (taking a long position) and simultaneously establishing a short position through derivatives like options or futures contracts. At some point, the two will converge, at which point a profit will be realized.

The risk is virtually zero, and the profit almost guaranteed.

Sounds too good to be true, right?

In a way, it is.

In mature, liquid markets, practically every single trader, hedge fund, and associated high frequency trading algorithm constantly searches for basis trade opportunities and capitalizes on them. That crowding narrows the spread between the spot and futures prices, reducing the profit potential that can be realized from this strategy.

Of course, crypto markets are not the most mature or liquid.

For more on the nature of the basis trade when it comes to crypto markets, we spoke with David Mercer, CEO of LMAX Group, which operates LMAX Digital, the number one institutional exchange for bitcoin in the world and the second-largest overall by volume. (LMAX Digital works with institutional clients only.)

“FX trades $7 trillion a day. The entire market cap of bitcoin is $1 trillion,” noted Mercer.

The relative lack of liquidity and market access (more on that later) in crypto leads to a market condition known as “contango” when the futures price trades at a premium to spot. Mercer described it this way:

“Typically, bitcoin trades in what we call contango ­– the futures price is well above the spot price. In commodities markets, typically that’s because you have to store the asset, you have to deliver the asset, hence why the futures price is higher than the spot price, because you have all those fees to add onto the spot price…the opposite is backwardation, where the futures trade below the spot.”

However, the basis trade in crypto isn’t all it’s cracked up to be on paper. While Mercer noted that the futures price in bitcoin often trades at prices as much as 20% to 30% above spot, that doesn’t reflect the actual profit potential of the basis trade in bitcoin:

“A large proportion of that yield is actually eaten up by credit risk.”

Credit risk for banks

This brings us to the next point, which involves credit risk for banks dabbling in the bitcoin market.

Why is the futures price for bitcoin so high? This is a factor that could change soon, as big market players are expected to gain the access and liquidity they need in the near future. This will, of course, dampen the appeal of the basis trade in bitcoin.

“The futures price is satisfying the relentless demand for crypto exposure. There’s not enough fiat…it’s very hard to get the requisite amount of fiat into the system to buy the spot on a non-leveraged basis,” Mercer noted.

In addition, the issue grows even more complicated by the use of stablecoins:

“A lot of the futures market isn’t fiat, it’s actually stablecoins…those stablecoins actually fragment dollar liquidity even more.”

This combination contributes to the dramatic and persistent condition of contango. As these factors change, so too could the spread between futures and spot.

Crypto markets grow up fast

While it has taken 12 years to get to the level of adoption we see today, current market inefficiencies could be stamped out in the near future. Mercer predicts that by 2023, the current contango in bitcoin will be much less pronounced:

“I expect the contango in bitcoin to compress in short order, between the next six and 24 months.”

While that’s generally considered a long time in the crypto world, it signals how rapidly the market has begun to mature. Consider the fact that just a year ago, few in the traditional investment community took bitcoin seriously. Its market cap was under $200 billion, while today that has risen to over $1 trillion.

Now we’re talking about the market approaching a level of liquidity and efficiency that, within the next few years, will rival its mainstream capital market competitors.

Mercer seems to have little doubt that bitcoin is well on its way to becoming accepted as a mainstream store of value or medium of exchange:

“As bitcoin becomes an accepted asset or currency, the market will become more efficient and more liquid.”

At that point, traders might look to other, less mature tokens to continue the basis trade in crypto.

“Perhaps that contango will move onto other tokens,” like Ethereum, for example, which is the second-largest crypto by market cap and also has a futures market as of early 2021.

The basis trade in bitcoin could be going away soon, and that’s a good sign for the market.

Providing market access

As the number one institutional exchange for bitcoin in the world, LMAX Digital has a key role to play in helping the bitcoin market grow. Institutions trade bitcoin using LMAX Digital because they know the platform and they trust the infrastructure. When asked how the exchange could serve customers looking to enter the market, Mercer said, “It’s trust and technology.”

There’s not much the exchange can’t do when it comes to crypto or markets in general, he said. “You name it, in terms of market access, we can provide it.”

While retail exchanges have a bad habit of crashing during times of peak market activity, LMAX Digital does not. “We haven’t had a down millisecond for seven years.”

Sometimes called the “best kept secret in crypto,” three-year-old LMAX Digital provides an easy and reliable way for institutions to get the crypto exposure they crave.

Today, LMAX has traded More than $400 billion of cryptocurrencies since launch in 2018 with 50 million trades completed in last year alone, and 450 institutional investors now trading on LMAX Digital globally.

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