In recent times I've been having a closer look at the futures markets and how they work.

With the opening of the new BTC futures product I've had a number of people ask me what implications this has so I've decided to make this post to discuss a few of the fundamentals before I talk about the specifics of the BTC futures products. The reason this is part of the monetary policy series is that some of the commodities that trade on the futures markets are de-facto treated as monetary items, we see this with things like Gold and I think we are increasingly seeing this with cryptocurrencies such as BTC. But that aside all commodities have an important impact on monetary policy because of the ways in which they interact with things like inflation/deflation and the broader cost of living and manufacturing, topics which are all very important to monetary policy as a whole.

My claim in this article is that futures markets can bring prices down. This is sometimes a good thing but other times this can be a bad symptom of market manipulations and outright market failure. Being able to clearly differentiate these two situations is important to understand not just the current futures market but how such a market should be structured.

Why do futures markets exist?

I think a good starting point to talk about the futures markets is to go over some of the history of why futures markets exist and what value they can provide?

Let's say I'm a manufacturer of a particular commodity product I have a number of factors that I much consider when deciding on my production plans for any given year.

I'll need to do things like hire people and potentially buy machinery, there's a number of costs that I have to front up before I can make some useful things that the world wants. From the perspective of a producer there's quite a bit of risk here, you need to ensure that you have enough money when you sell whatever you are making to cover those costs.

What the futures markets allow me to do as a producer is that I can promise that at some future date I can deliver my products to the futures market. In return for that I can open a short position on the futures market. The way this works is that if someone else buys the long position I get to hedge the risk for fluctuating prices. If the price goes up then the commodity can be sold for more but the futures contract will take a loss. If the price goes down then the commodity will be sold for less but the short contract will be sold for more.

If I couldn't hedge somehow I'd have to charge more to make up for the risks I'd be taking on. Eventually if there's enough risks it might not be profitable to make these things at all.

In some senses the reason futures markets have stayed around is that there are potential benefits to everyone by allowing producers of commodities to be able to hedge some of their financial risks.

The decreases in commodity prices that come from better insurance against risk are a good thing. There are unfortunately some major downsides for producers in the modern commodity futures markets due to the specifics of how these modern markets operate.

How can prices be artificially manipulated?

If you spend any amount of time researching modern commodities futures you'll see a lot of references about price manipulations. Even in pop culture you have movies like Trading Places, where manipulating the commodities market was a central part of the plot. The interesting bit being that the particular type of insider trading depicted in that movie wasn't even illegal at the time, and when the laws changed to specifically criminalize the behavior depicted in the movie people referred to it as "The Eddie Murphy Rule". But how do manipulations occur in practice in the modern commodities futures markets?

Perhaps the most insidious way in which prices can be manipulated is via the ability for non-producers to sell short positions on the futures market.

Consider the following situation, you sell a commodity and lets call this for the sake of the example widgets. Like all other commodities there's some natural scarcity to these and there's some production costs. What might seem like a somewhat pedantic rule ends up creating enormous structural differences to the operation of the market.

Let's say the average global production of widgets is 1,000 a year and you are producing 200 of them. There's a demand each year of around 1,000 so everything works out rather well in terms of supply and demand matching. In an average year this means that people can buy futures contracts and roughly speaking they clear each year. The exchange has some storage for these in case there's a bit of a difference or some direct liquidity is needed but for the most part participants know that if they buy a futures contract it's good for delivery if needed.

Now let's say that the market allows non-producers to sell short futures contracts. This is a situation which is called "Naked shorting", where companies are selling the short contract without the underlying product.

Let's come back to that example again, say 1,000 widgets are made a year but now some naked shorts are being sold, say 200 short contracts are made without backing, now there's 1,200 contracts going around. If everyone demanded delivery it would now maybe not be possible depending on how much was in the storage of the exchange. As long as there's no "run on the bank" so to speak this sort of situation could persist for quite some time, but it starts to introduce some distortions. If a futures contract is good for delivery then "supply" now looks like it has grown by 20%, but in reality no new supply might actually be brought onto the market. If the naked contracts aren't too numerous and liquidity is good this situation could persist for quite some time. However these naked shorts start to change the structure of the futures markets rather dramatically.

This isn't a great situation for the producers, as the market you are creating the commodities for now starts to look a lot less scarce than it really is. It is still feasible when people have faith in the market to be able to deliver those futures contracts.

But what happens when you start to get vastly more naked shorts than real producer backed shorts on the market?

Let's go back to the widget example, if there's 1,000 produced each year and other market participants make 5,000 naked shorts then you quickly get a situation whereby the naked shorts make up most of the volume. This turns into a much more unstable situation since any big delivery demand will start to see failures quickly. In these cases the markets might be tempted to start introducing changes that allow them to force the settlement of futures contracts in cash. This might seem like a small change but it's not, if the settlement can be forced to be in cash the instrument starts to act a lot more like a contract for difference rather than a futures contract. Where it gets even weirder is if the general investing public doesn't have a good understanding of the ratios of real deliverable stock to these naked contracts. That gap creates a situation where there can be a very substantial difference in what prices for delivery are vs the futures prices. This can then impact the spot price of the commodities themselves.

Let's say you have a situation where the number of naked contracts completely blows out, there's 1,000 widgets made a year but 1,000,000 naked contracts. In this case as a producer of a scarce commodity you start to be supplying real products that have scarcity to this huge market. This huge market of supposedly "good for delivery" contracts can then make your scarce commodity look a whole lot scarce which then puts downwards pressure on the prices of the commodity you are making. Also then people who want to actually get delivery of the commodity can start to then question if they'll actually get it. There's this game theoretic inflection point that comes about where actual industrial demand starts to go directly to the producers rather than the futures market. If you put yourself in the shoes of someone who needs the actual commodities as part of their supply chain you will set things up such that you get real deliveries. If I'm making electronics for example I most certainly do not want to have my futures contracts settled in cash in lieu of delivery, I'll even pay a premium to make sure I get the goods I need delivered because they are non-substitutable. If settlement were to be made in cash then the cash would just have to be used to source those commodities from somewhere else anyway. If cash settlement becomes too likely it doesn't make any sense to engage in the futures market at all if you need the actual commodities delivered to you.

Eventually when the futures market has overwhelmingly more contracts than actual underlying commodities the entire nature of the markets changes to be a pure paper market. This means that market participants tend to not take delivery and in more extreme cases either avoid delivering the commodities or discourage people from doing so. Some markets allow for delivery and some even explicitly ban it and force cash settlement only. To the average person this starts to expose a rather large disconnect when they ask "hey wasn't this market supposed to actually trade in commodities? I mean the real stuff?". This disconnect is important as well because many people in the real world who trade real commodities find that what happens on the futures market impacts the pricing more broadly. So when the futures market that is supposed to trade in these commodities stops actually trading in them and instead just trades around paper people can start to question why it is that they are actually setting any of their prices on what is really just a paper based derivatives only market.

I fully expect the BTC futures market to be dysfunctional due to this precise dynamic. As such as an investor I would not recommend having anything to do with it. There are minimal costs of carry for BTC so engaging in the futures market for the vast majority of people is a terrible idea, just buy the underlying asset and stay away from this whole mess of a system.

How can this be fixed?

I think there's very real economic value in the futures markets provided they operate as real markets. The more these markets become paper only markets the more chance they have to become detached from the reality of the situation with those commodities. The more detached these markets get from the underlying commodities they are supposed to be representing the worse they become as a hedge for real producers and real manufacturers that need these commodities. We want farmers and miners to make things without having to incur massive risks based on the volatility of prices. But the question is if the current futures markets are the right place for this? I think the way to solve most of these problems is to ensure that if anyone wants to make a short contract they are either a producer that is able to produce that commodity or have a sufficient amount of that commodity in proven non-fractional reserves to be able to back that position. If this is not the case we get these bizarre paper derivatives market situations arising that don't primarily serve the people who need to produce and consume the commodities. In those cases the value starts getting captured more by people who aren't building real economic value at the expense of those who actually do.