How to earn from Contango
What you'll learn
- What is Bitcoin Contango
- How Bitcoin Futures work
- Capturing a low-risk premium for holding Bitcoin
Learn crypto is targeted at newcomers to cryptocurrency, and this section, all about how you can earn crypto, has been structured to gradually build risk tolerance and complexity. If you’ve followed the learning path this far, you're ready to understand how institutional investors are capturing value within the growing crypto market, but hedging the inherent risk, through something called Contango.
What is Contango?
Bitcoin contango might sound like a weird kind of dance that happens at crypto parties, it is actually a way of capturing the value of holding Bitcoin but offsetting the risks of volatility.
In a buoyant market, such as crypto, the expectation is that the future price will be greater than it is right now. One way to benefit, as described earlier in this section, is just to buy and hodl.
Historically, cryptocurrencies like Bitcoin have performed very well over the long term, but past performance doesn’t guarantee future success. Hodling clear has risk, but smaller investors are generally happy to accept that, hoping for what is called an asymmetric return.
A small crypto investor might buy a few hundred euros of Bitcoin or Ethereum, and sit tight hoping for another 10 or 20 times increase over a few years.
Institutions, in contrast - with client and investor responsibilities - want to manage and mitigate risk, and generate reliable income streams rather than try for big risky plays.
Fixed income returns are dictated by interest rates, which have been near zero since the 2008 financial crisis so money managers are looking to alternatives. Bitcoin has the potential for significant returns, but is still a volatile asset and in any case, its market cap isn’t big enough to enable Pension Funds to invest.
One way that institutional investors can capture value, but mitigate risk is through something Bitcoin Contango, because since 2017 Bitcoin Future contracts have been offered by the CME Group, later Bakkt and the Intercontinental Exchange.
Futures & Bitcoin’s Path to Mature Asset
Futures are a type of financial derivative that enables you to buy and sell based on what you think the price of an asset will be at some point in the future. They are a necessary feature of any maturing asset as a control of manipulation and volatility, and a means of hedging risk.
Futures have a practical advantage for commodity producers like farmers who want to lock in the profit from future production today - crops that are still in the ground. They want revenue now to reinvest and scale operation, and mitigate against the risks - like bad weather or blight - which might mean those crops never reach the market.
Contango in crypto may seem a million miles from growing wheat, but the principle is largely the same. There is both a perceived value/risk in owning Bitcoin today but also a perceived future value.
That value can be measured by the expectation of future price, say one year from now, being higher than it is today.
The risk is that the positive price expectation is wrong, and that price will have actually declined once a year has passed. There is also the risk you take in simply safely storing bitcoin and interacting with a counterparty to trade it.
Bitcoin contango isn’t free money, it works so long as price slopes up to the right over time.
What contango does is give you the option to hedge the future value against the risks associated with simply hodling. You won’t enjoy the benefit of any increase in price over time, but equally you are immune to any of the obvious risks that might cause price to fall.
You are essentially collecting a premium for owning bitcoin in a rising market. The last part of that sentence is crucial ‘in a rising market’. Bitcoin contango isn’t free money, it works so long as price slopes up to the right over time. Using an example from May 4th, 2021
- The price of Bitcoin right now is $56,465 (Spot)
- September Futures are pricing Bitcoin at $59,080
If you are considering Bitcoin today your options are:
- Buy & Hodl - hope price meets or exceeds what you paid at Spot
- Buy Spot & Sell the Future - Lock in a premium; you don’t care what happens
The table below illustrates the scenarios for price movement, which are exaggerated to make it easier to understand the mechanics.
The Buy Hodl option will take all the upside - if price goes up - but also includes risk of ruin, if price collapses all the way to zero.
The Contango option will lock in a premium of 5.25% no matter what happens.
The table is a simplification of how Futures work:
- It doesn’t include the cost of placing the contract itself.
- Futures contracts with exchanges like CME also have minimum value - there’s is equivalent to 5 BTC
- They are only offered for the next six months and two Decembers.
- They are cash settled. No Bitcoin ever changes hands
It is unlikely that a small investor would need or want to employ a tactic like Bitcoin but it is worthwhile to understand as the premium functions as a benchmark for the wider crypto ecosystem.
In essence it is saying, this is what people should be rewarded for holding Bitcoin until September whatever happens - based on the perception on May 4th, 2021.
This number should then make it easier to understand how passive interest rates within CEFI are derived. If you can theoretically make 5.25% - less the fees associated with buying the Future contract - the rest of the opportunities within the market are logically going to fall somewhere around this number.
The expansion of Bitcoin derivatives continually improves the process of price discovery, which is discussed in our section on how to trade crypto. CME for example added the option of trading Micro Bitcoin Futures in April 2021, greatly reducing the entry level from around $250k per contract to around $5,000 or one tenth of the price of Bitcoin.
The kind of Futures Contracts offered by CME are fixed term and cash settled at the same time each month, as they are regulated by the CFTC - Commodities and Futures Trading Commission. They aren’t, however, the only type of Bitcoin Future available.
Perpetual Bitcoin Futures & Funding Rates
Most of the large cryptocurrency exchanges offer what are known as Perpetual Future Contracts. These are far more fluid than the fixed variety from the CME because they are updated every eight hours with what is known as the funding rate.
The funding rate is essentially what it will cost you to borrow a specific asset for eight hours in the expectation that its value will rise in excess of that rate. You need to post collateral with the exchange in order to access funding, and they are called Perpetuals as the rates keep rolling over until you decide to close them.
The Perpetuals market is one way of creating leverage, enabling you to speculate with more crypto assets than you actually own by paying the funding rate for the privilege of borrowing them. The funding rate will naturally fluctuate in relation to the expectation within the market for the price to increase.
Similar to the contango approach already described, you can capture a premium by buying Bitcoin at spot price and selling a Perpetual contract to earn the funding rate from someone willing to borrow it. Whatever happens to the price you are collecting the Premium.
The funding rate for Binance as of May 4th, 2021 is 0.0764% for the current eight hour period. It will update once that expires, but do a crude extrapolation from that figure you can work out the premium you could capture from the Perpetual Funding rates for Bitcoin.
- 0.0764*3= 0.229% return per day
- Multiply by 30 for an average monthly return of 6.9%
This compares well with the contango approach above, but doesn’t account for the cost of depositing, buying, and opening/closing your short positions on the Perpetual short contracts.