Institutions and multi-asset investors returned to the crypto market last week, but not in a way the bulls would have liked to see.
Analysts said these entities took short or bearish bets in bitcoin (BTC) futures listed on the Chicago Mercantile Exchange (CME), causing backwardation, where futures prices are lower than the spot price. And the market anomaly has created an "arbitrage opportunity" – a strategy aimed at profiting from price gap in different markets.
"Institutional activity in CME has blossomed, but activity has been heavily concentrated towards the short side," Vetle Lunde said in a note to clients on Tuesday. "CME’s November contract has traded at an extreme discount to spot in the last week."
Bitcoin's front-month CME futures traded at an average daily discount of around 3.6% (annualized 43.8%) last week, according to data provided by Arcane Research. That's wider than the discount seen during the coronavirus-induced crash of March 2020 and the steepest on record.
The number of active contracts, or open interest, on the CME has surged by nearly 37% to 93,000 BTC this month alongside an increase in discount, suggesting an influx of new money on the short side.
"The futures discount signals severe negative sentiment among multi-asset investors that tend to carve out a small trading allocation towards CME listed cryptocurrency futures," Markus Thielen, head of research and strategy at crypto services provider Matrixport, said.
Institutions' renewed bearish stance comes amid fears that the recent collapse of Sam Bankman-Fried's crypto exchange FTX, formerly the third-largest platform, will prolong the crypto winter.
Griffin Blofin, a volatility trader from the crypto asset management firm Blofin, said the discount on the CME has been more significant than unregulated exchanges like Deribit and the situation may persist going forward.
"Due to their generally cautious style, institutions will cut most high-risk exposures as fast as they can, causing a higher discount rate than other exchanges such as Deribit," Blofin said.
At press time, monthly futures on Deribit traded at an annualized discount of 13.675%, while those on CME traded at 11%.
The price discrepancy between spot and futures markets often attracts arbitrageurs – traders setting up market-neutral positions to profit from an eventual narrowing of futures premium/discount.
In case of discount, arbitrageurs set up reverse cash-and-carry strategy, as observed following the March 2020 crash. The strategy involves setting up a direction-neutral position by borrowing and selling the asset in the spot market and purchasing a futures contract. That helps traders lock in the discount as profit while bypassing directional risks and the strategy makes money as the discount narrows.
According to Thielen, the arbitrage window offered by bitcoin's futures discount could be short-lived.
"In light of the better macro environment, this arbitrage opportunity will likely close in the near term as the macro environment appears to improve with 1) the USD might have peaked as US interest rate expectations are plateauing, 2) the Ukraine war appears to run out of steam and 3) China takes incremental steps of re-opening," Thielen told CoinDesk.
The return from the strategy is limited to the extent of the discount at the time of setting up the trade adjusted for the cost incurred to borrow bitcoin. In other words, the strategy will make money only if the trader can borrow BTC at rates lower than the discount.
Besides, the strategy is not without risks and may not be profitable if the sentiment fails to improve, keeping futures at a discount relative to the spot price.
"For the reverse cash and carry trade, unless the market can quickly emerge from the shadow of FTX's bankruptcy, investors entering now are likely to be unprofitable, for the basis does not show signs of a significant return to the normal level," Ardern said.