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Cryptocurrency Basis Spreads

Basis spreads can have slightly different meanings in the financial world depending on the product being discussed. In the most general sense, and applicable to cryptocurrency trading, the basis spread refers to the difference between the spot price and the futures price. Futures are a type of derivative product that we discuss in another article, but in general: futures are a type of derivative instrument that allow a buyer and a seller to agree to exchange value at a predetermined price in the future. (Investopedia definition) Due to the fact that there is both a time value component and a funding cost to the derivative instrument, the futures price will be different than the physical or "spot" price of the security. This difference is known as the "basis".

Futures contracts can either be financially settled (only cash is exchanged at the end), or physically settled (the security is exchanged at the agreed upon price at maturity). The CME lists Bitcoin futures that are "cash settled", but ICE (Intercontinential Exchange) offers futures contracts that are physically settled. In theory, physically settled securities/instruments should see the spot price and the futures price converge as the time value component shrinks and the futures contract nears expiry. A quick Google search will show numerous results for "basis trading" or other trading strategies that attempt to capitalize on this price convergence. Using Bitcoin as an example, let us suppose that a trader buys 1 BTC at a price of $19,000. The Bakkt ICE deliverable future with the December 20th maturity (7 days until expiry) is currently trading at $19,147.50. The hypothetical trader in this scenario could sell the futures contract and would stand to gain $147.50 (minus commissions and cost of carry) for the time period. This scenario is often how commodity producers lock in prices/profits for physical commodities.

Basis spread refers to the difference between the spot and derivative price

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Basis trading, while seemingly low risk, is not without risk completely. Technically, the market participant is swapping outright directional price risk for another risk: basis risk. Basis risk is the risk that the difference between the spot and futures price will grow or shrink over time leading to expiry. Using the same Bitcoin example in the previous paragraph, the market participant is "long basis" of $147.50; and the bet is essentially that the futures price and spot price will converge to the same price at time of delivery. Given different time horizons and supply/demand dynamics, it is possible for the basis to increase. And due to the nature of the futures contract being marked to market and requiring maintenance margin, the market participant will take losses should the basis widen.



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