CFTC approvals open the door for mainstream investors
On Dec. 1, the Commodity Futures Trading Commission gave the green light for three exchanges to launch derivatives on bitcoin, opening the door for an influx of investors to an exciting but potentially risky new asset class.
The three exchanges are CME Group, the Cboe Futures Exchange, and the Cantor Exchange. They join LedgerX, a swap execution facility that began trading bitcoin options and day-ahead swaps in October. CFE and CME have set launch dates of Dec. 10 and 18, respectively; Cantor is expected to follow soon thereafter.
The CME and CFE contacts in particular are likely to get off to a fast start. The two exchanges rank among the largest derivatives exchanges in the world and their membership includes a number of professional traders already active in the underlying spot market for cryptocurrencies. In addition, both exchanges are well known to hedge funds, asset managers and other types of institutional investors, and their contracts will provide these institutions with a more convenient way to join the rapidly growing cryptocurrency market.
CFE's contract is based on the value of one bitcoin, CME's contract on five. Both are cash settled, which means that neither buyers nor sellers need to hold bitcoin in order to participate in the market. CFE's contract will be cleared by the OCC, the primary clearinghouse for the U.S. equity options markets; CME's contract will be cleared at CME's own clearinghouse alongside CME's existing range of futures on currencies, commodities, equity indices and interest rates.
Surge of institutional interest
Executives at companies active in the spot market say there has been a sea-change in attitudes towards cryptocurrencies over the last 12 months. The extraordinarily rapid rise in the price of bitcoin has created huge gains for the handful of people who entered this market a few years ago, triggering a surge of interest among traditional financial institutions and the general public.
Cryptocurrency experts from Bitgo, Coinbase and Cumberland Mining discuss the development of bitcoin derivatives with representatives of Cboe and LedgerX. Listen to the audio recording of their discussion, which took place at the FIA Expo on Oct. 19 in Chicago.
Speaking at the FIA Expo in Chicago on Oct. 19, Adam White, the head of GDAX, one of the top cryptocurrency trading platforms, said his firm is spending a lot of time talking with institutions about this new investment opportunity. "What has kind of been a soft interest over the last couple of years has really picked up in 2017," White said during a panel discussion. "It's still early days, but certainly the wave of institutional interest is one of the large themes this year."
One reason for the surge in interest, particularly among professional traders and hedge funds, is the extreme volatility of prices both up and down. That is the kind of market environment well suited for market making and trend-following strategies, Doug Greenig, the founder and chief executive of a London-based hedge fund called Florin Court Capital, recently told Bloomberg that he has begun trading cryptocurrencies because they offer more opportunities for trend-following trading strategies than traditional markets.
“It just makes sense to be involved even though the operational hurdles for an institutional-grade fund are considerable,” Greenig was quoted as saying. “Cryptocurrencies are an interesting asset class, with low correlations to the traditional asset classes and strong historical trending behavior.”
Despite this interest, most institutional investors have remained on the sidelines of the cryptocurrency market up to now. The market is not regulated and suffers from operational malfunctions, dodgy trading practices and even outright thefts. In addition, there are numerous legal and technical challenges that make it difficult for institutional investors to hold cryptocurrency assets in custody for their customers. Still another issue is the market's unreliable infrastructure. Specialists in cryptocurrency trading report that some trading platforms can take several minutes or even hours to confirm a trade, a lifetime in a highly volatile market. The launch of the CFE and CME contracts therefore could serve as a way for these investors to take an exposure to this market without actually holding the cryptocurrencies.
"Looking around the crypto landscape over the last couple of years, it became pretty obvious that bitcoin was becoming an asset class of its own [and] there was a need for some sort of derivative instrument to satisfy people who weren't completely comfortable with the security of holding physical bitcoin yet."
Michael Mollet
Cboe
"Looking around the crypto landscape over the last couple of years, it became pretty obvious that bitcoin was becoming an asset class of its own," Michael Mollet, a business development director at Cboe, said during the panel discussion at FIA Expo. "It became pretty clear that there was a need for some sort of derivative instrument to satisfy people who weren't completely comfortable with the security of holding physical bitcoin yet."
Clearing risks
Many market participants are concerned, however, about the potential risks of this new product. Although bitcoin enthusiasts believe cryptocurrencies have enormous future potential, actual usage outside the underground economy is relatively limited at present, and the recent rapid price appreciation appears to be driven mainly by speculative interest. Furthermore, the supply of bitcoin is limited, which means that the only way for the market to respond to changes in demand is through changes in price. That contrasts with more conventional commodity futures, where producers of the underlying commodities can increase or decrease their production in response to rising or falling prices.
For these reasons, numerous financial industry leaders have warned that the cryptocurrency market has all the hallmarks of a speculative bubble that sooner or later will lead to severe losses for investors. As a result, some firms have urged the exchanges to set higher than usual margin requirements, and some have even called for the exchanges to isolate the risks of bitcoin futures by separating them from other products in the clearinghouses.
Thomas Peterffy, the chief executive of Interactive Brokers, a brokerage firm that is a clearing member of both CME and OCC, has been among the most outspoken about these concerns. In a series of open letters published in November, he called for separate default funds from bitcoin futures and higher-than-normal capital requirements for clearing firms. These steps are necessary to protect the clearing system, he argued, if a clearing firm cannot cover losses incurred by its customers and is forced to default on its obligations.
"The CFTC and the clearing organizations must consider ways to limit the risk and potential contagion from large market moves in bitcoin," Peterffy said in a Nov. 27 letter to the members of the CME and OCC clearinghouses. "These could include the margining and clearing of bitcoin products only in a legally separate clearing subsidiary, or an explicit limit on the liability of the clearing organization, or the requirement that each clearing member authorized to clear bitcoin-related derivatives have a minimum regulatory capital of $10 billion or other large amount, or any combination of these."
The exchanges are well aware of these concerns and have sought to address them in various ways. CME, in its filing with the CFTC, explained that it has developed a proprietary index to track bitcoin prices and used the last two years of data from this index to set its margin requirements. Trading will begin with a margin level of 35%, far above the margin requirements for the rest of its contracts. CME estimates this would have covered 100% of all one and two-day price moves between 2016 and 2017. CFE also has set higher than normal margin requirements. The exchange initially set margin will be set at 30% for exchange members and hedgers and 33% for all other customers, then on Dec. 6 decided to bump that up to 40% and 44% respectively.
The exchanges also point out that volatility in other futures can reach extreme levels without damaging the integrity of the clearing system. "Crude oil volatility at times hovered near 125% in 2008-2009, and was consistently above 50% in 2015 and 2016," CME said in its CFTC filing. "Silver has also experienced periods of volatility near 100% in late 2008 and 2011. Likewise, natural gas has experienced volatility levels that are often routinely over 50% with highs over 100% in late 2009 and mid-2014. When compared to the volatility of the VIX, which periodically can reach 250%, bitcoin volatility can be viewed as relatively less significant."
Cash versus physical settlement
Members of the Chicago futures trading community listen intently as cryptocurrency experts discuss the development of bitcoin derivatives at the FIA Expo on Oct. 19.
The other big concern is the potential for market manipulation. This is a risk in any market, but the cryptocurrency market has a number of characteristics that make it more vulnerable to market manipulation than most. There is a large OTC cryptocurrency market that is completely unregulated, and the platforms that support cryptocurrency trading do not have the kinds of protections used by securities and derivatives exchanges to prevent attempts to manipulate prices.
That has raised questions about the decision by CME and CFE to rely on cash settlement. At settlement, the contracts are closed out through the transfer of cash, which means that neither buyers nor sellers need to hold bitcoin. This is certainly more convenient for mainstream users, but it creates the possibility that someone could distort the price of the futures contract by manipulating the spot market price used for settlement.
Both exchanges have developed relationships with trading platforms in the spot market that provide them with data for determining the settlement price for their bitcoin futures. CME's contract is based on its proprietary BRR index, which combines data from four bitcoin trading platforms: Bitstamp, GDAX, itBit and Kraken. CFE's contract is based on prices from a daily auction conducted by a single trading platform, Gemini Exchange.
LedgerX, which received CFTC approval for its bitcoin swaps and options in July and began trading in October, has taken a different approach. The exchange designed its contracts to settle through the transfer of physical bitcoin rather than cash. In addition, LedgerX's contracts are "fully collateralized," meaning that all exposures are covered by either cash or bitcoin. For example, if someone buys an option on a certain amount of bitcoin, the buyer pays in cash up front and the seller must post the entire amount of bitcoin covered by that option as collateral for the transaction. That way, if the buyer exercises the option, LedgerX will always have sufficient bitcoin at its clearinghouse to make the delivery.
So far LedgerX has not attracted a large amount of business. In November, its second month of trading, 1,737 day-ahead swaps and 453 options changed hands on the exchange. But the exchange is convinced that its business model is better for the market. On Nov. 30, a top executive at LedgerX posted a blog on the LedgerX website pointing out that two of the largest bitcoin trading platforms in the U.S. had suffered from trading outages that week amid extreme volatility and heavy trading, and questioned how a price index can be derived from such unreliable sources of data.
"I get it: if you’re a big exchange, cash-settled products seem easier to list," wrote Ian Darrow, the general counsel and chief regulatory officer of LedgerX. "You don’t have to use military-grade cryptographic hardware to store your customers’ bitcoin safely, then convince regulators that it works. You don’t have to understand the underlying technology at all. The downside is that the cash-settled product has no price integrity. Until we’re convinced we can solve that problem, LedgerX will stick to products that help grow the market responsibly."
The CFTC acknowledged these concerns about the risks of trading and clearing bitcoin derivatives when it gave the go-ahead to CFE, CME and Cantor on Dec. 1. In a statement explaining its decision, the CFTC emphasized that each exchange will be responsible for monitoring the cash market in order to protect their price discovery process from attempted manipulation as well as disruptions caused by sudden price movements or trading system outages.
"We expect that the futures exchanges, through information sharing agreements, will be monitoring the trading activity on the relevant cash platforms for potential impacts on the futures contracts’ price discovery process, including potential market manipulation and market dislocations due to flash rallies and crashes and trading outages."
Commodity Futures Trading Commission
“Market participants should take note that the relatively nascent underlying cash markets and exchanges for bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority," the agency said. "There are concerns about the price volatility and trading practices of participants in these markets. We expect that the futures exchanges, through information sharing agreements, will be monitoring the trading activity on the relevant cash platforms for potential impacts on the futures contracts’ price discovery process, including potential market manipulation and market dislocations due to flash rallies and crashes and trading outages."
Structural safeguards
The exchanges have attempted to address concerns about manipulation by installing a number of protective mechanisms. CFE, for example, relies on certain mechanisms on its own exchange, such as position limits to prevent any one market participant from taking an overly large position, as well as protections in the auction process operated by its partner.
"There are a number of structural safeguards built into the Gemini Exchange auction process that are specifically designed to promote the integrity of the auction price and make it difficult for a market participant to improperly affect the auction price," CFE said in its regulatory filing. These safeguards include an auction mechanism "similar to the closing cross used by stock exchanges," a requirement that all orders must be pre-funded, and a 5% "price collar" to keep the auction price from diverging too much from prices in other bitcoin markets.
In its filing with the CFTC, CME stressed that its BRR index has been carefully designed to be resistant to manipulation and has accurately tracked the spot market price since its launch in November 2016. CME also noted that the four exchanges that contribute data to the index collectively represent up to 35% of worldwide trading in U.S. dollar versus bitcoin. "Ultimately, influencing the BRR would require significant trading activity on several exchanges over an extended period of time," CME said.
"We are pleased to bring Bitcoin futures to market after working closely with the CFTC and market participants to design a regulated offering that will provide investors with transparency, price discovery, and risk transfer capabilities," Terry Duffy, CME Group Chairman and Chief Executive Officer, said when the exchange announced the launch. "We recognize bitcoin is a new, uncharted market that will continue to evolve, requiring continued collaboration with the Commission and our clients going forward. At launch, our new Bitcoin futures contract will be subject to a variety of risk management tools, including an initial margin of 35 percent, position and intraday price limits, and a number of other risk and credit controls that CME Group offers on all of its products."
