Cash-settled futures on bitcoin have been a smash success for CME, but they sometimes diverge from prices in the spot market. That has spurred interest in physically delivered contracts. Much like in the classic agricultural futures markets, the buyers and sellers of these contracts are obligated to exchange the underlying cryptocurrency when the contract expires. This mechanism effectively forces the spot and futures prices to converge at settlement.
Four U.S. exchanges now offer futures that deliver bitcoin or ether at settlement. For the futures industry, this could become an important new growth area, but there is a catch - the brokers must have the ability to hold bitcoin and ether for their customers, and that presents some unique challenges.
Currently there are more than 47 brokers registered as futures commission merchants with the Commodity Futures Trading Commission, the government agency that regulates futures markets. But only a handful are currently willing to take customer trades in cash settled bitcoin futures, and even fewer have the ability to support physically settled bitcoin futures.
Interest in these products remains high, however. To help FCMs delve into the details, FIA recently held a webinar with legal and operational experts.
CFTC advisory for FCMs
An important development for FCMs to consider is an October 2020 advisory from the CFTC regarding the holding of virtual currency in segregated customer accounts. This advisory addresses one of the key issues that arise when customers trade cryptocurrency futures that have physical delivery – what steps should the FCMs take when customers deposit bitcoin or ether as collateral to meet the margin requirements on these contracts.
"This was a very practical advisory about what do you do with crypto posted as margin for crypto futures contracts,” said Gary DeWaal, special counsel and chair of financial markets regulation at Katten, a law firm.
DeWaal noted that it does not apply to physically delivered contracts on non-U.S. platforms, nor did it involve in proprietary trading accounts. Still, he said the 2020 advisory has many important considerations for market participants interested in this nascent asset class.
Physically delivered crypto contracts
Traditionally, physically delivered contracts are margined with cash and not the actual commodity itself. Customers who trade oil futures, for example, are not using barrels of oil to meet their margin calls. But when those contracts expire, anyone holding a position must have the ability to either make or take delivery of the underlying commodity.
Crypto futures have an additional wrinkle. Some of the exchanges offering these contracts allow customers to deposit bitcoin or ether to meet their margin requirements. This feature was one reason for the 2020 CFTC advisory, which was narrowly focused on margining of derivatives instruments with physical delivery of a crypto asset.
At present, the only contracts on regulated exchanges that fit this description are bitcoin and ether products. That rules out, at least for now, the use of other virtual currencies such as stablecoins. Furthermore, Ian Polakoff, principal at RPM Financial Markets Group, points out there is also a requirement that the cryptocurrency is acceptable with the relevant derivative clearing organizations, or DCOs. "If the DCO doesn't accept the virtual currency as collateral, the FCM isn't supposed to hold onto it either," he says. ICE Futures US, for example, offers bitcoin futures with physical delivery, but currently it does not allow the posting of virtual currency as margin.
At present, three exchanges do offer this innovative approach to margaining digital asset contracts with the digital assets themselves as collateral -- Bitnomial, ErisX and LedgerX. The specific products include:
- Bitcoin futures contracts offered by Bitnomial, ErisX, and LedgerX
- Bitcoin options contracts offered by LedgerX
- Ether futures contracts offered by ErisX and LedgerX
- Ether options offered by LedgerX
It’s also worth noting that a recent flurry of acquisitions could open the door to more product innovation. Most noteworthy are the August deal for cryptocurrency exchange FTX to acquire LedgerX, Cboe's purchase of ErisX in October, Crypto.com's acquisition of the North American Derivatives Exchange in December, and most recently the January announcement that Coinbase plans to acquire FairX. In all four cases, the acquiror intends to use the exchange that they bought as a platform for offering crypto futures to US customers.
Digital assets used as margin
DeWaal noted that under recent guidance the crypto holdings in segregated funds, even when tied to any of these relevant contracts, must also be associated with active trading of a customer. Once per quarter FCMs must perform a lookback and if there is no associated trading then they have to return the cryptocurrency to the customer within 30 days.
Furthermore, the guidance does not allow cryptocurrency assets to be used for margin for other products or transactions.
“That prohibition means you can't use bitcoin to cover margin requirements on S&P 500 or Treasury futures, for instance,” he said. But perhaps more interestingly it also disallows the posting of bitcoin as margin for futures on other cryptocurrencies. That could be particularly meaningful if the list of products grows in the future to encompass a broader array of digital assets.
Despite these new challenges and issues, however, it’s important for market participants to remember that the core duties of any FCM will remain the same when it comes to client obligations.
"Just like with any other seg funds that an FCM can hold onto, you need to keep your seg assets with a bank, trust, another FCM or a DCO. One of those types of registrants also needs to be able to take custody of the virtual currency," said Polakoff. He said in the current environment that means either a regulated DCO that has outsourced that custody responsibility to a firm like Bitgo or Bakkt that offers provides these services. But regardless of the custodian, Polakoff stressed the standard FCMS rules apply as they do to traditional securities transactions including proper acknowledgement letters and titles.
Risks to FCMs
Tom Anderson, Senior Vice President of ADM Investor Services, notes that any FCM needs to think seriously about entering into these transactions given CFTC requirements to develop a risk management program that contemplates issues including challenges in crypto market liquidity, issues with mark-to-market pricing, and how to perform an orderly liquidation of a client portfolio in the event of default.
"Certain exchanges have solved for pricing their futures contracts, but when you're holding the physical you're taking about something different," said Anderson. "As an FCM we have to be in a position to demonstrate we have a readily marketable and highly liquid asset that we can price appropriately if it's used as margin.”
Anderson is uniquely positioned to understand market trends in digital assets. ADM Investor Services is currently one of the few firms that clears bitcoin futures and he serves as an independent director of Binomial, one of the exchanges that offers bitcoin futures. He also currently serves as a board member of the FIA North America Operations Division Board and is a co-chair of its Financial Management Committee.
Anderson notes some of the concerns faced in the unique universe of digital asset contracts are not altogether new, and he stressed that challenges exist with any physically settled futures products as well as accepting any non-cash collateral such as gold. However, the unique uncertainties around crypto demands a thoughtful approach from an FCM interested in entering the space, he added.
