Bitcoin’s price has skyrocketed on private exchanges, increasing the interest of Wall Street in the most popular virtual currency on the market. In December 2017, the Chicago Board Options Exchange (CBOE) took a major step in opening the doors to more institutional money into the digital currency world. It became the first major U.S. exchange to start trading bitcoin futures, allowing investors to take bets on the price of the cryptocurrency in the future. A week after, the Chicago Mercantile Exchange (CME) followed by launching another bitcoin futures contract. The introduction of these financial contracts is considered the latest chapter in a broader story about cryptocurrencies gaining traction among traditional players in financial services.
Bitcoin Futures: An Introduction
Bitcoin is the first decentralized digital currency, with no server or central authority. It is controlled by a network of computers that track all transactions taking place on a variety of unregulated virtual exchanges around the world. Allowing investors to trade bitcoin futures on U.S. regulated exchanges adds a whole new layer to the world of digital currency. Here’s how it works.
Futures are a type of contract where a buyer and seller agree on a price of a particular item, in this case bitcoin, to be delivered on a certain date in the future, irrespective of what the actual market price is at the execution date. Futures are available for nearly every type of security but are most familiarly used in commodities. There is no conceptual difference between running a future market on bitcoin or on gold. However, unlike with commodities, bitcoin futures have no underlying physical asset. The Commodity Futures Trading Commission (CFTC) has acknowledged that bitcoin is therefore a commodity “unlike any the Commission has dealt with in the past.” Consequently, bitcoin futures have much higher margin rates (the amount a trader has to set aside as collateral for potential losses) than typical futures contracts that typically only have margin requirements of 2 to 10 percent of the full value of the futures contract. The CBOE, for example, has a margin rate of 44 percent, likely because of bitcoin’s volatility and novelty.
When a futures contract settles, the buyer of the contract can generally receive his or her payment in the product itself or in cash. The bitcoin futures are cash settled futures, meaning that investors will receive their final payment in cash rather than in actual bitcoins. As a result, CBOE and CME do not have to deal with setting up their own Bitcoin wallet. The final settlement value of the contracts is based on an index of bitcoin prices on particular private exchanges. For example, CBOE bases the settlement value on the Gemini auction price for bitcoin.
What exactly makes bitcoin futures so interesting to Wall Street firms? Wary of unregulated bitcoin exchanges, bitcoin futures make the digital currency more accessible to fund managers who do not want to own bitcoins directly. They are however interested in speculating on its price in an already established exchange that is overseen by a regulator. Apart from opening its doors to more institutional money, bitcoin futures allow market participants to hedge any exposure to bitcoin pricing or harness its performance with a futures product. As the underlying asset of bitcoin futures is particularly volatile in price, it may therefore control risk in an investor’s portfolio. Finally, futures should also help reduce volatility in the underlying bitcoin market by bringing a deeper liquidity to the market.
What about investor protection?
It is said that the bitcoin futures contracts should bring Bitcoin more clearly into the realm of regulators and institutional investors. Bitcoin and other cryptocurrencies are currently not regulated but because of its scale, it is deemed increasingly necessary to discuss whether and what kind of regulation is suitable.
The trading and clearing of bitcoin futures will be regulated by the Commodity Futures Trading Commission (CFTC), a regulatory body with exclusive jurisdiction over the futures markets. The Commodity Exchange Act expressly permits exchanges to list new futures products by self-certifying that the listing of the new product for trading complies with the Act, as well as Commission and exchange rules. Under this self-certification process, the exchanges may self-certify a product for trading by the close of business day and then list the product for trading the next day. It does not require CFTC approval or input and allows little to no time for public review. While this process may be well-suited for standardized products, it is feared that it is insufficient for bitcoin futures given the riskiness of the underlying cryptocurrency products. As mentioned before, the bitcoin market is relatively young and remains largely unregulated.
The Futures Industry Association (FIA), which represents major banks, brokers and traders, wrote an open letter to the CFTC, stating that a “more thorough and considered process” is necessary. The launching of these products through the 1-day self-certification process did not allow for proper public transparency and input. Given the experienced volatility in the bitcoin market, a proper assessment of trading limits, stress testing, and related guarantee fund protections in the event of excessive price swings should have been considered.
To conclude, the launch of bitcoin futures has the potential to increase the appeal of the cryptocurrency to both institutional and retail investors. It is a further step in legitimizing cryptocurrencies as genuine financial assets, making it more likely that the virtual currency is here to stay. However, given the increasing concerns about investor protection, we can only wait and see what the future for these financial products will bring.
Heleen Boonen serves as a graduate editor of the NYU Journal of Law & Business. She is an LLM candidate at NYU School of Law where she focuses on corporate law and finance. Heleen is a Fulbright and B.A.E.F. grantee from Belgium. Prior to attending NYU she finished her Masters of Law at Ghent University summa cum laude where she was also a member of the University’s Honours programme. During law school, Heleen worked amongst others as a research assistant at Ghent University for the Department of Economic Law and as a summer associate at Linklaters Brussels.