Bitcoin futures have not taken off as expected and the underlying cryptocurrency has seen its price drop since the highs of last autumn. But many believe the market will grow and mature once investor and regulatory fears are laid to rest and as new exchanges bring more liquidity and innovation into the market. Lynn Strongin Dodds reports.
There has been a lot of hype about bitcoin over the past year and the launch of Chicago Board Options Exchange (Cboe) and Chicago Mercantile Exchange (CME) bitcoin futures in late 2017 did lend credence to their use in the derivative world. However, if consulting firm Perkins Coie’s Derivative and Repo report is anything to go by, there have been several challenges and acceptance will be a slow burn.
The Derivative and Repo data shows that volatility for the lead month of the Cboe bitcoin futures contract declined in each month since the beginning of 2018, while as of May 22, 2018, the daily exchange volume of the contracts remained below 6000 for the last month with one exception. At the broader level, the price of bitcoin – the world’s best-known cryptocurrency – has plunged over 70% from almost $20,000 in December, when the CME and Cboe contracts first made their appearance, to the current fluctuations between $5,800 and $6,200. In market capitalisation terms, bitcoin’s value has slid to $112.2 billion from its peak of $800 billion late last year.
Experts disagree over cause of bitcoin’s price drop
Ironically, some industry experts blame the introduction of futures for its downward spiral. In a recent paper, Galina Hale, Arvind Krishnamurthy, Marianna Kudlyak, and Patrick Shultz of the San Francisco Federal Reserve, said that, “from Bitcoin’s inception in 2009 through mid-2017, its price remained under $4,000. In the second half of 2017, it climbed dramatically to nearly $20,000, but descended rapidly starting in mid-December. The peak price coincided with the introduction of bitcoin futures trading on the Chicago Mercantile Exchange. The rapid run-up and subsequent fall in the price after the introduction of futures does not appear to be a coincidence. Rather, it is consistent with trading behaviour that typically accompanies the introduction of futures markets for an asset.”
This is not the first time the introduction of a derivative contract has been blamed for a dramatic price drop. In a 2012 paper, a pair of economists at George Washington University and Yale University argued that the 2005-06 introduction of credit default swaps (CDS) on certain mortgage-backed securities eventually caused a drastic fall in the price of those securities. This was because the CDS allowed bearish traders to express their view on an overvalued market.
Something similar happened with bitcoin, according to the San Francisco Fed’s note. “Once derivatives markets become sufficiently deep,” it says, “short-selling pressure from pessimists leads to a sharp decline in value.”
Price swings were at their worst in the run-up to the futures contracts expiration, according to research from Thomas Lee, head of research at Fundstrat Global Advisors. He found that the prices typically fell by an average of 18% in the ten days leading up to the expiry and then rebounded six days after the contracts expired.
Exchange operators have refuted that expiration dates have any impact. In a recent comment, Chris Concannon, president and chief operating officer of Cboe Global Markets, said that “the notion that they have materially affected the bitcoin price overstates their influence and ignores other critical facts. Our strict position limits and the limited open interest in our May and June settlements, suggest that the fall of bitcoin can be more easily explained by other factors such as the recent regulatory scrutiny around the globe, steps by government tax collectors, the rise of other cryptocurrencies, and declining media interest in the asset.”
Exchanges tout industry cooperation in bitcoin futures launches
John Tornatore, global head of cryptocurrencies at Cboe, also notes that the exchange consulted and worked closely with the CFTC and other market participants to ensure that they had the right prototype. “We believe it is a mistake to just throw a product out there and as with all our other products we did a lot of research and reached out to the CFTC (Commodity Futures Trading Commission), who is our regulator, FCMs (futures commission merchants) and other trading firms to ensure that it would be a successful product to put on the market,” he says. “We listened to their suggestions. For example, we originally thought we would have 10 bitcoins to one contract but changed it to one-to-one after listening to their feedback.”
A spokesperson for the CME Group adds that the products were launched under the self-certification process, where the exchange certifies that the product conforms to all the relevant laws. This procedure entails a designated exchange filing a submission to the CFTC confirming that the product complies with the Commodity Exchange Act and CFTC regulations – including a key provision that requires that the contract is not susceptible to manipulation.
Fears over security persist, adding to barriers to adoption
Some market participants, however, are calling for tighter legislation, particularly given the recent investigation into illegal practices launched by the US Justice Department and CFTC. While it is still early days, the regulators are specifically looking into spoofing – where a trader submits a spate of orders and then cancels them once prices move in a desired direction – as well as washing, which can give the appearance that more trading activity is happening than is actually occurring.
Concerns were allegedly raised over activity at the CME – which forms its bitcoin futures prices based on data from four crypto exchanges; Bitstamp, Coinbase, itBit and Kraken – and whether manipulative trading distorted the value of the futures. After the settlement of the first contract in January, CME asked the four exchanges to provide trading data, but several refused to cooperate, arguing that the request was intrusive. Some information was ultimately provided, but only after CME limited its request to a few hours of activity, instead of a full day, and restricted it to a few market participants.
In the meantime, Asian regulators have already taken action. China has prohibited cryptocurrencies, with authorities barring bitcoin trading and initial coin offerings after the People’s Bank of China said such activities could pose major financial risks to the world’s second-largest economy. More recently, South Korea’s Financial Services Commission (FSC), the country’s main financial agency, introduced new anti-money-laundering (AML) and know-your-customer (KYC) rules for crypto exchanges, which will be effective for one year. The new guidelines are much stricter in order to prevent fraud, money laundering activities and money transfers between local and foreign crypto exchanges.
The aim is to prevent hacking incidents such as the one seen in early June, when South Korean cryptocurrency exchange Coinrail was hacked, triggering a roughly 30% loss. It did not quantify the value, but estimates are that around 40 billion won ($37.28 million) worth of virtual coins was stolen.
It is not surprising then that against this backdrop, liquidity for the futures contracts has been sparse. There are also several restrictions that act as a barrier to adoption – trading is only allowed when the exchanges are open, initial margins of 35% to 45% are required, and deposits have to be made in dollars rather than bitcoins. However, institutional players that were expected to be more active, have been notable by their absence, even though the launch of cash-settled bitcoin futures on regulated exchanges was considered a major step in the digital currency’s path toward legitimacy.
“While there has been an explosive phase of interest, we have not yet seen a significant adoption rate as people do not want to leap into an illiquid contract,” says VJ Angelo, CEO of Cryptoindex-io. “It is too early for institutional investors to come into the market. At the moment there is too much fragmentation and different structures and I think there needs to be greater standardisation of prices and tighter regulation as well as market infrastructure before institutional investors participate.”
Volumes to grow as the market matures
Tornatore, however, believes the product is gaining traction. “People have been caught up in the hype, but we see a lot of people trading the bitcoin futures contract in the same way as they would any other commodity,” he says. “We have had six successful settlements so far and we are seeing people use it for a good mix of reasons — to hedge their physical positions, for buy and hold or long/short strategies or as part of their day trading.”
He also thinks that the strategic partnership the Cboe struck with US-based regulated bitcoin and cryptocurrency exchange Gemini has added a layer of comfort. Gemini, a New York trust company, is regulated by the New York State Department of Financial Services and has to adhere to all AML laws, KYC requirements, and consumer protections set forth by the Bank Secrecy Act (BSA) and NYSDFS.
The CME spokesperson adds that a futures contract trading on a regulated marketplace offers investors the benefits of transparency, price discovery and risk transfer – all of which better enable market participants to manage their risk as the bitcoin market develops. “Bitcoin futures offer a way for investors to hedge risk exposure in the bitcoin cash market, but the CME Group is creating a forward curve for this market so that investors can better manage price risk. Rather than just a spot price, there is now a price through September 2018,” he says.
As with any new investment it will take time for the market to mature although there are already several offerings at different stages in the pipeline. As Trading Technologies Vice President of Cryptocurrencies Michael Unetich points out, “As future regulation comes to market, the institutional ability to trade and trading volumes will increase. I think we will see other major exchanges in the U.S. roll out cryptocurrencies futures. We are already seeing some hints at ethereum futures. I also expect to see incremental changes to the products that are already being traded.”
Hirander Misra, the GMEX CEO, believes that that there will be greater institutional interest once these futures markets behave in a more normal manner. “I think they are now just dipping their toe in the water, but that will change as the market becomes more sophisticated, he says. “Also, the markets in general have been volatile and one of the problems with the cryptocurrencies is there is a lack of transactions and order depth.”
Startup exchange launches signal next wave of crypto futures offerings
In March, GMEX Technologies, a subsidiary of GMEX Group struck a partnership with Blockchain Board of Derivatives (BBOD) to launch an ethereum derivatives and spot exchange in order to inject further liquidity into the system and attract multiple diverse participants. More recently, UK-based cryptocurrency trading start up, Crypto Facilities, become the first crypto platform to launch regulated ethereum futures contracts while CME also joined the fray but only with two indices – the CF Ether-Dollar Reference Rate, which prints a daily price at 4 p.m. London time (11 a.m. ET), and the CME CF Ether-Dollar Real-Time Index.
Prices of both are calculated by UK-based exchange Crypto Facilities based on transaction data from Kraken and Bitstamp. The group said it currently has no plans for ethereum futures, but the structure of the indexes is very similar to the ones behind CME’s bitcoin futures.
GMEX has also looked further afield for opportunities. The group was part of the consortium behind the Mauritius based International Commodities and Derivatives Exchange (MINDEX) which aims to create multi-commodity spot and derivatives platforms, clearing house, secure vault storage, gold refinery and digitalised assets, with operations going live in the fourth quarter.
“The market is up for grabs,” says Misra. “We have seen the first waves of incumbent exchanges who have the benefits of an existing ecosystem that can better create flow. However, there will be a second wave of fledgling exchanges as well as other jurisdictions that will emerge to take lead in other digital futures.”