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Bitcoin derivatives are more in demand than ever, as bitcoin company
executives seek a way to hedge balance sheet risk. A liquid futures and
options exchange for bitcoin will provide commercial hedging
opportunities as well as increase overall price stability. This is not
disputed.
What will be contentious, however, are the paths and methods
necessary to get there. In this article, I examine exchange structure,
exchange jurisdiction, the practicality of various contracts, and
existing bitcoin futures markets.
What are derivatives?
Derivatives obtain their name from the fact that they are instruments derived from an underlying spot commodity or index.
In theory, the spot price of the physical commodity underlies and
provides the basis for pricing in the futures market due to the explicit
option for physical delivery. In the case of an index, cash settlements
are typically the norm.
‘Call options’ and ‘put options’ based on the futures contract can
also be offered. Exchange-traded products differ from customized
over-the-counter products in that they are standardized, easily traded
and underwritten by the pooled collateral of exchange members.
In the recent working paper
from the Mercatus Center, authors Jerry Brito, Houman Shadab, and
Andrea Castillo evaluate the emergence of derivatives in the context of
bitcoin.
As the most detailed analysis to date concerning bitcoin securities
and derivatives regulation, the paper argues that “financial regulators
should consider exempting or excluding certain financial transactions
denominated in bitcoin from the full scope of their regulations, much
like private securities offerings and forward contracts are treated”.
The authors also anticipate what form the second wave of bitcoin
regulation, mostly in the US, might take. I extend that thinking into
the rationale for multi-jurisdictional exchanges and the free market
emergence of bitcoin clearing houses to address counterparty risk.
Exchange structure
Any new bitcoin derivatives exchange will have to be electronic with
24/7 availability in order to mirror the existing spot markets for
bitcoin trading. Just as with commodity exchanges that trade gold,
silver, wheat and soybeans, warehousing partners will need to be
established to accommodate the safe storage of bitcoin necessary for
exchange integrity.
Ideally, the broker-dealer community will go through one of several
wholesale clearing members to access the exchange for their clients, and
these clearing members will underwrite the performance risk of their
clients.
Posted collateral from the clearing members can take the form of
cash, bonds or other liquid instruments determined by the exchange.
Furthermore, reasonable margin rules and position limits will have to
be enforced to insulate the exchange and its clearing members during
periods of extreme volatility.
Exchange jurisdiction
As evidenced by the likely manipulation in the precious metals markets and the MF Global
debacle, government oversight of an exchange is no panacea for
mischievous operators because the regulators themselves have been
complicit for years.
Obviously, jurisdiction is important for the enforcement of contract
performance, but exchanges would not require direct regulation for
legitimacy.
Properly structured exchanges could easily facilitate and apply best
practices for price discovery, trade clearing and trade settlement.
Luxembourg and Gibraltar would be favourable early selections for such
an exchange.
Also, multiple jurisdictions would be preferred for bitcoin
derivatives exchanges in order to prevent a single jurisdiction, like
the US, from exerting too much influence on an exchange that is vital to
the bitcoin ecosystem.
Moreover, as bitcoin absorbs a greater and greater portion of overall
economic activity, it could become tempting for certain jurisdictions
to interfere in the price-discovery mechanism by participating in or
encouraging naked short sales.
Former US Secretary of the Treasury Lawrence Summers clearly understood the importance of managing investor expectations by suppressing gold prices as he was one of its principal architects.
In dissecting the methods of manipulation, Paul Craig Roberts, former
Assistant Secretary of the Treasury for Economic Policy, and investment
expert Dave Kranzler conclude that the global volume concentration with
just one exchange creates a single point of manipulation.
From their January 2014 paper, Roberts and Kranzler summarize the process:
“When gold hit $1,900 per ounce in 2011, the Federal
Reserve realized that $2,000 per ounce could have a psychological impact
that would spread into the dollar’s exchange rate with other
currencies, resulting in a run on the dollar as both foreign and
domestic holders sold dollars to avoid the fall in value. Once this
realization hit, the manipulation of the gold price moved beyond central
bank leasing of gold to bullion dealers in order to create an
artificial market supply to absorb demand that otherwise would have
pushed gold prices higher. The manipulation consists of the Fed using
bullion banks as its agents to sell naked gold shorts in the New York
Comex futures market. Short selling drives down the gold price, triggers
stop-loss orders and margin calls, and scares participants out of the
gold trusts.”
As a Fed bullion bank through the acquisition of Bear Stearns, JP
Morgan has held aggregated positions in gold and silver far in excess of
CME Group position limits, frequently relying on hedger exemptions and waivers.
With digital commodity bitcoin, such brazen price suppression from
the authorities may prove to be the “last resort” option and the only
viable method for desperate governments seeking to maintain their unfair
legal tender monopoly.
Printing paper money to underwrite massive naked short selling on
bitcoin exchanges is the greatest single threat to bitcoin’s long-term
dominance as free market money. Multiple worldwide competitive exchanges
would mitigate the impact of such a grim scenario.
Practicality of contracts
From the balance sheet perspective, bitcoin futures contracts would
more logically adhere to the standards already in place for currency
futures contracts. Therefore, typical contract specifications for
bitcoin would include the following currency pairs: XBT/USD, XBT/EUR,
XBT/GBP and XBT/CNY (all currently tracked by CoinDesk’s BPI).
“Cryptocurrency futures markets seem poised to transform currency risk management again in the post-legal tender era.”
Contract months would be quarterly in March, June, September and
December, with the last trading day being the 15th of each settlement
month.
Contract sizes would vary based on bitcoin valuation and growth, but
it is logical to assume that 100-bitcoin and 250-bitcoin contracts would
be the early norm. Initially, the minimum trading interval (or tick)
would be 0.01 bitcoin.
Proposed margin requirements for the 100-bitcoin contract could be
structured at 10.00 bitcoin for initial margin deposit and 8.00 bitcoin
for maintenance margin deposit.
Accounts would be marked-to-market at the close of trading day for
purposes of determining new margin capital or forced liquidation. For
overall integrity, each exchange should also publish and adhere to
aggregated position limits.
As pointed out by the Mercatus study, an alternative would be to
denominate contract prices in bitcoin and hold margin funds in bitcoin,
thereby eliminating the need for traditional bank or financial
institution accounts. This would be possible if the contract was cash settled in bitcoin and the exchange maintained bitcoin warehousing requirements.
Existing bitcoin futures markets
Expect the terrain to shift dramatically in the coming months, but currently the largest and most significant bitcoin futures market is ICBIT.se
operated by Alex Stukalov. The company is in the process of registering
in an offshore jurisdiction and facilitated more than $15m-worth of
bitcoin futures trading during the last 30 days.
Romanian-based MPEx
operated by Mircea Popescu displays BTC/EUR futures with settlement each
month and displays contracts in the standard calendar months for
bitcoin “network difficulty” futures, however, it remains to be seen
whether sufficient and tradeable liquidity exists. Indeed, MPEx/MPOE shuttered its BTC/USD options trading in February 2014 due to lack of a robust pricing feed.
We can learn a lot about bitcoin futures exchanges by studying these
predecessors, especially in the areas of customer support, liquidity and
counterparty risk.
Neither ICBIT.se nor MPEx serve as a clearinghouse for their customers’
trades, which is an essential element of a formal futures exchange.
Furthermore, verifiable volume reporting will be critical as these
futures exchanges will most likely play an important role for bitcoin
price discovery.
The other operators claiming to be in the derivatives and hedging
business are actually offering non-standardized margin trading by
offering interest rates on borrowed funds. Notable entrants for margin
trading include BitFinex, BTC.sx, Bit4x and still-in-beta Coinsetter.
After the unwinding of the Bretton Woods currency arrangement in the
1970s, the gun-slinging traders of the Chicago pits transformed
financial futures with various products designed to manage floating
currency risk.
Now, nearly 45 years later, cryptocurrency futures markets seem
poised to transform currency risk management again in the post-legal
tender era.
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