Tuesday, May 27, 2014
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 structureAny 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 jurisdictionAs 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 contractsFrom 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 marketsExpect 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.