The Chicago Board Options Exchange (CBOE) became the first US derivatives exchange to start trading bitcoin futures on December 10, despite widespread concern surrounding high margin requirements.
According to reports, bitcoin’s inherent volatility and lack of regulatory oversight led CBOE to raise margin requirements to 44% from 33% to hedge protect against possible instability. In spite of this, the price of the futures shot up significantly overnight, a few hours after trading opened, and the value of bitcoin rose to over $16,000.
Fellow exchange CME will also begin to offer futures contracts similar to those traded by CBOE on December 18, with Nasdaq expected to follow suit. Late last week, some of the US’ biggest brokers suggested that they are unwilling to allow the majority of their clients to trade the futures. On Thursday, the chief executive and president of the Futures Industry Association Walt Lukken wrote an open letter to Commodity Futures Trading Commission (CFTC) Chairman Christopher Giancarlo expressing his apprehensions with the manner in which bitcoin futures have come to market.
“While suited for standardised products, this process does not distinguish for a product’s risk profile or unique nature. We believe that this expedited self-certification process for these novel products does not align with the potential risks that underlie their trading and should be reviewed,” Lukken’s letter read.
The CFTC confirmed that it will be monitoring trading activity: if it determines that the margin is inadequate, it will force the clearing organisation to increase the margin levels.
- CBOE became the first derivatives exchange to start trading bitcoin futures on December 10, despite widespread concern surrounding high margin requirements;
- Bitcoin’s inherent volatility and lack of regulatory oversight led CBOE to raise margin requirements to hedge protect against possible instability but the cryptocurrency rose significantly after trading opened;
- There are concerns about whether the margin is adequate, and some investors may perceive that the margin levels as too high;
- Allowing trading on these exchanges paves the way for US-based institutional investors to make bets on bitcoin to either rise or fall with a fair amount of leverage, which has led many to question once more if it needs to be regulated.
The amount of margin that an investor has to post determines how much leverage they have for their exposure - the higher the margin, the less leverage they get. According to Colin Lloyd, partner at Cleary Gottlieb, the question is how comfortable the futures community is with the risk management of these transactions to support open interest in the position.
“How do investors view the margin levels?” he said. “On the one hand, there were concerns at the CFTC and among FCMs [futures commission merchants] about whether the margin is adequate, but if you are an investor - particularly the more leveraged institutional investors like hedge funds - you may perceive a margin level as too high.”
He added: “It is not that there is too much risk but too much leverage.”
Allowing trading on the derivatives exchanges paves the way for institutional investors, particularly those in the US, to make bets on bitcoin with a fair amount of leverage. Large-scale institutional investors, hedge funds and others will be make potentially very large leveraged bets on both directions of the movement of bitcoin, which could allow for market manipulation and increasing volatility.
According to Christopher Grey, chief operating officer of CapLinked, it is very significant both for hedging long on bitcoin as well as making more speculative bets on the continued increase or a decline in the digital currency.
“It presents opportunities for additional liquidity and additional institutional money coming in,” he said. “It
presents potential risks for the underlying bitcoin markets, because they are
"[Trading] presents potential risks for the underlying bitcoin markets, because they are not regulated"
He conceded that the futures will be regulated to some extent because they are going to be trading on a regulated exchange.
There had been concerns that the product was rushed to the market, and the CBOE would not have the necessary tools to prevent market manipulation. Michael Mollet, director of product development at CBOE, said that the exchange had been working on the futures contract for six months, were more than ready for Sunday’s trading and don’t anticipate any problems.
“We have an active experienced regulatory team and we have certain risk controls on the exchange that have been in place for several years,” he said. “One of the things that we like about Gemini [the cash exchange Cboe is partnered with] is that they have taken on a regulatory framework that they haven’t been required to take on, they look a lot like a more traditional exchange from the perspective of clients, regulation - we are confident in their abilities and they are confident in ours.”
As digital currencies increase in size and popularity, it seems increasingly unlikely they will remain unregulated in the US. The Securities and Exchange Commission (SEC) has so far kept a safe distance from all things bitcoin, but has indicated that it is monitoring the situation closely. In March, the regulator declined to approve the Winklevoss’ Gemini Exchanges ETF. According to Lloyd this shows a reluctance to address the absence of regulation in the bitcoin cash market.
“They said it would be important that there was a well regulated bitcoin market for them to be comfortable,” he said. “So if these futures contracts take off then the securities exchange can apply to the SEC and say: ‘there is now a regulated bitcoin regulated derivatives market’.”
The fact exchanges with the weight of CME and CBOE are now offering bitcoin futures contracts shows the gravitas that the sector has accumulated in 2017 and could point to the overall progression of the industry, which could bode well for other similar cryptocurrencies.
Tor Bair, head of growth & marketing strategy at data company Enigma, suggested that but this is a trend that the company was anticipating.
“It is definitely indicative of an overall professionalisation that is bringing more institutional attention if not investment,” he said. “It’s not just the technology of blockchain but the entire class of crypto assets, and especially bitcoin, that is being taken more seriously by experienced professional investors.”
But he believes there are two major limitations for trading these crypto assets. One is the exchange infrastructure for bitcoin and other currencies – there are many small exchanges handling very little volume and little liquidity. The other issue is inconsistent data and not being able to accurately track in real time the price of any particular asset or order book.
Grey agreed that it could put more pressure on the existing exchanges, and expose their vulnerability and that of the entire sector.
“They need to take their own independent action to become more robust, and be able to handle more trading volume,” he said. “If someone is coming in and using a lot of leverage to move the price dramatically in one direction or another using the futures or derivatives in bitcoin, that could create mass surges in trading in these exchanges.”
If the exchanges haven’t prepared independently with their own infrastructure for these mass increases in trading that might be driven by large price swings from the futures market, the futures market could make the exchanges more vulnerable.
Moller, however, said that CBOE is not entering the space to try and effect professionalisation one way or the other. “The way we look at it there are clearly differing opinions about the direction of bitcoin, which is one of the underpinnings of having a good market for anything,” he said. “As bitcoin becomes more mainstream, whether that is in the form of acceptance for payment in places like Japan or online vendors, there will become a natural need for hedging.”
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