How to Regulate Bitcoin Futures

Bitcoin is a currency, technology, and, most recently, futures product.  Several clearinghouses have allowed bitcoin futures trading.  For example, CBOE launched trading in bitcoin futures on December 10, 2017, while CME Group did so a week later.[1]  NASDAQ and Cantor Fitzgerald’s exchange are also considering offering bitcoin futures.

Futures generally contribute to systemic risk,[2] but distinctive features of bitcoin futures heighten concerns.  Thus, the Futures Industry Association (FIA), a trade organization representing major banks and brokers, has protested the introduction of bitcoin futures to the market without more scrutiny, given their enormous potential to disrupt the economy.  This has created an unusual public gulf between institutional traders and the clearinghouses.

The Commodity Futures Trading Commission (CFTC) responded to FIA’s concerns with heightened review for cryptocurrency futures.[3]  Now, the question is how to minimize the systemic risk.  There are several possible approaches, each with its advantages and drawbacks, but the main factor is risk management, with the biggest risk posed by a default on a bitcoin futures contract.[4]  Particularly important to avoid is the bankruptcy or financial weakening of the clearinghouses through which bitcoin futures are traded.

The first regulatory method is to simply prohibit bitcoin futures entirely, as some banks and governments have done.[5]  However, a general rule prohibiting trading in bitcoin futures can be considered after other methods of preventing crises have been exhausted.

One option is to limit the number of positions that any one person may hold.  Position limits reduce excessive speculation, deter market manipulation, ensure sufficient market liquidity for bona fide hedgers, and protect the price discovery function of the market.[6]  These sorts of limits curtail the amount of risk each trader can carry when it comes to bitcoin futures.

Another option is to increase the margin deposits on bitcoin futures.  To control the risk of default, clearinghouses maintain a margin regime that includes an initial margin and a variation margin, both of which consist of collateral posted by a clearing member to protect the clearinghouse in the case of default.  Bitcoin’s volatility led CME to require traders to post margin deposits of more than 40 percent on their bitcoin futures.[7]  Most futures contracts require margin deposits of less than 10 percent.[8]  Reducing margin requirements would make bitcoin cheaper to trade and bitcoin futures more attractive but might also introduce risks to CME’s clearing system.

Clearinghouses have over the years also used transaction fees to create guarantee funds designed to cover bad trades.[9]  To minimize risk, separate guarantee funds could be introduced for bitcoin futures.  In other words, the party who creates the risk should pay for it.  These separate guarantee funds for bitcoin futures could be created by the clearinghouse or its members.

Finally, the health of much of the financial sector has been left to stress testing, which examines the performance of the regulated entity in hypothetical, challenging circumstances.[10]  Stress testing should continue in the bitcoin context by applying it to positions at the clearinghouses.[11]  A failed stress test would raise concerns about whether a firm or clearinghouse had enough capital to stay solvent in a crisis.

In sum, while bitcoin futures are new, their risks are old.  However, these familiar risks can be reduced with any of these approaches.

ENDNOTES

[1] CBOE, XBT-Cboe Bitcoin Futures, available at http://cfe.cboe.com/cfe-products/xbt-cboe-bitcoin-futures; CME Group, CME Bitcoin Futures Frequently Asked Questions, available at http://www.cmegroup.com/education/cme-bitcoin-futures-frequently-asked-questions.html.

[2] Sean J. Griffith, Substituted Compliance and Systemic Risk: How to Make a Global Market in Derivatives Regulation, 98 Minn. L. Rev. 1291, 1295 (2014) (defining systemic risk as “the linkages and interdependencies between participants in the financial market” and calling it “an appropriate target for regulatory attention”).  “Derivatives are all about risk. They are, at their core, nothing more than a contractual means by which parties allocate the risk of a fluctuation in price of an underlying reference asset.”  Id. at 1295.

[3] See, e.g., David Felsenthal, Daniel Silver, Jesse Overall & Brian Yin, Clifford Chance Discusses the Role of the CFTC in the Regulation of Bitcoin, The CLS Blue Sky Blog, available at http://clsbluesky.law.columbia.edu/2018/02/16/clifford-chance-discusses-the-role-of-the-cftc-in-the-regulation-of-bitcoin/#_ftnref13.

[4] Griffith, supra note 2, at 1295-96.

[5] Reuters Staff, Merrill Lynch Bans Clients from Investing in Silbert Bitcoin Fund (Jan. 3, 2018), available at https://www.reuters.com/article/us-bank-of-america-merrill-lynch-bitcoin/merrill-lynch-bans-clients-from-investing-in-silbert-bitcoin-fund-idUSKBN1ET02N; Evelyn Cheng & Cheang Ming, Bitcoin Briefly Falls 11% after South Korea Moves to Ban New Cryptocurrency Trading Accounts, CNBC (Dec. 28, 2017), available at https://www.cnbc.com/2017/12/28/bitcoin-drops-11-percent-as-south-korea-moves-to-regulate-cryptocurrency-trading.html.

[6] Andrew Notini, Note, Paper Tiger: The Validity of CFTC Position-Limit Rulemaking under Dodd-Frank, 46 Suffolk U. L. Rev. 185, 192-93 (2013).

[7] Reuters Staff, Bitcoin Futures Contracts at CME and Cboe, Reuters (Dec. 15, 2017), available at https://www.reuters.com/article/uk-bitcoin-futures-contracts/bitcoin-futures-contracts-at-cme-and-cboe-idUSKBN1E92K9.

[8] Gregory Meyer, Nicole Bullock, Joe Rennison, & Alexandra Scaggs, Bitcoin Futures Face Safeguards to Tackle Wild Gyrations, Financial Times (Nov. 16, 2017), available at https://www.ft.com/content/4bbf1ef6-ca4a-11e7-ab18-7a9fb7d6163e.

[9] Julia Lees Allen, Note, Derivatives Clearinghouses and Systematic Risk: A Bankruptcy and Dodd-Frank Analysis, 64 Stan. L. Rev. 1079, 1089 n.36 (2012).

[10] Id. at 1091 (describing the stress tests that the LCH clearing company uses for its default fund).

[11] U.S. Commodity Futures Trading Commission, CFTC Announces Clearinghouse Liquidity Stress Test Results (Oct. 16, 2017), available at http://www.cftc.gov/PressRoom/PressReleases/pr7630-17.

This post comes to us from Professor Margaret Ryznar at Indiana University’s McKinney School of Law.  It is based on her forthcoming Houston Law Review article, “The Future of Bitcoin Futures,” available here.