December 2017 marked a milestone in the short history of virtual currency. On Friday, December 1, 2017, the Chicago Mercantile Exchange Inc. (CME) and the CBOE Futures Exchange (CFE) self-certified new contracts for cash-settled bitcoin futures products. The self-certification process allows designated contract markets (DCMs) to list new derivative products one day after submitting in writing to the Commodity Futures Trading Commission (CFTC) that the product complies with the Commodity Exchange Act (CEA) and CFTC regulations.

Prior to December 2017, there were limited options for investors that wanted access to bitcoin derivatives. In 2014, TeraExchange, LLC, a Swap Execution Facility (“SEF”) registered with the CFTC, began listing bitcoin swaps for trading by “eligible contract participants.”[1] Also in 2014, North American Derivatives Exchange Inc., a DCM, listed binary bitcoin options that were available to retail investors. Then, in July of 2017, the CFTC approved LedgerX’s application to become a SEF and a Derivatives Clearing Organization (DCO), thereby allowing LedgerX to offer physically-settled bitcoin put and call options and day-ahead swaps to eligible contract participants.

Early bitcoin derivatives had limited appeal because they were illiquid, due in part to their bespoke features and the fact that they traded on venues that were relatively new and unknown. In addition, access to early bitcoin derivatives was primarily limited to wealthy investors. When bitcoin futures launched, they gave every investor access to a liquid product that traded on two of the world’s largest futures exchanges and that could be bought and sold through online retail brokers like E-Trade and TD Ameritrade.

The introduction of CFE’s contract on December 10, 2017, coincided with the largest one-week price increase (in dollar value) in bitcoin’s history, with the price rising from $15,168 on December 10 to an all-time high of $20,089 on December 17[2] – the day CME launched its futures contract. Researchers at the Federal Reserve Bank of San Francisco have attributed the rapid decline[3] in bitcoin’s price after the launch of the CME contract to the presence of speculators using bitcoin futures to bet against bitcoin.[4] Prior to bitcoin futures, these pessimists “had no mechanism available to put money behind their belief that the bitcoin price would collapse.”[5] Others have pushed back on the idea that bitcoin futures materially affect the price of bitcoin,[6] noting the limited open interest in the contracts and the fact that the contracts are cash settled,[7] meaning no actual bitcoins are exchanged.

While it is difficult to know the precise impact cash-settled futures have on bitcoin’s price, it is clear from early experience that bitcoin futures serve primarily as a means to speculate on the price of bitcoin and not as a true hedging instrument. This outcome was widely anticipated at the time bitcoin futures were launched and led many market participants and observers to question why the CFTC allowed bitcoin futures to come to market.[8] The CFTC responded by noting that Congress established the self-certification process and they had limited grounds for halting a self-certification – none of which were met in the case of bitcoin futures.[9]

My recent article challenges the CFTC’s assertion that CME and CFE met all the requirements to self-certify bitcoin futures contracts. CFTC regulation requires that any new contract not be readily susceptible to manipulation, but a careful review of the record indicates that bitcoin futures are susceptible to manipulation because the bitcoin spot market can be manipulated.

Because bitcoin futures are cash-settled, they can be manipulated if the reference rate used to price the contracts at settlement can be manipulated. The price of bitcoin varies, depending on the exchange it trades on, and so CME and CFE had to carefully construct a reference rate for their futures contracts that could not be manipulated. CFE’s futures contract relies on the Gemini Exchange’s daily bitcoin auction to determine the contract’s settlement value. However, Gemini lacks sufficient trading volume to facilitate price discovery and its daily auction often fails to clear a single bitcoin. CME calculates a bitcoin reference rate based upon data provided by four “Constituent Exchanges.” In its self-certification submission, CME noted two additional exchanges that are temporarily suspended from submitting pricing data – OkCoin and Bitfinex. The mention of these two exchanges should have been a red flag for the CFTC, as they both have a troubled history, especially Bitfinex, which has been accused of propping up the entire bitcoin spot market throughout much of 2017.[10]

The CFTC also ignored the systemic risk implications of allowing bitcoin futures to come to market. While the virtual currency market at present is not large enough to threaten financial stability, the introduction of bitcoin futures creates new interconnections within the financial system that could one day propagate systemic risk should the market continue to grow. Bitcoin futures pierced the previous barrier that had largely separated the virtual currency market from the regulated financial system. Now, large Wall Street firms offer their clients access to bitcoin futures, which trade on regulated exchanges and are cleared on systemically important clearinghouses. In addition, these parties may not fully understand the risks they are taking due to bitcoin’s novelty and complexity. The financial crisis of 2008 serves as a stark reminder of what can happen when seemingly sophisticated financial institutions trade complex derivatives.

By not halting the self-certifications of bitcoin futures, the CFTC placed the regulatory imprimatur on an asset class that, at the time, was in the midst of a speculative frenzy and whose true value remains questionable. In so doing, the CFTC contributed to a rapid integration of virtual currency with mainstream financial markets and institutions. In August 2018, Intercontinental Exchange announced that it was forming a new company called Bakkt, whose aim is to clear the way for major money managers to offer bitcoin mutual funds, pension funds, and ETFs as regulated investments.[11] In October 2018, Fidelity also announced the launch of a virtual currency company to provide enterprise-grade custody solutions, a virtual currency trading execution platform, and institutional advising services.[12] While these initiatives may have happened regardless, the introduction of bitcoin futures almost certainly played a role in accelerating their development.

ENDNOTES

[1] An “eligible contract participant” is a type of sophisticated trader, which includes various financial institutions and persons, with assets above specified statutory minimums.

[2] Bitcoin price data comes from CoinMarkepCap, https://coinmarketcap.com/currencies/bitcoin/historical-data/?start=20130428&end=20181110

[3] By January 17, 2018, bitcoin had declined to $11,431.

[4] Galina Hale, Arvind Krishnamurthy, Marianna Kudlyak, & Patrick Shultz, How Futures Trading Changed Bitcoin Prices, Federal Reserve Bank of San Francisco Economic Letter (May 7, 2018), https://www.frbsf.org/economic-research/publications/economic-letter/2018/may/how-futures-trading-changed-bitcoin-prices/.

[5] Id.

[6] Chris Concannon, president and chief operating officer at Cboe Global Markets, Inc. said, “While we are excited about our recently launched Bitcoin futures, 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.” See, Oscar Williams-Grut, Bitcoin futures could be hurting bitcoin’s price, Business Insider Australia (2018), https://www.businessinsider.com.au/bitcoin-price-could-be-hit-by-bitcoin-futures-contracts-says-tom-lee-2018-6.

[7] See, Zhuoqi Gao, Using CBOE Bitcoin Futures To Predict Underlying Bitcoin Price Direction, Seeking Alpha (Mar. 25,2018), https://seekingalpha.com/article/4158704-using-cboe-bitcoin-futures-predict-underlying-bitcoin-price-direction.

[8] See Gabriel T. Rubin, Rise of Bitcoin Futures Prompts Regulator to Revisit Hands-Off Approach, Wall St. J. (Jan. 31, 2018), https://www.wsj.com/articles/rise-of-bitcoin-futures-prompts-regulator-to-revisit-hands-off-approach-1517394600.

[9]Commodity Futures Trading Comm’n, CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets (Jan. 4, 2018), https://www.cftc.gov/sites/default/files/idc/groups/public/%40customerprotection/documents/file/backgrounder_virtualcurrency01.pdf.

[10] John M. Griffin & Amin Shams, Is Bitcoin Really Un-Tethered? (June 13, 2018), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3195066.

[11] Shawn Tully, The NYSE’s Owner Wants to Bring Bitcoin to Your 401(k). Are Crypto Credit Cards Next?, Fortune (Aug. 3, 2018),  http://fortune.com/longform/nyse-owner-bitcoin-exchange-startup/.

[12] Michael Del Castillo, Fidelity Launches Institutional Platform for Bitcoin and Ethereum, Forbes (Oct. 15, 2018), https://www.forbes.com/sites/michaeldelcastillo/2018/10/15/fidelity-launches-institutional-platform-for-bitcoin-and-ethereum/#7378a86c93c4.

This post comes to us from Lee Reiners, executive director of the Global Financial Markets Center and a lecturing fellow at Duke University School of Law. It is based on his recent article, “Bitcoin Futures: From Self-Certification to Systemic Risk,” available here.