Mainstream trading increasingly giving regulatory cover to cryptocurrency trading
Bitcoin growing up as futures open floodgates to Wall Street
Bitcoin is going legit, for better or worse.
The digital currency that JPMorgan Chase’s Jamie Dimon called a fraud is set to step into the mainstream of finance now that CME Group has announced it will introduce trading in bitcoin futures by the end of the year. The move by the world’s largest exchange owner will up the game for the software-created asset and finally bring it some regulatory cover.
Just a month ago, a top CME Group executive said he didn’t foresee listing bitcoin futures any time soon. Chief executive Terrence Duffy cited pent-up client demand as a key reason for the reversal. Bitcoin climbed to a record high after the news went out Tuesday — and is up more than 550 per cent this year.
“A fully regulated derivatives market is opening the floodgates of institutional demand,” said Spencer Bogart, head of research at Blockchain Capital, a San Francisco-based venture capital firm. And for Wall Street, bitcoin is attractive. “It’s volatile, it trades 24/7 and the markets are inefficient so they provide nice arbitrage opportunities.”
At the moment, a start-up, LedgerX, is trading bitcoin swaps and options, and Cboe Global Markets is planning a futures contract by year-end or early 2018, once it gets approval from the Commodity Futures Trading Commission (CFTC). CME will also need an OK from the CFTC.
With the availability of futures contracts, it will be easier to sell bitcoin short, betting on declines. Liquidity will increase with high-frequency traders acting as market makers allowed to pursue neutral strategies, ending the day even.
A functioning derivatives market could also give professional traders and investors access to bitcoin without having to deal on unfamiliar venues that may be risky in terms of anti-money laundering and know-your-customer rules. It will allow traders to hedge cash positions in the digital money, which to date has been difficult to do.
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“This is big news. As a proxy, gold derivatives markets are much larger than gold markets. The same could happen here,” said Kyle Samani, managing partner of cryptocurrency hedge fund Multicoin Capital. “Overall, this is a big deal for crypto."
Wall Street banks have generally been cautious. Goldman Sachs Group chief executive Lloyd Blankfein has said the company is open to finding to ways to get involved with the new technology, while Citigroup chief financial officer John Gerspach said his team is taking an “intense” look at cryptocurrencies and the blockchain technology that underlies them.
Dimon, JPMorgan’s chief executive, has been among the most outspoken, saying in September that he would fire any employee trading in bitcoin for being “stupid.” A month later, though, JPMorgan CFO Marianne Lake said the bank was “very open minded to the potential use cases in the future for digital currencies that are properly controlled and regulated.”
CME will face challenges to win over some investors. If the underlying pricing is unsound, that could steer people away, said Mark Williams, a finance lecturer at Boston University’s Questrom School of Business.
“The concern is that CME will attempt to treat bitcoin like a corn or wheat future, when this commodity is in a highly risky class of its own,” Williams said. “One of the major spots to buy and sell bitcoin are through unregulated bucket-shop exchanges located outside of the reach of US regulators.”
He noted that since 2009, almost half of these types of exchanges — including Mt. Gox, once the largest bitcoin market — have gone bust. “CME has no other commodity future that looks like or behaves like bitcoin. To me this means trouble.”
Jon West, head trader at digital-asset brokerage Omega One, said the amount of daily margin CME will require will be key. If it’s too high, “then it’s not very useful for hedging because you need to have so much money in your account,” he said. CME should take it slow as it designs its contract, he said. “It’s a very complex asset with a lot going on.”
The CME contract will settle in cash and use a daily price from the CME CF Bitcoin Reference Rate, which is supported by digital exchanges Bitstamp, GDAX, itBit and Kraken.
CME’s Duffy said on Bloomberg Television that his exchange’s futures contract should put sceptics at ease. “Bitcoin trading at CME will have an instant audit trail to the government regulator,” he said “That’s what the difference is between our offering and the way it is today.” Traders can’t “circumvent those procedures under our model.”
And CME will bring the cryptocurrency into the big league. “Institutions need derivatives and benchmarks to trade and hedge in order to take bitcoin to the next level,” said John Spallanzani, chief macro strategist at GFI Securities in New York. “It doesn’t make bitcoin trading less risky but the ability to hedge that risk is big.”
In the race for first to offer bitcoin derivatives, both CME and Cboe lost out to LedgerX, which won CFTC approval to offer swaps and options on bitcoin and began trading earlier this month. Volumes have been light so far. On Tuesday, 103 bitcoin swaps traded on LedgerX, while nine options contracts changed hands, according to the exchange. The LedgerX options trades are physically delivered, giving investors who hold a contract to maturity the ability to own bitcoin outright.
Ari Paul, a co-founder of Blocktower Capital, said LedgerX is starting out slowly on purpose. “DRW is a market maker there,” Paul said. “There’s pretty low volume. A million dollars a day. I do expect them to have a lot of volume very soon. They are intelligently ramping up.”
Many investors can’t maintain ownership of bitcoin now — what’s known as custody — “either for regulatory reasons or because it’s scary and hard,” Paul said. But in a regulated market like futures, that doesn’t become an issue. “The ability to easily short allows for market-neutral strategies and makes high-frequency trading much easier. That draws a lot of attention from hedge funds and the traditional finance world.”
The creation of bitcoin futures could make it easier to create an exchange-traded fund based on the digital asset. The US Securities and Exchange Commission in March rejected a bitcoin ETF proposed by Tyler and Cameron Winklevoss — co-creators of the Gemini exchange — saying necessary surveillance-sharing agreements were too difficult given that “significant markets for bitcoin are unregulated.”
CME is a giant in trading, with products including futures on the S&P 500, oil and gold and customer connections all around the world. Under Duffy’s leadership, it has pulled back from business interests that didn’t align with its historic role as a futures powerhouse, such as shutting down its European operations and exiting credit-default swap clearing. Its earlier resistance to bitcoin futures was seen as aligned with Duffy’s vision of keeping the company’s focus on what it has always done well.
“I’m a little concerned about the fact that both of those futures contracts are cash settled,” said Garrett See, chief executive of DV Chain, a sister company of DV Trading, which trades cryptocurrencies. The Cboe contract will be settled using auctions on the Gemini exchange.
See said there has not been a lot of volume in those auctions, raising the question of what will happens if an auction fails, or there’s not enough volume to keep it from being manipulated.
“I’m really excited to see derivatives come into the space,” See said. “I see it as a great step, but in an ideal world I’d really like to see physical delivery” in futures.
For all the potential downsides, the benefit of increased regulation can’t be overstated, Omega One’s West said. “Futures trading should deter some black-market business and push it into more regulated places.”