Major derivatives market operators CBOE Holdings and CME Group have jumped into the digital currency fray within the last two weeks by launching cash-settled bitcoin futures contracts (1). The exchanges recently cleared de facto regulatory hurdles when the Commodity Futures Trading Commission (CFTC) announced the completion of the exchanges’ “self-certification” process. The CFTC was quick to note that it has not formally approved or endorsed these products. Instead, the exchanges self-certified their products’ compliance with the Commodity Exchange Act and CFTC regulations. The distinction between self-certification and formal CFTC approval is mostly semantics for a product like bitcoin futures, as getting to this point involved extensive discussions between the exchanges and CFTC staff, during which the exchanges agreed to various CFTC-imposed requirements (regarding contract specifications, margining and information sharing with underlying bitcoin exchanges) to protect customers and support market integrity.
CBOE announced that it has partnered with Gemini Trust Company – the digital currency exchange started by Cameron and Tyler Winklevoss – for bitcoin market data, under a multi-year, exclusive license that allows CBOE to use Gemini’s data for bitcoin derivatives and indices (derived from the Gemini Exchange). CME’s product is based on the CME CF Bitcoin Reference Rate (BRR), a once-per-day reference rate of the price of bitcoin in U.S. dollars. According to CME Group, CME and Crypto Facilities Ltd. have calculated the BRR since November 2016, using pricing data contributed by Bitstamp, GDAX, itBit and Kraken (digital currency exchanges).
In the same press release in which it announced the self-certification of CBOE’s and CME’s futures products, the CFTC also announced that Cantor Futures Exchange (Cantor) self-certified a new contract for bitcoin binary options (2) (technically a swap (3) for regulatory purposes). Other bitcoin derivatives products and platforms include LedgerX, an exchange that lists and clears fully-collateralized, physically-settled bitcoin options; TeraExchange, which lists for trading a non-deliverable forward contract (4) based on the Tera Bitcoin Price Index (TeraBit); and NADEX, which lists for trading binary options based on TeraBit (retail customers may trade on NADEX).
So what does all this mean for digital currencies and for the financial markets generally? Arguably the biggest impact is the expanded ability of bitcoin holders to hedge against price volatility, using CBOE and CME bitcoin futures (and, looking ahead, Cantor binary options), in addition to forwards and options already available on other smaller exchanges. With the price of bitcoin having risen dramatically (and exhibited extreme volatility) in recent months, including flirting with the $20,000 mark this week, the ability to hedge against price movement is an attractive tool for those holding long positions in bitcoin who wish to protect against downside risk. This risk-hedging ability may encourage skeptical institutional investors to leave the sidelines and participate in the market for bitcoin. Additionally, the cash-settled nature of the CBOE and CME products provides an opportunity for participation for those who are wary of holding long positions in bitcoin. Bitcoin futures may also improve price transparency and aid in price discovery for current or prospective investors.
Bitcoin futures may even pave the way for additional mainstream products, such as bitcoin ETFs. In March 2017, the Securities and Exchange Commission (SEC) rejected a proposal by Bats BZX Exchange to list for trading shares of the Winklevoss Bitcoin Trust. The SEC based its decision, in part, on (1) the lack of a “surveillance-sharing agreement” between Bats and a “significant, regulated, bitcoin-related market” and (2) the failure to show that “the significant markets for bitcoin or derivatives on bitcoin are regulated markets with which [Bats] can enter into such an agreement.” In its decision, the SEC noted that, in its view, bitcoin was in an early stage of development, acknowledging that “regulated bitcoin-related markets of significant size may develop.” The SEC specifically referenced then-established bitcoin pricing indexes and the possibility that regulated futures or derivatives markets could eventually launch products based on those indexes. The Winklevoss Bitcoin Trust and other similar products could see a second chance at life as a result of the launch of the CME and CBOE futures products.
While the future of the markets for these mainstream bitcoin financial products remains unknown, one thing is for certain: Industry participants and regulators alike will be closely watching to see if bitcoin futures generate the level of sustained demand the exchange operators seem to expect.
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(1) A futures contract is an agreement to buy or sell an asset or commodity at a future date at a specified price. An option contract is similar, except that it conveys the right, but not the obligation, to buy or sell a particular asset or commodity at a future date at a specified price. These financial instruments are referred to as “derivatives” because they derive their value from the underlying asset or commodity (e.g., bitcoin or another digital currency). Derivatives are commonly used to hedge against the risk of price swings in the underlying asset/commodity. Derivatives can also be used for speculative purposes, being bought and sold as the value of the derivative changes based on various factors, including the price of the underlying asset/commodity and time to expiration.
(2) A binary option is a type of options contract that typically provides for payment based on the outcome of a specific yes/no result (hence the binary name) – typically whether the value of the underlying asset or commodity rises above or falls below a specified price.
(3) The term “swap” covers a wide array of derivative products. Swaps are generally used by institutions to transfer financial risk. Interest rate swaps are a common type of swap.
A swap generally refers to an agreement, contract, or transaction to exchange one or more payments based on the value or level of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset or commodity.
(4) Forward contracts share many characteristics with futures contracts. Both represent an agreement to buy or sell an asset or commodity at a future date at a specified price. However, a forward contact generally is privately negotiated between the parties and traded over-the-counter, whereas a futures contact generally has standardized terms and trades on an exchange.
