For the typical investor, cryptocurrency investment has, since its genesis in the open market, been made largely through direct purchase of the particular currencies via digital wallets or through exchanges such as CoinBase. The unfamiliarity of this process, and unproven structure, is often off-putting to the more traditional investor. Enter the derivative market, flipping the cliché on its head, making something new, old again.
Last week, the first ever cryptocurrency-based derivative, a future contract on Bitcoin, named “Cboe Bitcoin Futures”, was launched on the CBOE Futures Exchange (“CFE”). It was recently joined by another Bitcoin futures product from the Chicago Mercantile Exchange Inc. (“CME”) on December 18, 2017. Within forty-eight hours of going live, the CFE saw multiple trading halts due to over-demand for its Bitcoin future contract. In the initial week, rather than leading to a stabilization of Bitcoin prices, the Cboe Bitcoin Futures have been arguably more volatile than the underlying Bitcoin spot price, both of which have seen wild price swings in recent weeks. While CME’s fledgling future contract has shown more price resilience in its short run, the price of Bitcoin has continued to show massive volatility this week.
The move to cryptocurrency-based derivatives is significant. It allows many professional investors to trade on the price fluctuations of Bitcoin, and eventually other digital currencies or assets, as certain investors are prohibited or otherwise frustrated in efforts to directly trade on the underlying digital currency because of regional regulations, fiduciary duties, or other restrictions. At least with regards to these initial offerings, the futures are cash-settled contracts, meaning that investors are able to expose themselves to risks of Bitcoin price movement without needing to electronically, and often practically speaking physically, hold the underlying digital asset. Futures allow for more typical payout methods that are familiar and thus more attractive to traditional investor classes, along with being a more-sanctioned asset class in general. A demand for similar convenience has driven the rise of exchange-traded funds, or EFTs for short, in recent years.
The regulatory process guiding Bitcoin future offerings is ongoing. Earlier this month, on December 1, 2017, the Commodity Futures Trading Commission (“CFTC” or “Commission”) issued a statement and backgrounder on the contracts for derivative products listed with the CFE and CME, which outlined the self-certification process taken with respect to the new Bitcoin future offerings. Prior to listing new contracts, the Commodity Exchange Act (“CEA”) provides designated contract markets (“DCMs”) with the ability to either submit a written self-certification that the proposed contract complies with the CEA and CFTC regulations or voluntarily submit the contract to the CFTC for approval. The CFE and CME worked closely with the CFTC prior to self-certifying, particularly with respect to enhancing customer protections, creating an orderly market with well-functioning settlement, and structuring the contracts to be resistant to market manipulation. The CFTC highlighted that CFE and CME will coordinate with it on forward-going surveillance activities, which will assist the Commission with its continual assessment of whether further changes are required to the contract design and settlement processes.
The CFTC also highlighted that it was working closely with the National Futures Associations (“NFA”) in monitoring that organization’s member trading involving the Bitcoin futures. If the Commission later determines that the margins being held by CFE and CME are insufficient, the CFTC vows to take action to increase margin protection, including the requiring of longer margin periods. CME has already raised its margin requirements from its initial proposal. The CFTC also noted that, despite its involvement in the launch of these Bitcoin derivative products, it has not endorsed their creation or promulgation.
As we move into 2018, investors and their counsel will be interested in monitoring the CFTC’s evolution on its view of not just digital currency derivatives, but cryptocurrencies in general, and also the affect these Bitcoin derivatives will have the price of Bitcoin.