Bitcoin is an encrypted global electronics payment system in which prices are stored in an electronic, publicly available ledger called blockchain. Blockchain and associated cryptotechnologies hold out the promise of — and in some ways already are — revolutionizing the ecosystem of trading and settlement, as John Plansky, Tim O’Donnell, and Kimberly Richards laid out comprehensively in strategy+business in early 2016.
Many of the institutions that facilitate the movement of capital around the world and manage investments have cast a jaundiced eye on bitcoin. Jamie Dimon, chief executive of JPMorgan Chase, this month dismissed it as a “fraud,” while Larry Fink, head of BlackRock, said the cryptocurrency’s rise “just shows you how much demand for money laundering there is in the world.”
Others are taking a more proactive approach to bitcoin and other digital currencies. It was reported in early October, for example, that Goldman Sachs was exploring the possibility of trading bitcoin. And in late October, the operator of the world’s biggest futures exchange, CME Group, appeared to give a vote of confidence in the cryptocurrency by announcing its planned launch of futures contracts on bitcoin.
CME, which runs the Chicago Mercantile Exchange, plans in the fourth quarter to offer bitcoin futures “given increasing client interest in evolving cryptocurrency markets.” Futures, of course, are financial instruments that allow investors and companies to hedge against future rises or falls in the price of the assets such as crude oil, an interest rate, or a currency. CME is best known for its benchmark interest rate futures, which are used globally by companies and traders to protect against — and speculate in — the future movement of interest rates.
But the group also has a track record of getting into some pretty esoteric products, which is what bitcoin might look like to some. Back in 2006, CME launched a futures contract on the likelihood of snow falling (pdf) at certain locations — such as airports — as a way of helping tourism companies and local governments “prepare for winter,” as it said at the time.
So, are bitcoin futures just another punt on trading exotica, or are they a sign that one of the most systemically significant financial institutions in the U.S. is making a bold bet on the future of cryptocurrency?
Bitcoin has certainly been volatile in its short life as a traded instrument. But even without CME offering futures contracts, there’s evidence it is being taken seriously by traders as an asset class in its own right. Bitcoin is the largest convertible virtual currency by market capitalization — worth close to US$72 billion as of August 2017 (pdf), according to the Commodity Futures Trading Commission (CFTC), the U.S. futures regulator that also oversees CME Group.
Indeed, the CFTC in 2015 designated bitcoin and other virtual currencies a “commodity.” Other regulators around the world have similarly given it their stamp of approval, although one suspects these designations have been made as much to be able to regulate bitcoin as anything else. (The tax and regulatory treatment of bitcoin and other cryptocurrencies continues to evolve, and there are significant open questions about how cryptocurrency is treated on balance sheets, and how profits and losses should be taxed.)
But, bottom line, bitcoin is not in the same speculative league as snowflakes. Nor is the CME’s move a sign that it necessarily thinks bitcoin has legs as a new way of conducting transactions.
Bitcoin is not in the same speculative league as snowflakes.
The clue lies in the fact that the planned futures contract is cash-settled as opposed to physically settled. Physically settled futures require the holder to either produce the commodity or take delivery from an exchange’s clearing house once the contract expires, as was the case when pork belly futures first started trading in Chicago in 1961.
Cash-settled futures involve the issuance of a final debit or credit to a customer when the contract expires, with the amount determined by the level at which the trader’s speculation on the future price of the underlying asset ended up at contract expiry.
Futures traders love cash-settled plays because there’s therefore no need to store or hold a particular commodity or underlying asset to make good on the bet embedded in the futures contract once it expires. It’s a purely financial transaction. CME’s popular e-mini S&P futures contracts are cash-settled. In other words, the new bitcoin futures allow speculation on bitcoin without the need to make the financial commitment to take possession of bitcoin itself.
This type of product is appealing because, at a time of historically low volatility, instruments that have the potential to move quickly are likely to be well-received by a trading community starved of high-beta opportunities. Traders make money when markets are volatile and struggle to do so when they are not.
And we have been stuck in a period of low volatility for some time now: The Chicago Board Options Exchange’s VIX index — or “fear index” — is reading 9.8, well below its long-term average of 20. The latest quarter’s bank earnings show how low volatility continues to crimp the trading business. BNP Paribas was the latest last week to blame “unfavorable” market conditions for a sharp fall in revenues. In such an environment, the recent wild swings in bitcoin’s value mean that bitcoin is effectively the only volatility play in town.
In the physical bitcoin market, there is already a feeding frenzy under way, with specialist trading firms taking often large positions. As the Financial Times reported, DRW — a firm that has its roots in the open-outcry trading pits of the Chicago Mercantile Exchange — has a team of people trading nothing but bitcoin at a subsidiary called Cumberland Mining.
With many such firms building up possibly large positions in bitcoin, it was only a matter of time before futures contracts emerged as a way for firms to hedge their exposures — and as a way to offer a purely speculative product.
In addition, CME doubtless has an eye on the high-frequency traders who provide so much of the volume of global futures exchanges these days. This breed — made famous by Michael Lewis in his book Flash Boys — make money by exploiting tiny pricing differentials in split-second computer dealing.
So for CME, it will not matter whether bitcoin is ultimately successful as a new form of carrying out transactions in order to justify the launch of bitcoin futures. They just need to be popular as a trade for a while — and with luck, a long while. After all, exchanges like CME make money each time a “buy” or “sell” order is punched into a computer and a deal completed.
It’s true that the heads of some large financial institutions may not want to talk about bitcoin anymore. But it’s also fair to say that as more institutions embrace the mining and trading of bitcoin, it will become much more difficult to ignore this new commodity.