Last Friday, December 1, 2017, the U.S. Commodity Futures Trading Commission (CFTC) announced that three futures exchanges—the Chicago Mercantile Exchange Inc. (CME), the CBOE Futures Exchange (CBOE) and the Cantor Exchange (Cantor)—self-certified that they will be listing futures contracts (CME and CBOE) and options (Cantor) referencing bitcoin. Trading in bitcoin futures will commence at the CBOE on December 10 and on CME on December 18, with Cantor’s options trading to follow. Listing these contracts will allow both institutional and retail investors to obtain long or short exposure to bitcoin without buying or selling the underlying bitcoin itself.
The CFTC regulates trading in futures, options and swaps, as well as fraud or manipulation in the spot market for commodities referenced by those derivatives. Since 2015, the CFTC has taken the position that bitcoin is a commodity subject to its jurisdiction, and CFTC-regulated markets have listed bitcoin-related derivatives since 2014. Until now, however, these derivatives have been limited to swaps or options, with availability mostly limited to institutional investors.
A U.S. futures exchange can bring a new derivatives contract to market either by submitting the contract to the CFTC for pre-approval or, more commonly, by self-certifying to the CFTC that the contract complies with the Commodity Exchange Act and CFTC regulations. Here, CME, CBOE and Cantor opted for the self-certification approach. Although the CFTC consequently did not specifically approve these contracts, it did engage in an extensive dialogue with the exchanges before they filed their self-certifications. Some of the key matters the exchanges sought to address as part of this dialogue include:
- Contract Design and Settlement. In designing their contracts, the exchanges had to make decisions about contract size, tenor, and trading and settlement conventions. Some notable consequences of these decisions include:
- Limited Retail Participation? The exchanges generally opted for larger contract sizes, which might lead to less retail participation in the market. The futures self-regulatory organization, the National Futures Association, also issued an investor advisory outlining the risks of bitcoin futures trading, noting that trading in these products “may not be suitable for all investors.”
- No Need to Hold Bitcoin. The exchanges opted for cash-settled contracts, so at expiry the parties will exchange a cash amount calculated by comparing their contract terms to the bitcoin spot price, instead of delivering bitcoin itself.
- This feature will facilitate trading by investors wary of the operational risks of holding bitcoin. These investors might also take comfort from the presence of a CFTC-regulated broker (called a “futures commission merchant” or “FCM”) and clearing organization to backstop their trading.
- To facilitate cash settlement, the exchanges need robust methods for calculating bitcoin spot prices—a challenging task given the decentralized nature of the bitcoin market. In this case, each exchange opted for a different calculation method: CME will use an index compiled from prices at multiple bitcoin spot market exchanges; CBOE will use prices at the Gemini Exchange; and Cantor will take a more open-ended approach, relying on a mix of publicly available bitcoin price sources, market analytics, and prices from its futures exchange. It is unclear what method investors will prefer or whether a significant pricing difference among the contracts will emerge.
- Spot Market Surveillance. Regulators have expressed concerns about the unregulated nature of trading in the bitcoin spot market. This concern largely motivated the March 2017 decision by the U.S. Securities and Exchange Commission (SEC) to deny a proposal by a securities exchange to list an exchange-traded fund (ETF) designed to track bitcoin prices. Here, CME, CBOE and Cantor had to certify to the CFTC that their contracts are not “readily susceptible to manipulation.” To help make this finding and address related CFTC staff feedback, the exchanges agreed to enhanced information sharing with the underlying bitcoin spot market exchanges.
- Margin and Risk Management. Futures and options allow an investor to obtain leveraged exposure because an investor typically does not need to pay the full amount of its contract upfront. The extent of leverage depends on how much collateral (“margin”) the exchange or the FCM requires an investor to post in order to secure its obligations. Typically, the margin amount is higher for contracts with more volatile prices.
- Given the high volatility of bitcoin prices, a key consideration for the CFTC was whether CME, CBOE and Cantor were setting their margin levels high enough. The CFTC has indicated, for example, that CME enhanced its margining in response to CFTC staff feedback. The CFTC also noted that it will monitor market dynamics to assess whether the exchanges need to increase margin levels.
- FCMs will independently consider whether margin levels are adequate. They will also likely consider how to close-out customers’ bitcoin futures and option positions and what the consequences would be for this process if there was a significant disruption in the bitcoin market.
- FIA, an important FCM trade association, in a December 6, 2017 letter to Chairman Giancarlo asserted that the one-day self-certification process is ill-suited to novel bitcoin products, whose unique nature requires greater opportunity for public comment. FIA also expressed concern that clearing members—rather than CME, CBOE and Cantor—will bear the lion’s share of the risk associated with the proposed futures and options.
Overall, the CFTC struck a cautionary tone in Friday’s announcement. CFTC Chairman J. Christopher Giancarlo called bitcoin “a commodity unlike any the Commission has dealt with in the past,” and he warned investors of the current lack of regulation in the underlying bitcoin spot market, as well as bitcoin’s “extreme volatility” and “unique risks.” The CFTC will actively monitor the market, as noted above.
Time will tell whether these bitcoin derivatives are successful or any regulatory adjustments are necessary. And not all potential market participants are on board—a number of large financial institutions, including JPMorgan Chase & Co., Bank of America Merrill Lynch, and Citigroup Inc., have indicated they will sit out the debut of the bitcoin futures market for now. If an active and well-functioning market develops, however, it might encourage additional mainstreaming of bitcoin and other cryptocurrency products. For example, market participants might ask the SEC to revisit its bitcoin ETF denial, since that denial was premised in part on the absence of a “significant, regulated, bitcoin-related market.” More generally, providing a well-regulated outlet for trading interest in bitcoin should be seen as a welcome development.