How do we “fix” this?

Long winded thoughts on the challenges of cash settled futures

First, a bit of trivia — LedgerX’s first pitch decks in 2014 focused on us offering cash settled Bitcoin contracts. It seemed like the easy way out, and the most convenient for all market participants who wanted to do pure speculation. So certainly the idea of doing cash only settlement (where neither party needs to touch Bitcoin) did not escape our consideration many years ago.

Obviously, we evolved our approach significantly over time to focus on physical delivery and in particular, doing so under the oversight umbrella of a clearing organization. I wanted to lay down our reasoning for why we believe at the current stage of the digital currency market’s maturity, physically delivered contracts are the only responsible financial tool.

Cash settled instruments are derivatives that offer participants the ability to lock in a price difference between the purchased price and the settlement price. The settlement price is by far the most sensitive, and potentially dangerous quantity for the trader. How it is set can create or evaporate enormous fortunes, especially if the notional of the derivatives being traded exceeds the entire value of the underlying commodity (which often happens — Credit Default Swaps are the poster child of this phenomenon).

So how does an exchange create a fair methodology to fix the settlement price? A naive approach would be to say, why not take the last price traded at the close (for example, 4pm.) But this would be just one data point — potentially a single share that was traded thoughtlessly at the very end and which is now being used to move billions of profits and losses around. That is clearly not a stable mechanism.

Instead, the standard practice is to do a closing auction for the final price. Well before 4pm eastern, market participants are encouraged to send in the prices they would be willing to execute at one final auction, and market takers are willing to say which side they want to participate no matter what final price is reached. When all of these orders are collected, one final analysis of the book will be done to maximize the final price at which the greatest number of trades will be completed. The volume that is involved in this final auction is typically enormous and gives credibility to the efficiency and fairness of the final price.

Perhaps the most successful example of a cash settled future is the S&P500. This derivative settles to a weighted average price representing more than 22 TRILLION dollars of market value among 500 of the most important companies in the world. Here, the law of large numbers comes into play. If a handful of auctions among all 500 stocks are randomly one sided, we can rely on averaging to make sure the final fixing print is fair to holders of the future.

It should be obvious that to manipulate something of this scale would be an enormous, if not impossible undertaking. One would have to literally try to manipulate 500 simultaneous auctions, all of which are run on multi billion dollar companies, and all of which are participated in by thousands of the most sophisticated traders in the world, all bidding and offering to be part of the process. Finally, the venues in which traders can trade the future as well as the auctions for the underlying stocks are  established platforms such as NASDAQ and the New York Stock Exchange for the underlying stocks, and the Chicago Mercantile Exchange for the futures.

These conditions make for a robust cash settled futures market for the S&P500, but also provide a blueprint for why cash settled Bitcoin futures are simply not a safe or viable instrument to be listed in the present circumstances.

With the CBOE / Gemini approach, traders have to rely on an auction that is unconventional to say the least, where it follows no well defined algorithmic matching norms of price time priority layered with the very real risk of the auction possibly not taking place. Even if one were to overlook the opacity of the underlying process that determines the clearing price, characterizing the volumes that end up clearing in those auctions as thin would be overly generous. No careful risk manager in an institution would allow a trading group’s request to hold on their books several millions of dollars, let alone billions, of synthetic cash settled futures marked to such an auction.

The second path to cash settled futures is being explored by CME via the index weighting approach which was first pioneered by Tera Exchange. Tera’s effort didn’t gain traction for several reasons, some that are unique to Tera’s structure but many of which have bearing to CME’s approach.

Bitcoin spot exchanges globally are thinly regulated, retail-oriented venues. In the worst examples, some are unregulated exchanges rife with market abuses such as wash trading designed solely to inflate volume and activity optics. Many exchanges purposely do not list their locations or domicile of incorporation. They often have no regulatory oversight, and the ones that come even close claim they are regulated due to their status as a money services business operating the requisite money transmitter licenses.

That’s right, the regulator administering their licenses, FinCEN, is the same entity that has oversight over your local Western Union, Check’n Go (a very nice place where they generously advance a loan against your paycheck) and the ubiquitous foreign currency conversion desk you will find at an airport.

Now, my personal view is that a money services business regulator, while incredibly necessary to prevent abuse in those types of businesses, is not designed nor equipped by any stretch of the imagination to oversee complex financial trading. The issues of limit order book monitoring, potential spoofing abuses, wash trading, self trading, fair auction mechanism design, correctly segregating risk collateral, surveilling cascade risk and managing the fallout of potentially catastrophic flash crashes are all highly complex issues more appropriately overseen by the SEC and CFTC.

To return to the issue at hand — are cash settled futures on Bitcoin, where the settlement price is either an index from a patchwork of exchanges or the clearing price derived from a single auction on a captive exchange, ready for the big leagues of institutional investors? I suggest it is not.

For the S&P500, institutional investors trade both on CME and NYSE, constantly trading stock against futures in large scale to ensure no arbitrage constraints are maintained and prices are fair. For CBOE/Gemini’s proposed BTC future, someone would have to trade on CBOE (which is fine), but then — participate in an opaque, minuscule volume event that would inevitably create havoc upon the various futures holders who are perplexed as to how such a minority of volume can determine the fate of billions of dollars worth of futures.

How about a future based on a price index among exchanges? For a cash settled future to be as successful as something like the S&P 500, you would require real professional investors to be deeply involved and active in the various spot exchanges. This helps to create the liquidity and visibility among both spot and futures traders to ensure fair price discovery and therefore settlement. So in this case of a CME future, an institution such as JP Morgan could join their futures platform (which is fine) — and then…sign up to join Kraken? GDAX? Bitstamp? I’m often wrong, but my suspicion is that this integration is unlikely to happen.

There will come a day when cash settled futures will make sense for Bitcoin, and that the supporting infrastructure will develop to make this a safe and viable market. But that time is not now, and frankly not soon.

In my view, the current rush for leverage is completely unnecessary. Bitcoin is so volatile, it’s already a naturally leveraged instrument. If the day comes when BTC moves only a few cents a day and people want to leverage it 100x using futures, that is an economically reasonable product to pursue. But I don’t think any of us are involved in Bitcoin right now because it moves too little.

In the meantime, the risks for manipulation of a cash settled future are far too great. I would hate to have Bitcoin suffer its equivalent of a LIBOR scandal just as it is starting to make inroads into the institutional market. Prudence is probably the best course here.

Paul
(Opinions expressed are solely my own and do not express the views or opinions of my employer)