The easy way and the right way

Yesterday was a good illustration of the problems someone has to solve before cash-settled bitcoin futures work. Bitcoin showed a little volatility: a 12% percent rise followed by an 18% percent drop over a total of fifteen hours. (This happens many times each year.) Simultaneously, both of the largest U.S.-based spot exchanges went down for most of the day.

A cash-settled future relies on a price index to effect settlement. The index determines who wins and who loses at expiry. There’s some secret sauce to building an index, but I’d be surprised if you could make a defensible bitcoin price index today without relying on data from these U.S.-based spot exchanges.

This isn’t academic – people are issuing press releases saying they’re going to list cash-settled futures in a few weeks. Let’s pretend some had settled yesterday. We can assume the folks listing them are smart and did their best to build a good price index, which means they relied at least partially (and probably heavily) on those U.S.-based spot exchanges.

So, we have to pick a settlement price, but our price sources have been down all day as the market swung drastically. They’re still down. We’re also pretty sure there’s a lot of market manipulation on overseas exchanges, and no one at the exchanges cares. With two major exchanges down, book depth on our remaining price sources is non-existent – the global market might move 3% on a $5 million buy or sell.

At this point, to set our price index, we can rely on known-bad, unregulated, un-surveilled overseas data, or we can make it up. There are no other options.

Incentives for this sort of short-term manipulation are limited today because there aren’t really cash-settled products. But imagine you have a $100 million futures position settling to cash at a $10,000 fixing price and the spot price at an unregulated, un-surveilled overseas exchange (which is now our best price source) is $9,900. The incentives get a little more interesting. If this happens enough, someone’s going to bite.

The SEC understood this back in March when they denied the BATS rule change to list a bitcoin ETF. Read Section III(B) of the order. There just aren’t good spot price sources yet.

I get it: if you’re a big exchange, cash-settled products seem easier to list. You don’t have to use military-grade cryptographic hardware to store your customers’ bitcoin safely, then convince regulators that it works. You don’t have to understand the underlying technology at all. The downside is that the cash-settled product has no price integrity. Until we’re convinced we can solve that problem, LedgerX will stick to products that help grow the market responsibly.

– Ian