Bitcoin futures and the meaning of finance – how did we get here?

Photo by Brandon Morgan on Unsplash
Photo by Brandon Morgan on Unsplash

One outstanding note in the cacophony of the bitcoin futures debate is an intriguing claim that I confess I didn’t understand at first: that bitcoin has no “natural sellers”. What’s unnatural, I thought, about people wanting to sell to realize profits? It turns out that’s not what the phrase means.

It means that nobody needs bitcoin. So why hedge it?

To go deeper, let’s look at why capital markets exist. They were developed to enable firms to raise money outside of bank loans. Bonds and equities pair those that need funds with investors who want a return.

Derivative markets emerged to protect cash flows. This both gives producers more security, and helps to raise funds – investors are more likely to “lend” to a company with protected income than to one subject to the vagaries of nature.

In essence, capital markets exist to help businesses flourish. Old-school capitalism.

Here’s where the “natural seller” part becomes important.

Farmers need to sell wheat. It’s what they do. Oil producers need to sell oil. Steel manufacturers need to sell steel. Gold miners need to sell gold. So, they all should protect those sales in the derivative markets.

No-one needs to sell bitcoin.

So what income flows are the derivatives protecting? Mutual fund redemptions, maybe. Pension plan payouts. But do we really think that mutual funds and pension plans should have significant exposure to bitcoin?

This question is important for whatever side of the bitcoin debate you’re on. If you’re a sceptic and think that it’s all a ponzi scheme, surely you don’t want institutional funds heavily invested in an asset that will no doubt crash. If you’re a bitcoin believer, do you really want the “money of the future” stuck in funds? Where’s the decentralizing potential in that?

So, it could be that the constructive purpose of bitcoin derivatives is to protect flows for funds that are either taking irrational risks or hijacking the finance of tomorrow. This is a far cry from ensuring that farmers can make a living and oil producers don’t go bust.

We could argue that all this started to go awry back in the ‘80s with the creation of synthetic derivatives that had as their sole aim to make a profit at the expense of others (trading being a zero-sum game). We could also argue that back then we got ahead of ourselves by letting markets run far ahead of the infrastructure. We know what happened next. (Ok, I’m simplifying, but the point still holds.)

And we could ask ourselves what good bitcoin futures will do the economy as a whole. To what productive use will their markets contribute? Are they adding stability, as per the original intent of derivatives? Or could they be adding yet another layer of complexity that masks a deepening fragility?

Of course, playing the long game, this could be what true bitcoin believers have known would happen all along. That the world will see (again) how unstable the current financial system is. And to what will people turn when widening cracks send central banks scrambling?

True, the bitcoin price would also likely tumble. But the technology would still work. People would still be able to independently transfer funds. And the advantage to having an alternative to an interconnected and unstable system would become more apparent than ever.

The threat of bitcoin futures

photo by Jesse Bowser on Unsplash
photo by Jesse Bowser on Unsplash

The financial press has been in a flutter of excitement over the launch of bitcoin futures trading on not one but two reputable, regulated and liquid exchanges: CME and Cboe.

CME Group (Chicago Mercantile Exchange) is the largest derivatives exchange in the world, as well as one of the oldest, with roots going back to the 19th century. It will launch bitcoin futures trading on December 18th.

Cboe Global Markets owns the Chicago Board Options Exchange (the largest US options exchange) and BATS Global Markets (the platform on which the Gemini-backed bitcoin ETF would have been listed had it been approved). It plans to beat CME to the punch by launching bitcoin futures trading on December 10th.

In theory this opens the doors to institutional and retail investors who want exposure to bitcoin but for some reason (such as internal rules, or an aversion to risky and complicated bitcoin exchanges and wallets) can’t trade actual bitcoin.

And that expected flood of interest is, from what I hear, part of the reason that bitcoin’s price recently shot past $11,000 (which, considering it started the year at $1,000, is phenomenal).

I’m missing something. I don’t understand why the market thinks there will be a huge demand for bitcoin itself as a result of futures trading.

First, a brief primer on how futures work: let’s say that I think that the price of xyz, which is currently trading at $50, will go up to $100 in two months. Someone offers me the chance to commit to paying $80 for xyz in two months’ time. I accept, which means that I’ve just “bought” a futures contract. If I’m right, I’ll be paying $80 for something that’s worth $100. If I’m wrong, and the price is lower, then I’ll be paying more than it’s worth in the market, and I will not be happy.

Alternatively, if I think that xyz is going to go down in price, I can “sell” a futures contract: I commit to delivering an xyz in two months’ time for a set price, say $80. When the contract is up, I buy an xyz at the market price, and deliver it to the contract holder in return for the promised amount. If I’m right and the market price is lower than $80, I’ve made a profit.

Beyond this basic premise there are all sorts of hybrid strategies that involve holding the underlying asset and hedging: for instance, I hold xyz and sell a futures contract (I commit to selling) at a higher price. If the price goes up, I make money on the underlying asset but lose on the futures contract, and if it goes down the situation is reversed. Another common strategy involves simultaneously buying and selling futures contracts to “lock in” a price.

Futures contracts currently exist for a vast range of commodities and financial instruments, with different terms and conditions. It’s a complex field that moves a lot of money. The futures market for gold is almost 10x the size (measuring the underlying asset of the contracts) of the physical gold market.

How can this be? How can you have more futures contracts for gold than actual gold? Because you don’t have to deliver an actual bar of gold when the contract matures. Many futures contracts settle on a “cash” basis – instead of physical delivery for the sale, the buyer receives the difference between the futures price (= the agreed-upon price) and the spot (= market) price. If the aforementioned xyz contract were on a cash settlement basis and the market price was $100 at the end of two months (as I had predicted), instead of an xyz, I would receive $20 (the difference between the $100 market price and the $80 that I committed to pay).

Both the CME and the Cboe futures settle in cash, not in actual bitcoin. Just imagine the legal and logistical hassle if two reputable and regulated exchanges had to set up custodial wallets, with all the security that would entail.

So, it’s likely that the bitcoin futures market will end up being even larger than the actual bitcoin market. That’s important.

Why? Because institutional investors will like that. Size and liquidity make fund managers feel less stressed than usual.

The bitcoin market seems to be excited at all the institutional money that will come pouring into bitcoin as a result of futures trading. That’s the part I don’t understand.

It’s true that the possibility of getting exposure to this mysterious asset that is producing outstanding returns on a regulated and liquid exchange will no doubt entice serious money to take a bitcoin punt. Many funds that are by charter prohibited from dealing in “alternative assets” on unregulated exchanges will now be able to participate. And the opportunity to leverage positions (get even more exposure than the money you’re putting in would normally warrant) to magnify the already outrageous returns will almost certainly attract funds that need the extra edge.

But here’s the thing: the money will not be pouring into the bitcoin market. It will be buying synthetic derivatives, that don’t directly impact bitcoin at all. For every $100 million (or whatever) that supermegahedgefundX puts into bitcoin futures, no extra money goes into bitcoin itself. These futures do not require ownership of actual bitcoins, not even on contract maturity.

Sure, many will argue that more funds will be interested in holding actual bitcoins now that they can hedge those positions. If supermegahedgefundX can offset any potential losses with futures trading, then maybe it will be more willing to buy bitcoin – although why it would allow its potential gains to be reduced with the same futures trade is beyond me. And, why hold the bitcoin when you can get similar profits with less initial outlay just by trading the synthetic derivatives?

That’s the part that most worries me. Why buy bitcoin when you can go long a futures contract? Or a combination of futures contracts that either exaggerates your potential gains or limits your potential loss? In other words, I’m concerned that institutional investors that would have purchased bitcoin for its potential gains will now just head to the futures market. Cleaner, cheaper, safer and more regulated.

So, if the market is discounting an inflow of institutional funds into actual bitcoins, it’s likely to be disappointed.

What worries me even more is the possibility that the institutional funds that have already bought bitcoin (and pushed the price up to current levels) will decide that the official futures market is safer. And they will sell.

Now, it’s possible that the demand for bitcoin futures and the general optimism that seems prevalent in the sector will push up futures prices (in other words, there will be more demand for contracts that commit to buying bitcoin at $20,000 in a year’s time than those that commit to buying at $12,000 – I know, but the market is strange). This will most likely influence the actual market price (“hey, the futures market knows something we don’t, right?”).

And the launch of liquid futures exchanges increases the likelihood of a bitcoin ETF being approved by the SEC in the near future. That would bring a lot of money into an already crowded space.

Buuuut… it’s also possible that the institutional investors that are negative on bitcoin’s prospects (and there’s no shortage of those) may use the futures markets to put money behind their conviction. It’s much easier to sell a futures contract with a lower-than-market price than it is to actually short bitcoin. These investors may well send signals to the actual bitcoin market that sends prices tumbling.

And the leverage inherent in futures contracts, especially those that settle for cash, could increase the volatility in a downturn.

That’s pretty scary.

Let’s not even go into the paradigm shift that this development implies. The growth of a bitcoin futures market positions it even more as a commodity than a currency (in the US, the Commodity Futures Trading Commission regulates futures markets). And even more as an investment asset than a technology that has the potential to change the plumbing of finance.

So, while the market appears to be greeting the launch of not one but two bitcoin futures exchanges in the next two weeks (with two more potentially important ones on the near horizon) with ebullience, we really should be regarding this development as the end of the beginning.

And the beginning of a new path.

The Bitcoin ETF – is Bats the right exchange?

trading 700 - Bitcoin ETF exchange

The Bats exchange has been in the news this week – and not just because it is the preferred venue for the listing of the Winklevoss Bitcoin ETF, also much in the news recently.

Why the extra attention? Because CBOE Holdings Inc., has completed the acquisition of the operator of the Bats exchanges.

The merger represents a major shift in the exchange landscape in the US. CBOE Holdings Inc. is the owner of the Chicago Board Options Exchange, the largest options exchange in the US. Bats is the second largest stock exchange operator in the US, and the largest in Europe.

Could this affect the probability of the SEC approving the Winklevoss’ fund?

Let’s look at why they chose Bats for the listing. They were originally going to go with Nasdaq, but in mid-2016, they filed an amendment changing the exchange to Bats. Press comment at the time stressed the advanced technology of the trading platform, hinting that the Winklevoss brothers were choosing the more forward-thinking option.

No doubt the technology is part of it, but it’s likely that a larger role was played by Bats’ experience with ETFs: it is the largest ETF exchange in the US.

Nasdaq is no slouch in the technology department. Of all the US exchanges, it has invested the most in blockchain exploration. Its Linq platform enables private company shares to trade on the blockchain, and it recently released the results of a blockchain-based voting trial it conducted with Chain in Estonia last year.

But Nasdaq has fallen behind Bats in market share, and does not have its clout in ETFs.

Also, Bats technology is by many accounts the best in the business (all of CBOE Holding’s operations will migrate to Bats’ platform, a strong vote of confidence). However, at its first attempt at an IPO in 2012, the technology failed and the IPO had to be withdrawn at the last minute. The systems have been considerably strengthened since then, but the SEC could see the dependence on technology as a vulnerability.

That is unlikely, though, since the trend for exchanges is to move to electronic trading. Bats was founded in Kansas in 2005 out of frustration at the duopoly of trading markets, shared between Nasdaq and the NYSE. Unlike other, older exchanges that have incorporated technology bit by bit into their operations, Bats was technology-first.

The merger with the CBOE could be interpreted as enhancing Bats’ stability and reputation. The new entity is expected to have a market capitalization of approximately $10bn, close to that of Nasdaq. While Bats is a relative newcomer, the CBOE is over 40 years old. While Bats is known for its technology, the CBOE still operates physical trading pits. And CBOE Holdings is poised to join the S&P 500.

Furthermore, the CBOE is strong in options, and already talk is circulating of the new enterprise developing an exchange for options on ETFs. This could enhance the revenue prospects in a sector suffering from declining volatility, tougher competition and lower fees.

Even if the SEC denies approval for the Winklevoss ETF fund, it is only a matter of time before a proposal is presented that it will approve. When that day happens, the exchange of choice will probably be Bats.

The merger with CBOE is likely to work in favour of the ruling: if the SEC harboured any doubts about Bats’ durability and reliability, the additional clout and growth potential should put those to rest. Furthermore, the expertise in ETFs should facilitate sensible governance and compliance. And the combined entity’s reach across financial products and geographical jurisdictions underscore the potential that innovation in ETFs could bring to a diversifying segment of the economy.

That does not mean that approval is probable – there are a host of other complications to consider. It does mean that the choice of exchange unlikely to be a negative factor.

Bitcoin volumes and volatility – now what?

trading 700

CoinDesk reported yesterday on the change in the pricing strategy of the three largest Chinese bitcoin exchanges: BTCC, Huobi and OKCoin. This weekend they announced that they were suspending their “no fee” policy and moving to a 0.2% flat fee, “in response to guidance from the People’s Bank of China”.

Today we reported on the impact of this decision on trading volumes. No surprise – they’re much lower.

A bit of background: the “no fee” model may sound like an extraordinary business strategy (not charging for your main business), but it’s actually not very different from the “Freemium” models we see all over the place, in which most stuff is free, but some things not. The basic service is available to anyone, but for better content or service, you pay something. It’s an old strategy, even used by physical retail outlets – to get you in the store, they price some products so cheaply that they lose money on them. These are called “loss leaders”. The idea is that while you’re there, you’ll buy other stuff as well, and the store will make money there.

In the case of bitcoin exchanges, they don’t make money on the trades they execute, but they do charge a fee for entries and withdrawals. If you want to put money into your account, there’s a fee for that. If you want to take money out, also. But the trading you do in between, no charge.

The practice recently seeped into European exchanges, with London-based Coinfloor (number 25 in terms of fee-based bitcoin trading volume, according to Coinmarketcap, and the largest in the UK) announcing last week that it would adopt this pricing strategy.

The objective is to bring in liquidity. The result is to inflate volumes.

Since there is no charge for buying and selling, traders feel that they can churn holdings as much as they wish. And even small gains are worth it, especially if repeated several times during the trading day, since there is no associated monetary cost.

So, volumes are much higher under a “no fee” policy than they would be otherwise, and the PBoC regarded this as “fake volume” which added unnecessary volatility to the market.

In fact, the impact of no fees is so stark that Coinmarketcap (where I get my relative exchange volumes) only includes exchanges with fees in their main ranking (although you can get the whole list in another tab).

So, the volume hit was not a surprise. The announcement last week that the exchanges have halted margin trading (in which the exchange lends you the money to trade, which further encourages speculation) is no doubt also likely to have an impact.

The question now is: will this lower volatility? Or will it increase it?

Intuitively, less “churning” of holdings should make prices more stable. Trades are more “real” in that they are not about grasping at small gains. Positions are (in theory) held for longer, since changing them now incurs a cost. Less “fake” volumes, the PBoC’s reasoning goes, means more stable markets and less risk for non-professional investors.

But, lower volumes means lower liquidity, which means more vulnerability to swings due to large buy or sell orders. With higher liquidity, large orders have less of an impact as there are more funds available to settle those orders. Lower liquidity means that prices move more to tempt traders to take a side.

That, at least, was the argument that LedgerX gave in a CoinDesk interview yesterday. Here we have a derivatives exchange arguing that approval by the Commodity Futures Trading Commission (CFTC) would decrease bitcoin’s volume. Yes, you heard right, derivative trading can decrease volatility. Or so they say, and maybe they’re right, but I’m having a hard time getting my head around this.

The argument is that the increased liquidity from regulated bitcoin options will provide the market with a cushion to absorb large orders and avoid the price swings that usually result. My skepticism stems from the fact that it often is the need to close out derivative positions that generates these large orders in the first place, orders that often need to be filled in a hurry, at any price.

I do buy the argument that increased derivatives trading enhances price discovery, as future expected prices tend to react less to current events. And I understand that an active (and regulated) futures market can reduce the need to place large market-moving buy orders to “bet” on a certain direction – it’s cheaper and easier to buy futures contracts instead. They can also reduce the need to liquidate large positions, by “insuring” them at a relatively low cost.

However, here’s what has me worried: with derivatives, it is not very costly to accumulate large enough a position to benefit from sharp moves. It is conceivable that a speculator could accumulate a ton of puts, and then attack the bitcoin blockchain. The potential profit from the derivatives position from a sharp plunge in price could outweigh the cost of the attack.

And, I am not yet convinced by the increased liquidity argument. It could reduce volatility, but it could also increase it by encouraging speculative positions. That seems to be the PBoC’s position, that “fake” volumes are not good for the market nor for its investors.

As always, time will tell. And no doubt, other factors will throw in additional complications. Attributing changes in trends to any one announcement, in bitcoin as in life, tends to miss the bigger picture.

 

The blockchain and the stockchain

At the very end of last year, a major milestone was reached in the bitcoin world. Or it wasn’t, depending on who you listen to. And what your definition of “stock” is. Either way, what happened was a big step forward, and a harbinger of important changes coming to securities trading and business finance.

What happened is this: Chain, which specializes in enterprise blockchain platforms, issued shares on Nasdaq. Only they weren’t traditional shares, they were digital. And not on the “regular” Nasdaq, but on a subsidiary newly created to handle this kind of transaction.

stock exchange

But how does that work?

Nasdaq Linq, part of Nasdaq Private Markets, was set up to facilitate the issuance, transfer and settlement of shares of privately-held companies on The NASDAQ Private Market using a digital ledger technology similar to that which powers bitcoin. (For more on the difference between bitcoin and the blockchain, see here.) Rather than a stock exchange mirror, Linq is more a shareholding management tool, especially useful for de-mystifying the chaotic structures thought up in the early days of a business. The ledger allows settlement time to be slashed (minutes rather than days), issued shares to be easily tracked, and related documents to be dealt with and executed online.

The mechanism was developed by Chain, so it is appropriate (or symbiotic, if you prefer) that its own securities be the first to try it out. Chain creates Nasdaq’s Linq platform, Nasdaq owns part of Chain, Chain is the first to issue shares using this technology… You get the picture.

Yet Chain won’t be the last to use this technology. Nasdaq has hinted that further digital share offerings are in the pipeline from ChangeTip, PeerNova and other blockchain startups. NXT, Ripple and Digital Assets Holdings, among others, are working on similar technologies, and we will definitely see several more transactions of this type over the next few months.

peernova

And depending on your definition of “security”, it wasn’t even the first. In August of last year, smart contracts platform Symbiont sold its own digitized private equity on the blockchain to an investor, and registered its founders’ stakes as well as stock options and shares granted to employees. Symbiont’s innovation is the creation of “Smart Securities”, which not only settles and records transfers, but can also pay dividends and convert stock options automatically.

Broadening the definition a bit, in June of last year US-based retailer Overstock sold a $5m “cryptobond” on its tØ blockchain-based security trading platform. In December it got regulatory approval for the issue of company shares on the bitcoin blockchain.

Whoever came first, all three innovations stand to make a big impact: Overstock because its tØ platform and upcoming digital share offering “proves that cryptotechnology can facilitate transparent and secure access to capital by emerging companies”, according to founder Patrick Byrne; Symbiont because it is leveraging the decentralized power of the bitcoin blockchain to make trades cheaper, faster and “smarter”, which will expand the use cases for bitcoin and open up trading to non-market players; Nasdaq because it is a globally recognized name with exchanges around the world. All of them increase efficiency by reducing settlement time, increasing transparency and removing middlemen.

This is exciting, but at the same time fraught with significant obstacles.

One is the inherent conservatism of investors. New technologies can be scary, especially ones that are not easy to understand. Institutions are used to the delayed settlement systems currently in place, and could well prefer to bear the steep economic cost of that inefficiency rather than risk not only losing their investment due to a tech malfunction, but also of looking foolish.

Another is the lack of understanding of the mechanism on the part of the private companies, and the fear of attracting the attention of the regulators. Especially in the US, where each state has different securities legislation, a non-physical security residing in “cyberspace” is too much of a conceptual leap for most funds and investors to feel comfortable with.

Another is the need to balance the open nature of the blockchain with investors’ need for privacy. What some might see as an advantage – the ability to track the ownership history of a share or bond – others might see as an encroachment on their desire for anonymity.

Yet these obstacles can be overcome with time, just as other technology adoption obstacles have been overcome in the past (remember the “no-one will use the Internet” prediction?). The advantages of blockchain-based securities settlement are clear: faster, cheaper and global. The need for simpler financing is also clear: initial cap tables and shareholding structures are usually a mess, scribbled on napkins and promised in meeting rooms. A secure and inexpensive method of issuing shares will make setting up a business easier, which could help to foster entrepreneurial activity. And as more and more high-growth startups avoid regulation-heavy IPOs, a reliable and liquid alternative will empower businesses of all sizes and make them less beholden to Wall Street and its international counterparts.

Who will be the winner here? Which business model will triumph? Will shares be on private ledgers or the public blockchain? I expect we will see a combination of forms and formats, with various platforms offering different advantages, with smaller businesses benefitting from enhanced control and transparency, and with an explosive growth in creative instruments backed by cryptography and maths.

It won’t be a smooth transition, and it won’t be quick. Nor should it. When it comes to investors’ money and companies’ financing, care needs to be taken. But the shift will happen, and as it does, it will lead to a more accessible and fair financial system.