Sunday evening marked the latest chapter in the Bitcoin bonanza when the Chicago Board Options Exchange (CBOE) began offering Bitcoin futures contracts. To the surprise of no one, the launch did not go smoothly. CBOE was forced to halt trading two and a half hours after trading opened when the futures price rose by 10%, tripping the exchange’s automatic circuit breaker. Interest in the contracts was so intense that CBOE’s website temporarily shut down due to heavy traffic.
Given these entirely predictable events, it is worth asking: why did the Commodity Futures Trading Commission (CFTC) allow Bitcoin futures to come to market? The CFTC is responsible for regulating the commodity futures markets and because the CFTC found Bitcoin to be a commodity in 2015, they have authority over Bitcoin futures. The Commodity Exchange Act (CEA), which created the CFTC, stipulates that a new futures contract can be listed by an exchange only after either: 1) the exchange submits a written self-certification to the CFTC that the contract complies with CEA and CFTC regulations, or 2) the exchange voluntarily submits the contract for CFTC approval.
CBOE, and the Chicago Mercantile Exchange (CME), who will begin listing Bitcoin futures contracts next week, chose to self-certify. As the name implies, self-certification is a process whereby the exchange verifies that a new contract complies with CEA and CFTC regulations. Provided the CFTC does not object to the findings of the self-certification, which they have the authority to do, the exchange may list the new product the day after submitting the self-certification.
Link Between Spot Price and Futures Price
Self-certification requires the exchange to prove the new contract is not readily susceptible to manipulation. Many cryptocurrency market observers, including myself, are skeptical that any kind of Bitcoin derivative cannot be easily manipulated. Our skepticism comes from the fact that Bitcoin is not a liquid market; large trades can lead to wild swings in Bitcoin’s price. Because the price of Bitcoin futures are based on the price of Bitcoin, a manipulator could place a large trade in the Bitcoin spot market in order to have the price of the futures contract move in her favor. This is referred to as banging-the-settlement, and it typically only occurs when the futures contract is cash settled, which Bitcoin futures are. The potential for manipulation has focused attention on CBOE’s and CME’s choice of Bitcoin reference rate. If the reference rate can be easily manipulated, so too can the price of the futures contract.
CBOE Bitcoin Reference Rate
CBOE and CME have chosen different Bitcoin reference rates. CBOE Bitcoin futures are priced off the daily 4pm (Chicago time) Gemini Exchange Auction. The auction determines Bitcoin’s price by matching the aggregate buy and sell demands – which can be submitted starting at 5pm the day prior – from all participating orders and determining the price (“cross-price”) at which the largest quantity can be filled. The more orders that are placed for the daily auction, the harder it is to manipulate the auction price, which is why Gemini incentivizes maximum participation in the auction by providing instant settlement for auction trades along with reduced fees for trades executed at auction. Despite these efforts to attract volume, Gemini is a very small exchange compared to its rivals, ranking twenty-fourth globally by 24-hour trading volumes and accounting for barely more than 1% of trading in the entire Bitcoin market. Such low trading volume makes the Gemini auction easily susceptible to manipulation.
Even large volume auctions can be manipulated. Earlier this decade, the foreign exchange (FX) market, which is orders of magnitude larger than the Bitcoin market, was manipulated by a handful of traders at large broker-dealers who colluded to submit large trades during the auction window in order to move benchmark FX rates in their favor. While there are technical differences between the FX auction process and the Gemini auction, the story serves as a cautionary tale for those concerned about manipulation in Bitcoin futures.
CME Bitcoin Reference Rate
CME developed its own reference rate to price their Bitcoin futures contracts, which they are calling the CME CF Bitcoin Reference Rate (“BRR”). The methodology for calculating the BRR is more sophisticated than the Gemini auction and is designed to minimize the potential for manipulation. The BRR is calculated based on all transactions from 3 to 4pm London time across four Constituent Exchanges (Bitstamp, GDAX, itBit, Kraken.) Calculation steps for the BRR on any given Calculation Day are as follows:
- All Relevant Transactions are added to a joint list, recording the trade price and size for each transaction.
- The list is partitioned into 12 equally-sized time intervals of 5 minutes each.
- For each partition separately, the volume-weighted median trade price is calculated from the trade prices and sizes of all Relevant Transactions, i.e. across all Constituent Exchanges. A volume-weighted median differs from a standard median in that a weighting factor, in this case trade size, is factored into the calculation.
- The BRR is then given by the equally-weighted average of the volume-weighted medians of all partitions.
The BRR has several properties which make it more difficult to manipulate than the Gemini auction rate. For starters, the use of multiple exchanges over multiple time increments requires would-be manipulators to influence the price on several exchanges over an extended period of time. In addition, the use of medians reduces the impact of outlier prices and the volume-weighting of medians “ﬁlters out high numbers of small trades that may otherwise dominate a non volume-weighted median.”
While the BRR is a more robust reference rate compared to the Gemini auction rate, it can still be manipulated. The fundamental problem is that Bitcoin is simply not traded in large enough volumes to prevent a determined manipulator from placing several large trades across multiple exchanges and moving the price of Bitcoin in their desired direction.
Regulators Concerned About Price Manipulation
Bitcoin’s susceptibility to price manipulation is one reason why earlier this year, the SEC rejected a proposed Bitcoin ETF which would have tracked the price of Bitcoin on the Gemini Exchange. In their ruling, the SEC noted that because Bitcoin markets are unregulated, any exchange seeking to list a Bitcoin ETF would be “unable to enter into, the type of surveillance-sharing agreement that helps address concerns about the potential for fraudulent or manipulative acts and practices in the market for the Shares.”
In a statement announcing CBOE’s and CME’s self-certification of Bitcoin futures contracts, CFTC Chairman Christopher Giancarlo echoed the SEC’s concerns: “Market participants should take note that the relatively nascent underlying cash markets and exchanges for bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority. There are concerns about the price volatility and trading practices of participants in these markets.” Giancarlo’s warning is ironic, given that his refusal to squelch Bitcoin futures will only make the problem worse.
Cybersecurity at Bitcoin Exchanges
Market observers are also concerned about cybersecurity risks at Bitcoin exchanges. This past Saturday, the day before CBOE launched their Bitcoin futures contract, Gemini was forced to extend scheduled maintenance of its site, which prevented customers from accessing their Bitcoin for most of the day. This came on the heels of a “504 Gateway Time-out” message earlier this month, which meant Gemini’s servers were not responding to requests. “The exchange also experienced outages lasting as long as 10 hours in August, according to reporting by Quartz.”
Yesterday, two of the largest Bitcoin exchanges suffered partial service outages. Bitfinix indicated via Twitter that it was experiencing denial of service attacks, while Coinbase stated they were down for maintenance – most likely in response to heavy traffic. Just last week, the CEO of Coinbase warned in a blog post that: “Despite the sizable and ongoing increases in our technical infrastructure and engineering staff, we wanted to remind customers that access to Coinbase services may become degraded or unavailable during times of significant volatility or volume. This could result in the inability to buy or sell for periods of time.” It is astounding to think that the Bitcoin exchanges responsible for providing the information necessary to price Bitcoin futures contract could be nonoperational on any given day.
Over the first few trading days, the January Bitcoin futures contract has been trading for approximately $1,000 more than the current price of Bitcoin. This violates the no-arbitrage principle, which states there should not be a riskless profit to be gained by a combination of a futures contract position with positions in other assets. As of 11:30am on December 13th, you could borrow $17,150 to purchase one Bitcoin, and then turn around and sell a January Bitcoin futures contract for $17,830, which would lock-in a risk-free profit of $680, minus the cost of borrowing. Upon the contract’s expiration in January, you would sell your Bitcoin and deliver the cash necessary to settle the contract. These kind of cash-and-carry arbitrage opportunities rarely exist in financial markets because investors/arbitrageurs typically act quickly to exploit them, and in so doing eliminate the arbitrage opportunity.
So why is there a persistent arbitrage opportunity available in the Bitcoin futures market? The first reason is that most investors don’t want to own actual Bitcoin, and are therefore willing to pay a premium to own the futures contract. Over at Bloomberg View, Matt Levine has noted that “perhaps the cost of bitcoin storage — keeping your private key in a vault, worrying about hackers, etc. — is so high that arbitrageurs need to charge $1,000 for a month of it.” According to Levine, the $1,000 difference between the spot and futures price of Bitcoin could simply be the markets way of indicating “how much — in out-of-pocket expenses, in theft risk, in psychic pain — it costs to store bitcoin.”
Another explanation for the difference between the spot and futures price is that there are significant frictions in the market which prevent arbitrageurs from capturing the risk-free profit. The same efficient markets theory that states any difference between the spot and futures price will be arbitraged away, also stipulates that the price across various Bitcoin exchanges should be the same – the law of one price. After all, if the prices are not the same across exchanges, you should buy Bitcoin on the exchange offering it for the lowest price and sell it on the exchange offering the highest price.
We have known for some time that the law of one price does not hold with Bitcoin. Last year, researchers at the New York Federal Reserve attempted to answer the question: why does Bitcoin’s price vary across exchanges? One partial explanation, according to the authors, is that exchange trading fees reduce the profits from arbitrage. But the most compelling explanation for persistent differences in price, is the risk associated with “price changes due to delays in executing transactions” and “counterparty risk from exchange failure or fraud.”
On one of the exchanges the authors analyzed (BTC-E) they found that it took five to ten days to deposit U.S. dollars into an account at the exchange. Given Bitcoin’s volatility, five to ten days is more than enough time for the price of Bitcoin to move in such a way that the arbitrage opportunity evaporates. If an arbitrageur wanted to take advantage of the difference between the spot and futures price of Bitcoin, they would have to leave a large amount of US dollars in an exchange account. Given what we know about Bitcoin exchanges, this would be a risky move.
Ultimately, the discrepancy between the spot and futures price of Bitcoin is due to a combination of investor preference to hold futures instead of actual Bitcoin, and market frictions which make it difficult, and risky, to capture the arbitrage profit. As the market continues to develop and as exchanges upgrade their infrastructure, the frictions will be reduced – along with arbitrage profits – and any ongoing difference between the spot and futures price will primarily reflect investor preference for futures over actual Bitcoin.
In a previous article, I wrote that the cryptocurrency market, for the moment, does not credibly threaten financial stability. This conclusion was partially premised on the market being relatively insulated from the traditional financial system. The introduction of Bitcoin futures erodes that barrier and exposes broker-dealers to risks in the Bitcoin market through mandatory central clearing.
Central clearinghouses act as the counterparty to the buyer and the seller, and guarantee the terms of a trade even if one party defaults on the contract. Dodd-Frank required most derivatives to be guaranteed at clearinghouses in order to eliminate the risks associated with bilateral trading, which spilled into full view during the financial crisis. Now these risks are concentrated in the clearinghouses, and regulators and market participants have expressed concern that clearinghouses now threaten financial stability. In October, President Trump’s chief economic adviser Gary Cohn stated that as “we get less transparency, we get less liquid assets in the clearinghouse, it does start to resonate to me to be a new systemic problem in the system.”
Clearinghouses are thinly capitalized and rely on their members, through guarantee fund contributions, to meet any shortfalls associated with counterparty defaults. Clearinghouse members, who are typically broker-dealers, are concerned that even if they don’t deal in Bitcoin futures, they will be forced to cover any losses should a counterparty to a Bitcoin futures contract default. Speaking through their trade association, the Futures Industry Association, the brokers argued that a “public discussion should have been had on whether a separate guarantee fund for this product was appropriate or whether exchanges put additional capital in front of the clearing member guarantee fund.”
The CFTC disagrees with the brokers. In a background note accompanying the self-certification announcement, the Commission states: “based on feedback received from a number of market participants, Commission staff did not find widespread support for these contracts to be cleared in a separate guaranty fund.” The CFTC also acknowledged they do not have the authority to require a separate guarantee fund and that a decision to create one would have to be made by the clearinghouse.
University of Houston finance professor, Craig Pirrong, believes concerns about systemic risk associated with central clearing of Bitcoin futures contracts are unfounded. He notes that the clearinghouses, like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) will likely increase initial margin requirements to reflect the greater risk (volatility) associated with Bitcoin. Indeed just yesterday, CME, after observing the initial volatility in CBOE Bitcoin futures contracts, announced they were increasing the initial margin requirement from 35 percent to 47 percent when they launch their futures contract next week.
There is also the risk that given the extreme volatility associated with Bitcoin, futures counterparties will be unable to meet ongoing variation margin requirements. To reduce this risk, both CBOE and CME limit the amount of contracts any entity can own at one time to 5,000.
It is easy to see why exchanges are so eager to offer Bitcoin futures contracts. Institutional investors, like the rest of us, have witnessed Bitcoin’s meteoric rise and are now demanding in on the action. Bitcoin futures provide these investors with an opportunity to gain exposure to Bitcoin through a regulated instrument. By offering Bitcoin futures, exchanges are simply capitalizing on investor demand and making a tidy profit in the process. CBOE is even luring market participants to its platform by waiving all transaction fees for Bitcoin futures in the month of December.
But it is hard to understand why the CFTC allowed Bitcoin futures to come to market. Rarely have the risks associated with a new financial product been so obvious – the CFTC even acknowledges these risks! The Commission claims they held “rigorous discussions” with the exchanges in the weeks and months prior to self-certification and that these conversations resulted in “significant enhancements to contract design and settlement.” To use an oft-quoted expression: you can put lipstick on a pig, but it’s still a pig.
 CME has a process in place for adding and removing Constituent Exchanges.
 Both CBOE and CME Bitcoin futures contracts list additional pricing sources that can be used if the primary source is unavailable.