In a previous blog post, I criticized the Commodity Futures Trading Commission’s decision to allow the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) to self-certify Bitcoin futures contract. Self-certification allows designated contract markets (DCMs)[1] to list new futures contracts one day after submitting documentation to the CFTC that demonstrates the new contract complies with Commodity Exchange Act (CEA) and CFTC regulations.
My criticism is based upon the inability of Bitcoin futures to comply with DCM Core Principle 3, which stipulates that a futures contract is “not readily susceptible to manipulation.” The reality is that Bitcoin futures contracts ARE susceptible to manipulation because their underlying Bitcoin reference price can be easily manipulated due to the unregulated nature of most Bitcoin exchanges and the thin trading volume that occurs on them.
The first few weeks of Bitcoin futures trading have validated my concerns. On January 1st, the Gemini auction, which is used to price CBOE Bitcoin futures, cleared 0.07 Bitcoin – a stunningly low number. Given such low volume, a would-be manipulator could simply submit a large trade during the Gemini auction window to move the futures price in their desired direction.
CFTC Responds to Critics
Earlier today, the CFTC took the unusual step of defending their decision to allow CBOE and CME to self-certify by releasing a “backgrounder on its oversight of and approach to virtual currency futures markets.” The Commission’s primary defense is that they had little choice in the matter. From the backgrounder: “there are limited grounds for the CFTC to “stay” self-certification such as filing a false statement in the certification” and that “in the case of the CME and CFE self-certifications, no such grounds were evident.” According to this logic, an exchange can list whatever kind of futures contract they want, provided they don’t tell a flat-out lie in their self-certification.
Incredibly, the Commission’s secondary defense is that blocking the self-certifications would have done nothing to stop the rampant speculation occurring in the Bitcoin market: “Had it even been possible, blocking self -certification would not have stemmed interest in Bitcoin or other virtual currencies nor their spectacular and volatile valuations.” Did it ever occur to the Commission that by NOT blocking the self-certifications, thereby allowing Bitcoin futures contracts to enter the market, they would exacerbate Bitcoin’s “spectacular and volatile valuations?”
Fuel on the Fire
The CFTC seems unwilling to entertain the idea that Bitcoin futures contracts will add fuel to what is clearly a speculative asset bubble. Regulated futures contracts provide investors who were previously turned off by the unregulated status of Bitcoin an opportunity to bet on the asset without having to go through the hassle of acquiring physical Bitcoin. These investors could suffer severe losses when the bubble inevitably bursts.
In an unusual role reversal, Bitcoin futures have led large financial institutions to proceed with greater caution than the regulator. JPMorgan, Bank of America Merrill Lynch, RBC and Citigroup all refuse to offer their clients access to the bitcoin futures market, due to concerns that Bitcoin’s volatility make it an unsuitable investment for most of their clients. Bitcoin’s recent performance, in which it went from an all-time high of over $19,000 on December 19th to under $13,000 nearly 10 days later, has likely reinforced Wall-Street’s decision to sit on the sidelines for now.
What are the Benefits?
The CFTC believes that Bitcoin futures contracts will provide them with greater visibility into Bitcoin spot markets. The Commission acknowledged that they worked closely with CBOE and CME in the months leading up to the self-certification in a process they refer to as “heightened review.” From the backgrounder: “At the heart of the CFTC’s heightened review is extensive visibility and monitoring of markets for virtual currency derivatives and underlying settlement reference rates. Virtual currency self-certification under heightened review means that the CFTC not only has clear legal authority, but now also will have the means to police certain underlying spot markets for fraud and manipulation.”
The information supplied to the CFTC by the exchanges is only useful if it allows the Commission to identify fraud or manipulation in the Bitcoin spot market. Absent that, the CFTC has no jurisdiction over “spot or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage, or financing.” Furthermore, given Bitcoin’s borderless and pseudonymous nature, I am skeptical that any exchange or regulatory agency will ever be able to root out fraud and manipulation in the Bitcoin market.
Conclusion
In a statement accompanying today’s backgrounder, CFTC Chairman Christopher Giancarlo announced that the CFTC’s Market Risk Advisory Committee (MRAC) will holding a meeting on January 31st “to consider the process of self-certification of new products and operational rules by Designated Contract Markets (DCMs) under the Commodity Exchange Act (CEA) and CFTC regulations.”
While it is likely too late for Bitcoin futures to be put back in the bottle, the meeting will provide an opportunity for stakeholders, other than the exchanges, to express their concerns over Bitcoin futures and the self-certification process more generally.
In the same statement, Chairman Giancarlo noted that: “One thing is certain: ignoring virtual currency trading will not make it go away. Nor is it a responsible regulatory strategy.” I agree, and I commend the CFTC’s desire to proactively address new technological developments; financial regulators have been notoriously slow in reacting to previous market innovations. However, Giancarlo is attacking a straw man, for no one is advocating that the CFTC ignore virtual currencies. The truth is that rather than ignore virtual currencies, the CFTC has done the opposite. By acquiescing to Bitcoin futures contracts, the CFTC has placed the regulatory imprimatur on an asset class that is currently in the midst of a speculative frenzy. Buyer beware.
[1] Designated contract markets (DCMs) are boards of trade (or exchanges) that operate under the regulatory oversight of the CFTC, pursuant to Section 5 of the Commodity Exchange Act (CEA), 7 USC 7. DCMs are most like traditional futures exchanges, which may allow access to their facilities by all types of traders, including retail customers.
