Futures are one of the three main types of derivative alongside options and contracts for difference (CFDs).

Derivatives are s0-called because they derive their value from an underlying asset. As Lawrence J Trautman writes in Bitcoin, Virtual Currencies and the Struggle of Law and Regulation to Keep Pace: “Gold is an asset, but gold futures are derivatives. Creating and deploying new ways of holding and trading assets and their attendant risks is the creative heart of the financial world.”

When the Chicago Board Options Exchange (Cboe) introduced Bitcoin futures trading on 10 December 2017, it incited intense interest in cryptocurrency derivatives.

Now, North America’s largest options exchange has revealed it will suspend Bitcoin futures trading when the current crop of contracts ends in June 2019.

What are Bitcoin futures?

Bitcoin futures are a way for investors to speculate on the future price of Bitcoin. These contracts trade both on cryptocurrency-only exchanges, such as BitMex, eToro and BitFlyer, as well as decades-old commodity exchanges like Cboe and the Chicago Mercantile Exchange (CME).

If an investor agrees a Bitcoin futures contract, he is agreeing to buy a specific amount of that cryptocurrency at a certain price at some point in the future. Delivery of assets is rare and futures contracts are usually settled with cash instead.

Futures contracts tend to be heavily leveraged because the margins set by exchanges are low compared to the value of a contract.

For the incautious trader high levels of margin, or borrowing from a broker to trade an asset, is a recipe for losing a lot of money in a very short space of time.

An investor who is heavily leveraged, one who has borrowed far more than his initial stake, has little ability to control his losses. On the other hand, futures are attractive because the gains can be so great.

How big is the Bitcoin futures market?

The market for traditional derivatives is, to put it mildly, really rather large. Somewhere around $800 trillion is invested in derivatives globally. That figure, 10 times higher than combined global GDP, is hotly debated.

By contrast, the size of the Bitcoin futures market is tiny. Numbers are similarly hard to reconcile but recent estimates put it around $3 billion.

Volatility plays a part, too. The dynamic between price volatility and trading volume is not well understood, but in very broad strokes, where there is more volatility, there is more opportunity for gain, and hence more trading volume.

With more volatility from uncertainty around Brexit and a global growth slowdown, futures volume should be rising.

But commodity futures volume is shrinking. According to the Futures Industry Association (FIA), the trade body that represents major banks and brokers, volume fell by 6.6% from 2016 to 2017.

CME exchange data shows that daily Bitcoin futures volume too is falling, although not by much. While February 2019 saw a record 18,000 daily trades, average daily volume now sits in the 3,000-4,000 range.

Who regulates Bitcoin futures?

In the US, the Commodity Futures Trading Commission (CFTC) has jurisdiction over futures contracts.

In the wake of the 2008 financial crisis and the collapse of historic banking institutions, Congress passed the Dodd-Frank Act. The Act could not have foreseen Bitcoin futures, but was a response to regulatory failings exposed by the repackaging and reselling of highly complex derivatives.

Dodd-Frank calls on clearinghouses to be the go-between for buyers and sellers of futures contracts, in order to spread defaulting risks. The three largest US clearinghouses are ICE Clear US, a part of New York Stock Exchange owner Intercontinental Exchange; CME Clearing; and LCH Ltd, part of the London Stock Exchange group.

While these centralised organisations are charged with preventing another financial crisis, they are themselves for-profit institutions.

It may be a surprise to learn that any exchange that wants to list a new Bitcoin futures product need only self-certify that it complies with CFTC regulations. If the CFTC does not object, new Bitcoin futures can be listed for sale on an exchange the day after they are submitted.

While the market for Bitcoin futures is relatively small, derivatives clearinghouses still manage risk for large portions of the US financial sector. Bitcoin futures could raise the spectre of bankruptcy if multiple defaults meant that clearinghouses had insufficient collateral to settle contracts.

What could regulators do?

The CFTC could tighten the rules, pointing to serious concerns from trade bodies.

FIA members, who guarantee their customers’ trades, raised the alarm in the days before the Cboe listing that they would have to settle outstanding futures contracts caused by Bitcoin price volatility.

Professor Margaret Ryznar, writing for the Houston Law Review, proposes five potential ways that US regulators could intervene to minimise the systemic risk posed by Bitcoin futures.

  • Ban Bitcoin futures entirely. Merrill Lynch

    its advisors from selling Bitcoin futures in January 2018. South Korea’s Financial Services Commission

    brokers from offering Bitcoin futures at almost the same time the Cboe and CME ratified trading.

  • Limit positions. Part of Dodd-Frank allows the CFTC to set limits on the number of positions that any one trader can hold. This manages risk by ensuring liquidity on both sides of a futures contract. Clearinghouses can also set limits on who can invest in Bitcoin futures. For example, CME’s contract requires 5 BTC, while Cboe needs only 1 BTC to trade.

  • Guarantee funds. Funds to cover defaults are normally created through a clearinghouse’s transaction fees. Higher fees would allow for separate guarantee funds for Bitcoin futures, set apart from funds for derivatives like options and swaps.

  • Lower margins. A deposit, called the initial margin, is set by the exchange or clearinghouse for each kind of futures contract. Cutting margin would make Bitcoin futures more attractive and cheaper to trade, but may introduce more risk into the clearing system.

  • Regular stress testing. Stress testing Bitcoin positions would ensure clearinghouses have enough capital to cope with a crisis.

Ryznar writes: “Distinctive features of Bitcoin futures heighten concerns [of systemic risk]. Indeed, the FIA has protested the introduction of Bitcoin futures to the market without much scrutiny, given their enormous potential to disrupt the economy.”

Some financial watchdogs have already made their move.

Regulators in Canada and Japan have cracked down on the amount a cryptocurrency trader is allowed to borrow when making margin trades.

The European Securities and Markets Authority (ESMA) set historically low 2:1 leverage caps on cryptocurrency CFDs on 1 August 2018. It meant losses could be minimised but the potential gains were also much lower, making cryptocurrency derivatives less attractive.

The UK’s Financial Conduct Authority (FCA) followed the ESMA ruling and reintroduced the cap on 1 November 2018. It is also proposing to ban cryptocurrency derivatives entirely for retail investors and began a consultation in early 2019.

The Crypto-asset Taskforce, a UK Parliamentary body set up to deal with these thorny issues, noted in its final October 2018 report that HM Treasury, the FCA and the Bank of England would consult on “a potential prohibition of the sale to retail consumers of derivatives referencing certain types of crypto-assets including CFDs, options, futures and transferable securities.”

Bitcoin futures fans could take some hope from a previous statement that this intervention is temporary, but caution is paramount at the FCA and market-watchers will draw a more realistic conclusion.

What the future holds

As the Cboe steps back to consider Bitcoin futures, other markets and exchanges will necessarily fill the gap.

Higher risk, after all, equals potential higher reward. As the global slowdown bites, there is less money to be made in equities, and relatively safer instruments such as government bonds are seeing historically lower yields.

Piecemeal, country-level regulation can only go so far, as the ESMA has recognised.

That body has since called for Europe-wide regulations on all crypto-asset trading, which you can read more on here. It is unlikely to pull back from outright bans as it has done on binary options. Regulators are especially wary of being too laissez-faire, especially when faced with the trading of heavily-leveraged complex derivatives.

If regulators step in too harshly on Bitcoin futures, global growth will be hampered.

But if they are too lax, retail and larger investors alike may enjoy freedoms to leverage themselves to the hilt, until the ‘too big to fail’ institutions find themselves at the precipice again.

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