Last week, bitcoin’s price skyrocketed after the Chicago Mercantile Exchange (CME) said it would begin bitcoin futures trading on December 18th. (See also: Bitcoin Price Reverses Course After CME Announces Futures Trading Date.)
CME is just one among many institutions with plans to introduce bitcoin futures trading. For example, the Chicago Board Options Exchange (CBOE) is expected to follow suit soon after CME and Nasdaq are reportedly considering the launch of a bitcoin futures trading platform for the second quarter of 2018.
The announcements have been cheered by traders and investors alike in the hope that regulation will bring transparency and price discovery to the otherwise opaque market. “One would hope the advent of a futures market now will provide us with idea of the future price of bitcoin and perhaps take out some of the speculative bubble element,” said Ben Jessel, managing principal at Capco. (See also: CME To Launch Bitcoin Futures.)
Bitcoin's Identity Crisis
But futures trading may not be enough to resolve crucial questions plaguing bitcoin.
For starters, there’s bitcoin’s identity crisis. Is it a stateless digital currency for daily transactions or a store of value? Bitcoin has a long way to go in terms of volume to lay claim to the former. For their purposes, government agencies have begun treating bitcoin as a store of value. (See also: Could Bitcoin Futures Destabilize The Broader Economy?)
But their approaches to the cryptocurrency differ. For example, the IRS taxes bitcoin as property even as Commodity Futures Trading Commission (CFTC) treats it as a traded commodity. A clarification of bitcoin’s identity will also curtail dissent within its ranks. An effort to increase the number of transactions (and increase bitcoin’s velocity as a currency) has already split the cryptocurrency’s core development community and led to the emergence of Bitcoin Cash, which forked off bitcoin’s blockchain and has a valuation of $1.3 billion, as of this writing.
Then there is the problem with the unregulated markets associated with bitcoin. “The problem with the (CME's) futures contracts is that they are regulated derivatives that are based off underlying trading in unregulated markets,” said Richard Johnson, a market structure analyst at Greenwich associates, in a conversation with Bloomberg. This lack of regulation is reflected in bitcoin’s wild price swings.
That bitcoin is not a physical commodity or currency has only added to the problem. For example, CME will use a daily bitcoin reference rate (BRR) to compute the settlement amount for bitcoin futures. The BRR will be computed by aggregating trade flow of four major bitcoin spot exchanges - Bitstamp, GDAX, itBit and Kraken - during a calculation window into USD prices, as of 4:00 p.m. Easter time. Again, given the opaque nature of bitcoin trading volumes, the price index is susceptible to being gamed, especially as the settlements will be made in cash.
Finally, there is the question of the effect of hard forks. As bitcoin has garnered media attention, several developers have broken away from its blockchain to start their own cryptocurrencies. Bitcoin Cash was just the start. A flood of cryptocurrencies based off bitcoin’s blockchain is expected to enter the market in 2018. Since the forks have a direct impact on bitcoin’s price, CME will have to contend with their effect on its futures contracts.
Should Retail Investors Lay Off Bitcoin Futures?
While CME may not be able to solve all problems associated with bitcoin, it has made provisions to account for some of them. It has instituted price limits of 20% above or below bitcoin’s reference price to prevent excess volatility. In an interview with Bloomberg, Terry Duffy, Chairman and Chief Executive Officer at CME, indicated that the agency was likely to make spec design changes for its contracts for bitcoin forks.
According to Duffy, most of the trade in bitcoin futures will happen upfront; hence, contract spec changes will have minimal effect on its future price trajectory. This is unlike EUR/USD contracts, where the open interest is spread out over a long period, such as 10 years and 40 quarters. The agency will also bring transparency to bitcoin by creating an “instant audit trail” that will identify traders in the cryptocurrency.
CME and CBOE trading is expected to legitimize bitcoin trading. To a large extent, this will be determined by the number of traders who will sign up for it as well as market size of the transactions. In the latter respect, bitcoin is at a disadvantage. In comparison to gold, a commodity to which it is often compared and which is a $7 trillion market, bitcoin has a valuation of $197 billion. Some investors anticipate bitcoin trading will mainly consist of miners and institutional investors. In that respect, bitcoin is similar to gold, whose derivatives are hedging tools for commercial producers and users of gold.