Four Problems With Bitcoin Futures

Excitement over the introduction of bitcoin futures at the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) has rallied the cryptocurrency’s prices to record highs.

After the CME and CBOE announced start dates for bitcoin futures trading on their respective platforms, the price of a single bitcoin jumped from $10,000 at the end of last week to a peak of $20,000 on some bitcoin exchanges yesterday. 

Investors are enthusiastic about bitcoin futures because institutional investors will bring liquidity and price stability to an otherwise volatile entity. But the hasty move by exchanges has attracted critics. For example, Sir Howard Davies, chair of the Royal Bank of Scotland, criticized the exchanges for not soliciting enough feedback from market participants before setting price limits and margin trading levels.

That bitcoin is a stateless digital currency and unregulated entity is only expected to add to its complications in futures trading. (See also: CME To Launch Bitcoin Futures.) 

Here are four problems that CME and CBOE can expect when they begin bitcoin futures trading in coming weeks. 

1. Price Limits Will Cut Into Trading Profits

CME’s contracts have price limits of 20% above or below bitcoin’s reference price to curtail volatility. The price limits are aimed at minimizing the adverse impact of bitcoin’s wild price swings on futures markets. 

But they might end up cutting into trader profits. This is because the reference price for bitcoin derivatives is based off exchanges in unregulated markets, where price swings of greater than 20% have become fairly common. Thus, futures traders will not benefit from a spike of greater than 20 percent in bitcoin prices at the underlying exchanges.

“Having limits on the derivatives rather than the base asset is counterproductive because it reduces effectiveness of the (futures) instrument,” says Bharath Rao, CEO and co-founder of Leverj. According to Rao, price limits at CME might force traders to look elsewhere to realize the full value of their profits.

2. Bitcoin Futures Could Pose a Systemic Risk at the Exchanges 

Bitcoin’s brief history has been marked by volatile spikes and crashes. But these price changes have occurred in short spurts, enabling traders to recover in a short span. “The cumulative impact of such an event (on bitcoin exchanges) is very less,” says Bharath Rao.

However, if the issue is a systemic one, then CME’s price limits could prolong the decline through the domino effect of futures traders selling their contracts en masse. A snowballing sell move could crash the entire market.

In a letter to the CFTC chair yesterday, the Futures Industry Association (FIA) highlighted bitcoin’s volatile prices and asked for a “separate guarantee fund” for bitcoin futures to clear settlements for the commodity.

“The idea (behind their request) is to isolate risk,” explains Rao. (See also: Can Futures Trading Solve Bitcoin's Problems?)

3. Bitcoin Exchanges Are Unstable

Bitcoin exchanges, which provide a reference price for the asset, mostly work in unregulated markets. Without the overseeing hand of a regulator, they are subject to manipulation.

Bitcoin’s wild price swings have also been characterized by frequent outages in exchanges. As an example, prominent exchanges such as Coinbase and IG Group stopped trading yesterday when the cryptocurrency’s price shot up and then crashed within 20 minutes. (See more: What Was Behind Bitcoin’s Insane Price Moves On Dec. 7?)

Such outages could prolong trader losses and cut into their profits. “I don’t see how you can get a smooth trading experience, if the exchange shuts down every time the price jerks,” says Rao.    

4. The Timing of Bitcoin Futures May Increase Volatility

Typically, futures markets are precursors to price stability for a commodity because they draw in speculators and traders. Given the recent whipsaw in bitcoin’s price, however, some question the wisdom of bringing in new players to the bitcoin market at this time.

“There is already enough speculation surrounding bitcoin given the recent price increase, and it is clear that it will only increase if more people are capable of participating,” says Gabriele Giancola, co-founder and CEO of quibee, a decentralized loyalty platform. 

Christopher Grey, COO of CapLinked, an enterprise collaboration and data sharing platform, cites bitcoin price’s recent parabolic curves as an added incentive for traders and investors to play with its price. “I would expect these wild swings to become even bigger and more commonplace,” he said.