Headlines virtually ooze sensationalism as they inform investors that BitCoin a.k.a. The boogeyman is coming, in the form of futures contracts on the CME. The news coverage ranges from the reasonable from Business Insider and the Wall Street Journal to the ludicrous from CNBC, who stokes investor fears by comparing approval of BitCoin Futures to the cause of the Financial Crisis.
Such a comparison is simply idiotic, as the leveraged derivatives and rampant speculation on real estate was carried out in markets that are multiple orders of magnitude more systemically important than cryptocurrencies are today. That crisis created almost complete paralysis in the debt markets, and threatened the solvency of the banking system.
That CNBC article quotes noted CryptoCurrency and Trading Technology expert, Joe Saluzzi, who also wrote his own blog on the topic yesterday. As usual, the Themis blog starts from their typical HFT firms are evil meme, but they do make a valid point, which is that basing a futures contract on an INDEX of BitCoin prices would be subject to manipulation. If the CME, however, created a futures contract that was physically settled, then such concerns would evaporate. That does not mean that such a contract would have no volatility (It would likely have quite a bit), nor would it mean that investors wont lose money. It would, however, mean that the contract itself would be much less susceptible to manipulation.
I realize that the notion of “physical” settlement is odd, since BitCoin is a digital asset, but the point is that sellers of BitCoin futures could be required to make delivery of the asset to the exchange on settlement, and the buyers could be required to take delivery. IF that was the proposal, then manipulation of settlement prices becomes irrelevant, and BitCoin would be no different than any other commodity futures the CFTC regulates. They could judge the proposal based on the CMEs capabilities of ensuring that the resulting blockchain transactions, which constitute the physical settlement, were able to be verified and secured. This would, in actuality, be far easier to accomplish than with other commodities, since BitCoin delivery doesnt require warehouses, grain elevators, or vaults to handle the transactions. It has a well-established method for verifying on chain transactions and member firms trading the future would be capable of constructing or leveraging service providers to create the necessary secure systems to either deliver or accept delivery and maintain the resulting inventory.
If the CME proposes to settle this contract on the basis of an index, however, I would be forced to agree with Themiss conclusion that the CFTC should reject the proposal. This is not because of irrational HFT-phobia since it is unclear that speed would have anything to do with the capacity for manipulating the price and such firms have substantial franchises to protect. Other firms, including clients of CME members who are not subject to regulation, however, would be in position to That said, I would characterize the idea of using a 5 minute VWAP of some Bitcoin exchanges to create an Index of the Bitcoin price, as extremely susceptible to manipulation.
I have studied the BitCoin market extensively using software built by my soon-to-be-launched technology company[1] and would argue that it is currently very disorganized. A recent look at the market for BitCoin in October, shows that, even limiting the search to three large exchanges that offer data feeds, the market was CROSSED (meaning the highest bid was above the lowest offer) almost the entire time and a lot of the time it was crossed by more than 0.25% of notional value. In addition, among the three exchanges, there was significant rotation at both best bid and offer, so it is not a matter of one exchange being persistently lower or higher. This can all be seen in the following graphic:
In addition to the disorganization of the markets, the liquidity on the various exchange order books is inconsistent, meaning that there will often be times where a single order book can be manipulated. As an example, compare two situations, where an investor buying approximately $1 million of BTC chooses to buy exclusively on Gemini, one of the exchanges likely to be in the index, vs spreading their order out over three exchanges:
In this example, compiled using our proprietary software at a point in time just after 1:30 today, you can see that a trading firm, even in the middle of the trading day, can create almost $60 of additional market impact (or 90 basis points) by trading on one exchange for $1 million of notional value at a single point in time. (Note that while this example isolates Gemini, the same effect can be seen by trading on any individual exchange.)
What makes this a serious problem, is that there are no regulators to ensure that all markets are prohibiting wash sales (defined as buying and selling on one exchange simultaneously, for the purpose of showing volume). If someone wanted to manipulate an index, they could push the price up or down on one exchange, then trade with themselves for large volume on that exchange to influence the Volume Weighted Average Price (VWAP) the index uses. (Incidentally, the use of VWAP in the proposed index is why HFT firms have no advantage, since large wash trades and manipulation could easily be accomplished with very basic technology as the time periods are every 5 MINUTES)
Now, I am not suggesting that this will occur, nor am I suggesting that this product, if approved, will necessarily hurt retail investors. My point is that futures should rely upon well regulated, transparently priced markets when they are cash settled products. If, however, they are physically settled, then the only considerations are if there is both liquidity in the specific market for the commodity and sufficient interest in the futures contract. Both of those conditions seem to exist for a successful launch of BitCoin futures, so I would suggest such an approach.
[1] That company will be formally launched with a whitepaper soon, but it has fully functional software to help understand and trade the cryptocurrency markets already. For details, contact me personally.
