The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.
Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.
So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.
If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.
Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg:
“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”
Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.
Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.
Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:
“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”
Petterfy has expressed worries about weaker FCMs in particular:
“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”
He has recommended clearing crypto separately from other instruments.
These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.
Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.
As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).
Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.
Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.) The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.
This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?
(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)
What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.
Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.
All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.
Leave a Reply