Bakkt to the Drawing Board for the World’s First Deliverable Bitcoin Futures

Henry Harianto wipes another bead of sweat off his forehead with the back of his hand. His tattered singlet plastered with sweat against his skinny bony back, the 24-year-old Indonesian is waiting patiently at the docks of Jakarta’s Tanjung Priok port to load a delivery.

Formerly known as the Dutch possession of Batavia, the docks of Jakarta’s port have served as a gateway to spices and all manner of exotic commodities so craved by the western hemisphere from the early 17th century.

But today, Harianto is not waiting for nutmeg or cloves, instead he’s waiting for large, white bales of something far more essential to the global economy — rubber.

 

Unbeknownst to Harianto however is that the bale of rubber which he’s about to load at the docks started its life as a futures contract at another port city not far north of Jakarta — Singapore.

And today, is delivery day for that particular futures contract.

The Futures of Cryptocurrencies

All across the world, whether it’s pork bellies or frozen orange juice, coffee or copper, futures contracts have served as a way for commodity producers to protect themselves against future price variation and as a way for users of such commodities or feedstock to protect themselves against fluctuations in the input price for their manufacturing activities.

And while arguably miners of cryptocurrencies such as Bitcoin could benefit from a futures contract on the production side — they would be able to know before hand the amount of energy and resources that they could spend to mine Bitcoin — there is little value on the opposite end of the transaction.

 

Bitcoin is (for now at least) not a feedstock for any downstream use.

But all that may change if ICE manages to get regulatory approval for its Bitcoin futures contract.

Bakkt — ICE’s name for the project — has partnered with companies such as Microsoft and Starbucks and its long term goal is to make cryptocurrency transparent and regulated enough to allow individuals to use it in retail purchases — a potential downstream use for Bitcoin beyond speculation.

With a retail network that spans the globe as well as an operating system used in 95% of computers globally, Bakkt is backed by some serious players.

And ICE also intends to launch its Bitcoin futures contract on the same exchange where it already lists U.S. natural gas, cotton and coffee futures.

But Bakkt has run into regulatory hurdles from the Commodity Futures Trading Commission (CFTC).

The latest of these snags has been disagreement between ICE and the CFTC over how customer’s Bitcoins should be stored or held in custody.

Whose Bitcoin is it Anyway?

ICE has specified that its Bitcoin futures contract will be a daily, physically delivered contract, which means that at the end of each trading day, counterparties would settle gains or losses by accepting Bitcoin or delivering them to Bakkt’s “warehouse” — a secure digital vault for the storage of cryptocurrencies.

But therein lies the main issue.

With other commodities, the exchange is not the custodian of the commodities as well, with most futures contract for physical delivery specifying delivery at predetermined locations, governed by other entities or custodians.

 

The main issue that the CFTC has with the Bakkt solution is that it would be acting as both the exchange as well as the custodian for Bitcoin — something that is a major no-no in regular commodity trading.

But the concept behind Bakkt’s physically deliverable Bitcoin contracts would at least be a major improvement from the Bitcoin futures offered by CME and Cboe, which are settled in cash, create no underlying demand for Bitcoin and actually help to fuel speculation.

Bakkt would also help to ensure a tighter link between the price of ICE’s Bitcoin futures and the price of Bitcoin itself — because a futures contract would create actual demand for the Bitcoin commodity.

Furthermore, price discovery would be more dynamic and underlying demand would presumably be more evident.

All that would help to improve price information for Bitcoin — a precursor to facilitate increased (and hopefully genuine) trading activity.

But Bakkt’s plan to act as both custodian and exchange is also why the CFTC has stalled Bakkt’s application to list Bitcoin futures on ICE’s commodity exchange.

Too Cool for School

For starters, there’s no precedent for how cryptocurrencies should be disposed of in the event that either Bakkt or one of its counterparties should go bankrupt.

The recent litigation surrounding the collapse of the world’s first Bitcoin exchange Mt. Gox raised similar issues — with the remainder Bitcoin left after the hacking sufficient to make customers of Mt. Gox whole in dollar terms, but far behind in Bitcoin terms.

Then there’s also the issue of client funds.

In a typical futures contract, a client posts dollars as collateral that would be held by a bank or trust company. With Bakkt’s Bitcoin futures, collateral would take the form of cryptocurrency.

Is that a High Quality Pork Belly?

And as anyone who’s ever traded in natural commodities will tell you, there are variations in the quality of the commodity — something which commodity traders have had to deal with in various ways.

Singapore’s rubber futures contracts for instance are based on what has been termed “Technically Specified Rubber” — a block form of the commodity that has to conform to strict regulations governing size and quality.

 

By contrast, rubber sheets that underpin the futures contract on the Tokyo Commodity Exchange or TOCOM are only subject to a visual inspection.

When it comes to cryptocurrencies such as Bitcoin — each Bitcoin has a unique provenance — because the Bitcoin in any public address may have been transferred many, many times before it reaches the hands of the latest Bitcoin public address— does that make it somehow more “used”?

Because owning Bitcoin is essentially owning the private key that controls the Bitcoin held by a specific public address, there is the risk that (if properly traced) some of that Bitcoin may have been the profits of a hacking or linked to some other criminal activity.

In which case, whose responsibility would it be to ensure that only “untainted” Bitcoin is ever used to back a futures contract? Is it buyer beware or the job of the exchange?

And while the issue of custody could technically be seconded to established trust companies such as Northern Trust, who have already experimented in this area — would they then take responsibility for validating the provenance of Bitcoin that they custody?

But while most of these problems are not intractable, they do raise significant cost issues. Because tracing the provenance of Bitcoin is neither easy nor cheap.

And if the idea is to increase the volume of trading Bitcoin futures to generate an active and vibrant market, the issue will be bound to crop up sooner or later.

Regardless, the work of Bakkt is certainly a step in the right direction and brings the cryptosphere as a whole one step closer to institutionalization.

However given the substantial regulatory and technical hurdles that need to be surmounted to achieve institutionalization of cryptocurrency trading, within the existing regulatory framework and safeguards, the process will likely take a lot longer than anticipated.