Has The Future Of Bitcoin Futures Changed?

James Stoker Cunningham III stood bolt upright as he smoothed the lapels on his four thousand-dollar Gieves & Hawkes suit, acquired on a recent visit to London’s Savile Row. As he stood to speak, Cunningham III, or “Cunny” as he was known to his friends seem nonplussed,

“And so you see your honor because the Supreme Court had decided in Williams v. Sonoma, this court is bound by precedent to rule in my client’s favor.”

The district judge looked up from his glasses and with a deep sigh of resignation,

“Whilst it pains me to have to rule in such a manner, counsel has to his credit reminded me that I am bound by precedent to decide this case in favor of the defendant.”

“And while no doubt, on a personal level, such a ruling causes me no shortage of grief, if the law intended me to decide differently, that is not a matter for this court, but one for the Supreme Court.”

“In light of that precedent, I find in favor of the defendant.”

And with that, a collective gasp was heard throughout the courtroom.

For those unfamiliar with the common law system, case law, precedent or “judge-made” law, especially when made by a higher court, is often treated as binding on a lower court, where the legal principle passed down from a higher court is applicable to similar factual matrices in the lower court.

But precedent, convenient as a guide to what will likely happen again, is not strictly determinative, nor a guarantee of what can happen next.

Different Day, Different Future?

And so while traders may have rightly priced in the “precedent” effect for Bitcoin and other cryptocurrencies following the launch of Bakkt’s physically-deliverable Bitcoin futures, it’s harder to say where things will go here on out.

Back in December 2017, when the more speculative corners of the investing world were in the throes of cryptocurrency fever, the Chicago Mercantile Exchange (CME) launched cash-settled Bitcoin future, marking the first time that a regulated entity had entered the cryptocurrency derivatives market.

And while the popular view back then was that “institutional” interest would propel Bitcoin prices even further north, the CME Bitcoin futures had the unintended effect of sinking Bitcoin, sending it crashing from highs that it has yet to recover to.

To be sure, there are plenty of reasons why institutional investors sat on the sidelines, chief of which would have been that these seasoned players are not in the habit of making unhedged directional bets — which is precisely what a cash-settled Bitcoin future is — a one-way bet.

So the idea that putting cryptocurrency participation on a regulated and transparent exchange would lure in institutional money and send a demand for cryptocurrency soaring was misleading at best.

There were many issues with CME’s Bitcoin futures, to begin with. Because while the CME Bitcoin futures were regulated and on a regulated exchange, the price posted for Bitcoin, its sources and other necessary data to effectively trade in the CME Bitcoin futures continued to come from opaque and unregulated sources.

Instead of sending cryptocurrencies to the moon, the CME Bitcoin futures facilitated the beginning of price discovery that blew up the cryptocurrency rocket on the launchpad itself.

In a market dominated by pump-and-dump schemes, wash trading, frontrunning, spoofing, and outright scams, traders dumped Bitcoin just days after the CME Bitcoin futures were launched, plummeting the world’s favorite cryptocurrency from US$19,000 to US$12,000 in just five days.

The Future Is Bold

So when the Intercontinental Exchange (ICE), owner of the New York Stock Exchange, boldly launched its own hotly anticipated Bitcoin futures this month, many traders were bracing for a repeat of 2017 — and they were not disappointed.

By the end of Bakkt’s physically deliverable Bitcoin futures launch day, nearly US$8 billion was wiped off from cryptocurrencies.

Litecoin dropped by 10% in a manner of minutes. Bitcoin punched through US$10,000 and US$9,000 support levels and at the time of writing is precipitously hovering a hair’s breadth over US$8,000.

But Bakkt’s Bitcoin futures are not quite of the same complexion as CME’s Bitcoin futures are they?

Similar Yet Different

For one, Bakkt’s Bitcoin futures require physically-deliverable Bitcoin, which is why the product took several years to develop as ICE had to set up a scrupulously operated depository, aptly called the “Bakkt Warehouse,” as well as jump through all sorts of regulatory hoops to set up the system, not least of which was obtaining the approval of the finicky New York Department of Financial Services.

So while Bakkt’s Bitcoin futures product may look the same, this really marks the first time that Bitcoin futures are settled in actual Bitcoin, which means that ICE is not just competing against CME, but the cryptocurrency exchanges themselves — which in many ways is a big deal.

Because if Bakkt is successful with its Bitcoin futures, it’s just a matter of time before it starts expanding trading to encompass cryptocurrencies themselves as well as other derivative products for cryptocurrencies — and facilitate genuine price discovery.

And as Craig Pirrong outlined in his blog Streetwise Professor, physically-deliverable Bitcoin futures are in many cases a far superior price discovery mechanism when held up against cash-settled Bitcoin futures.

The latter, notes Pirrong is far more susceptible to manipulation due to its dependence on benchmarks of spot rates, which in the cryptocurrency markets are sourced from opaque, unregulated and often unreliable sources.

According to Pirrong,

For decades — over a quarter-century, in fact — I have argued that physical delivery is a far superior mechanism for price discovery and ensuring convergence than cash settlement. The myriad issues that were uncovered in natural gas when rocks were overturned in the post-Enron era, the chronic controversies over Platts windows, and the IBORs have demonstrated the frailty, and vulnerability to manipulation of cash settlement mechanisms.

Crypto is somewhat different — or at least, has the potential to be — because the CME’s cash settlement mechanism is based off prices determined on several BTC exchanges, in much the same way as the S&P 500 settlement mechanism is based on prices determined at centralised auction markets.

But the crypto exchanges are not the NYSE or Nasdaq. They are a rather dodgy lot, and there is some evidence of manipulation and inflated volumes on these exchanges.

As I have written on several occasions on this Medium page, when even reputable media outlets such as CNBC, Bloomberg, and Forbes, regularly quote cryptocurrency information sites such as CoinMarketCap.com, whose methodologies, algorithms and formula for deriving price information of cryptocurrencies and exchange volume is somewhere between divination and conjecture, cash-settled Bitcoin futures products were always at risk of being gamed.

So while the intent behind both CME and the Chicago Board of Exchange’s (CBoE) Bitcoin futures may have been to act as a disciplinary force to aid in the price discovery of Bitcoin, it was instead used by traders straddling both the regulated and unregulated markets to game cryptocurrencies for wild amounts of profit.

Putting It In A Jacket Doesn’t Make It Straight

And therein lies the difficulty with trying to introduce a regulated product for an unregulated asset.

To be sure, Bitcoin and its brethren were never going to be amenable to regulation. Decentralized and opaque, cryptocurrencies are only susceptible to regulation at transaction choke points, specifically exchanges, OTC and fiat-cryptocurrency on and off-ramps.

But the introduction of physically-delivered Bitcoin futures arguably reasserts discipline by making the sort of gaming that marred the CME and CBoE’s cash-settled Bitcoin futures far more difficult.

For starters, it’s not possible to sell a “PUT” on Bakkt for more Bitcoin than you actually have, whereas on a variety of other cryptocurrency exchanges, it’s absolutely possible.

Some argue Bakkt volumes are currently too low to really be making a difference. But if a market is extremely mispriced it doesn’t necessarily
take much volume to move the price in the opposite direction anyway.

And statistically, most new futures contracts start off with fairly low volumes before traders start figuring out firstly, if there’s a sufficient market (volume) for them, secondly how to profit using them and finally whether or not they can work as an effective hedge.

The beauty of Bakkt is that if there is a genuine imbalance between buyers and sellers, that imbalance must eventually feed through to the core price of Bitcoin in dollar terms on the exchange because somebody somewhere has to be prepared to pay real-world dollars (as opposed to Tethers) to keep the price supported.

That Bakkt’s Bitcoin futures contract is paid for in real greenbacks is not an insignificant detail. For years, it has been alleged that Bitfinex, the cryptocurrency exchange whose owners are also the creators of Tether, the dollar-backed stablecoin, has actively manipulated the price of Bitcoin using Bitcoin’s relationship with Tether — with Bakkt, we might actually find out if that’s true.

The only constraint comes if the price of Bakkt’s Bitcoin futures in real dollars cannot be arbitraged versus OTC (over-the-counter) exchange prices (more often than not in Tether) because the credit profile of those who operate in the latter market is so much lower than those in the former.

For now, at least, Bitcoin seems to be holding above US$8,000. Whether or not that level of support will persist remains to be seen.

There is at least a reasoned and reasonable argument to be made that this time really is different. For just as in law, precedents when applied to similar factual matrices, may result in circumstances completely opposite to expectations — similar is not the same.