Regulatory Progress for US Crypto Derivative Platforms

VeradiVerdict - Issue #45

TL;DR

  • Futures contracts are legal agreements to trade commodities at a predetermined price at some set price in the future. Futures exchanges are where these contracts are organized and traded to parties that want to enter into the contracts.

  • Currently, the biggest (and only notable) player in the cryptocurrency futures space is the CME Group. CME offers Bitcoin futures, and has been getting huge interest, peaking at $400M total value in futures contracts on its platform in June. However, CME futures are settled in fiat currency, not cryptocurrency, and rely on price-calculations from CME itself instead of purely contractual data.

  • Two of three major cryptocurrency exchanges, Ledger X and Eris-X, have recently received licensing from the Commodity Futures Trading Commission (CFTC) to launch futures trading platforms that can be physically-settled, meaning they’re settled in actual cryptocurrency, not fiat. I’m sure Bakkt will not be too far behind.

  • Ledger X plans to launch a platform called Omni, which is primarily targeted towards retail (day-to-day) traders who want to trade. It’s the oldest of the three exchanges and has been seeing substantial but unimpressive growth in the options and spot space.

  • Eris-X received a license to clear fully collateralized futures from the CFTC and has been licensed by the CFTC as a futures exchange since 2011. It’s new futures platform is geared towards institutional investors. Eris-X is fully collateralized and has the licensing that signals huge confidence for institutional investors interested in the cryptocurrency futures space.

  • Bakkt, which operates under Intercontinental Exchange (ICE), also presents a new platform for Bitcoin futures. Bakkt will manage and clear all its futures through ICE, which gives the platform way more control over how its cryptocurrency futures are managed, and also signals more confidence to users since ICE is well-established.

  • The new licensing opens up a huge market for futures that are actually settled in cryptocurrency, a concept that’s been getting a lot of user interest recently. Additionally, the licensing represents huge advances in cryptocurrency’s credibility and legitimacy; futures present a new space for a financial asset that’s becoming more and more established.

What even is a futures contract or exchange?

Futures contracts are essentially legal agreements to trade a commodity for currency at a predetermined price at some set time in the future. An example would be party A wants to buy three BTC at $12,000 per BTC in January 2020. Party B is willing to sell three BTC at that price and time, and thus, parties A and B enter into a legal agreement to trade with the designated price and time. This differs from a spot contract, which is settled immediately after (generally, ~two business days) both parties agree to trade. Futures contracts are important financial vehicles to (1) speculate and profit from changing asset prices, or (2) hedge against risky investments made later.

There are two major kinds of futures contracts: cash-settled and physically-settled. In cash-settled contracts, parties pay or receive the difference between the current price of the commodity (spot price) and the price of the commodity at the predetermined date (futures price). In physically-settled contracts, parties use a price that’s set in the contract itself.

Futures exchanges are essentially marketplaces where the public can trade futures contracts and enter into them; with regards to the analogy above, a future exchange is where party A and party B would meet each other once they decided what they were looking for in terms of a futures contract. Some of the largest future exchanges domestically include the CME Group, NASDAQ Futures Exchange, and Intercontinental Exchange. Thus far, the cryptocurrency futures market has been very nascent and nebulous and not a ton of players have gotten involved in this space––that’s very recently changed.

What’s the history of the cryptocurrency futures market?

Honestly, there’s not been much. The CME Group and Cboe Global Markets were the two biggest players in cryptocurrency futures, offering cash-settled futures contracts that were generally settled in fiat currency, not cryptocurrency. This means that buyers and sellers didn’t exchange actual cryptocurrency, but rather the fiat value of whatever commodity they chose to trade. Additionally, the futures contracts were less reliable than ideal, because they were cash-settled; CME calculated the currency price of the commodity as a weighted average of four of the largest cryptocurrency exchanges’ prices for that commodity and used that to price their contracts. Physically-settled futures contracts would attract more confidence because it doesn’t rely on vague calculations.

Cboe recently left the futures market in March, citing insufficient interest in the platform. CME, on the other hand, has been seeing great success in the space––the open interest (essentially number of contracts outstanding for sale on a futures exchange) hit $400M in June 2019, indicating that more and more people are becoming interested in cryptocurrency futures.

Why the sudden change?

With more interest in cryptocurrency futures, more exchanges and financial institutions are becoming interested in being a platform for trading futures contracts. NASDAQ, the New York Stock Exchange, and several other players have expressed interest in launching a futures platform for cryptocurrencies––but also to improve on the success of CME’s future exchange. These new players have hopes of (1) having futures-settled contracts, as to not rely on arbitrary pricing calculations, and (2) allowing parties to settle in cryptocurrency entirely as opposed to the fiat value of the commodities.

So far, no exchange has been able to meet those criteria because it requires special approval from the US Commodity Futures Trading Commission (CFTC) to exchange physically-settled contracts and to settle through delivery. This is called a Designated Contract Market (DCM) license.  But recently, Ledger X has received CFTC licensing to host these kinds of futures contracts for trade on their platform, and Eris-X (backed by TD Ameritrade) received a CFTC license to clear futures contracts traded on their platform (which has been licensed for futures trading since 2011. Bakkt (backed by the NYSE’s Intercontinental Exchange) should not be far behind.

What are the differences among these three players?

LedgerX is a platform for trading spot, options, and futures for just Bitcoin­­, and no other cryptocurrency. It’s been operating since October 2017 and is the oldest of the three exchanges to trade cryptocurrency swaps (LedgerX does not yet offer futures). However, despite huge growth in the cryptocurrency derivatives market, Ledger X’s growth pales in comparison. In 2018, they grew 35% monthly and added 200 new institutional partners, but that represents less than 5% of the total growth in the Bitcoin options market. Competitors like BitMEX, CBE, and Deribit have been driving the growth in the options space. Despite its first-mover advantage, Ledger X has not been able to lead in Bitcoin spot or options. With its new DCM license, Ledger X plans to launch a new futures trading platform called Omni that exchanges futures-settled contracts that are settled in actual Bitcoin, but not fiat; the platform will only support Bitcoin trades as well, and no other cryptocurrencies. Given Ledger’s substantial but unprolific growth in the options space, it’s unclear where it stands in terms of the futures space, but it’s unlikely to be the leader of the pack.

Eris-X is another exchange for trading digital assets­­––but unlike Ledger X who only currently offers swaps, Eris-X supports four cryptocurrencies: Bitcoin (BTC), Bitcoin Cash (BCH), Ethereum (ETH), and Litecoin (LTC) on its spot market and hopes to launch futures on the same cryptocurrencies. Eris-X recently received a Derivatives Clearing Organization (DCO) license and has been approved by the CFTC to launch futures on digital assets. Eris-X’s trades are also fully collateralized and don’t offer margins, which exempts Eris X from certain parts of CFTC regulations that make things particularly tricky for institutional investors. In short, Eris-X’s licensing is geared towards individual and institutional investors looking to access spot and regulated futures contracts on digital assets on a unified platform. Eris-X launched their spot market in April 2019, which follows the same order book that their futures market will follow, and plans to launch futures on digital assets later this year. It’s likely that Eris X will pave the way for institutional futures trade and be a major player in the futures space moving forward.

Bakkt operates under the Intercontinental Exchange (ICE), which itself operates under the New York Stock Exchange. Bakkt lists the same four cryptocurrencies that Eris X does and is a comparable player in the digital assets trading space. Bakkt’s organizational structure, however, gives the platform huge confidence and power over the way that it handles futures trade. Bakkt will trade its futures through ICE Futures US, which is a broader marketplace for all kinds of futures that has tons of users. This is critical because Bakkt’s cryptocurrency futures contracts will be listed as another futures option for the already-substantial customer base of ICE Futures US. Additionally, its futures will be cleared through ICE Clear US, which gives Bakkt more control over how its futures are managed; it has total custody over all its assets, which makes futures trading on Bakkt apparently more secure than most other platforms.

What does licensing mean for the future (pun not-intended)?

In terms of the three players discussed, they’ll all be launching their platform relatively soon to have physically-settled futures that are settled in cryptocurrency, not Bitcoin. Ledger X seems to be targeting retail consumers who casually buy futures, Eris X seems to be gearing up for institutional investors, and Bakkt is capitalizing on its ties to the already-established ICE Futures Space. We can expect all three exchanges to grow substantially following the launch of their futures platforms; given how much interest cryptocurrency futures have been getting recently, it’s a fair bet that all three exchanges will see high usage, at least initially.

For the broader cryptocurrency market, these developments mean two things:

First, CME’s effective monopoly on the cryptocurrency futures will be on the decline; recall that the new futures exchanges are physically-settled, which means they are settled cryptocurrency and not fiat currency. This presents huge value for users that see cryptocurrency as means for trading, not just as commodities to trade for fiat; additionally, the newer contracts are settled with predetermined pricing rather than relying on calculations from CME.

Second, cryptocurrency is gaining more legitimacy as an asset class in domestic markets. CFTC approval for this kind of futures contract trading isn’t easy to get––the fact that two of the three exchanges have been able to secure, or on track to obtain, effective licensing and that there’s huge interest in something like this reflects cryptocurrency’s growing credibility in the US financial space. Futures present a huge new market for cryptocurrency, which has primarily been focused on options and spot trading in the past. It’s unclear who will be the front runner of the new futures space or what that looks like for institutional and retail consumers, but it’s definite that there’s huge interest and potential for the futures space to bloom.

-Paul


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Additional Info

Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing into blockchain companies and cryptocurrencies. The firm invests in equity, pre-sales/IEO rounds, and cryptocurrencies on the secondary markets. I focus on early investments and want to share my thoughts and what’s going on in the industry in this weekly newsletter.

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