A new set of CFTC-submitted futures contract applications moves the futures industry one more step along the path to independence from spot markets. The unique nature of ownership and control of cryptocurrencies forces the futures exchanges to take a step – management of the spot market underlying their futures contract – that is in the exchanges’ interest in every market. If regulators are not caught napping, this issue will have their full attention, since it blurs the roles of the CFTC (derivatives regulation) and the SEC (securities regulation) decisively. To be coherent, the two agencies will combine.
Why crypto is different.
Cryptocurrencies have no ownership record aside from their public and private keys (two multi-digit numbers that identify each currency unit). Thus, cryptocurrencies create unique custody issues, making the protection of customers of exchanges and broker-dealers trading crypto futures from loss a different, more difficult, problem than with securities futures.
The solution of the existing futures markets trading crypto futures has been to avoid the issue by trading a cryptocurrency index. This is not without problems of its own since it simply passes the issue of crypto custody to someone else, typically a cash cryptocurrency exchange, unregulated and prone to error and abuse.
The more recent entrants into the contest for dominance in crypto-exchange trading have realized their window of opportunity is to solve the custody issue. Their solution is to take custody of the currency during the period when a customer has an open position in the exchange marketplace. Ironic, since the philosophical basis for crypto is to avoid third-party and regulatory involvement. In other words, to trade cryptocurrency safely, it is necessary to change a cryptocurrency into an ordinary, third party-controlled, government regulated entity – a security by another name.
But as a result, the new cryptocurrency exchanges are forced to do what is in the best interest of every futures market for every commodity. They are forced to take responsibility for ownership and management of the cash market, without DTCC (Depositary Trust and Clearing Corporation) or broker-dealer involvement.
Bakkt, a startup subsidiary of ICE (Intercontinental Exchange, Inc.), a putative futures contract market in cryptocurrencies, is the center of focus of this second (the earlier article about LIBOR substitute-created spot problems is here) discussion of the signs that the futures markets are escaping their cash market straitjacket. Bakkt is one of the exchanges proposing physical delivery of a futures contract in a cryptocurrency, bitcoin. And Bakkt is part of an exchange powerhouse, ICE, that has major cash and futures exchanges already under its management.
Because it’s crypto, the Bakkt contract market is getting lost in a maze of other exchanges, for example, LedgerX, which has made a similar application.
LedgerX, by limiting its early applications to institutional customer services only, received regulatory approval from the CFTC immediately. Thus, it’s already up and running at the institutional level. The apparent price of immediate regulatory approval for LedgerX was that it cannot accept retail orders. Thus, it’s an options and swaps exchange only – no futures. But LedgerX is also seeking SEC approval to list a futures contract available to the retail public.
Addressing the issue of custody presents multiple opportunities.
Bakkt seeks to list a single-day futures contract. The request is a big ask and, if CFTC approved, promises to start a regulatory firestorm. Unlike LedgerX, Bakkt futures trading in bitcoin would set precedents that could be immediately applied to other markets.
What is interesting for the purposes of this article is the bit about a one-day futures contract with exchange-provided custody. Other than the exchange being each trader’s counterparty for a few hours only, the status of the Bakkt transactions as futures transactions, not spot transactions, is dubious. The common sense meaning of spot – now – and futures – later – makes Bakkt at least as much a spot transaction as any stock market trade.
Single day settlement futures contracts raise a significant question – what is a futures contract? The details of Bakkt’s plans are a mystery (The website-listed tweets help.)
What does Bakkt have in mind? The public information is sketchy.
- Trade a one-day bitcoin futures contract.
- Write the contract for physical settlement, not index settlement, as with the CME cryptocurrency futures contract, for example.
- Provide custody services for bitcoin. [Hence, I suspect Bakkt will settle deliveries by payment to Bakkt against delivery of bitcoin. Or perhaps provide electronic warehouse receipts for Bakkt-stored bitcoin in delivery.]
- Wallet Architecture and Key Security [Don’t ask. You can find Bakkt’s explanation here.]
- Physical security to be supplied by Bank of New York Mellon (BNY).
Bakkt has hired a bitcoin security company with employees who understand the turgid description of Bakkt custody provided to Medium.
The bottom line is that there is a reason Bakkt handles settlement. It is not particularly attractive, from a transactions point of view, to own bitcoin itself. Hence, one key to the success of Bakkt will be the ease with which customers can trade the futures (spot?) contract without taking ownership.
If Bakkt succeeds in gaining CFTC approval of the contract, and if customers can trade it without involvement in the bitcoin cash market directly, the precedent of a spot market traded in a futures-like way will have been established once and for all.
This opens enormous possibilities for the future of risk management generally. The liberation of trading from the DTCC will reduce transactions costs and increase efficiency. Ultimately markets can assume full responsibility for transactions, ownership, and custody. The current system, with its multiple points of failure, where traders are nickeled and dimed to death at every turn by unnecessary exchange and broker-dealer fees, arbitrage between redundant marketplaces is rife, and major broker-dealer firms profit enormously from poor quality SEC quotes will be eliminated.
Which market manager will see the possibilities first? Will it be CME (CME Group) currently in the best position to act; ICE, which is the first major exchange management firm to address the issue; a new and fresh face like LedgerX; a buy-side managed firm; or a dark horse?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.