CME's Bitcoin Foray Has Three Plausible Outcomes
CME Group announced plans to offer a bitcoin futures contract this year. This brings it in line with Cboe Global Markets, which announced similar plans in August, and LedgerX, which began trading in bitcoin options and day-ahead swaps two weeks ago. These contracts are important steps toward integrating bitcoin with the global financial system. I see three plausible scenarios, though only one leads to bitcoin becoming more mainstream.
All three exchanges are regulated by the Commodity Futures Trading Commission, which appears willing to treat bitcoin as a commodity such as wheat and oil. The Securities and Exchange Commission has been less accommodating, and without a friendlier SEC, institutions will be reluctant to offer bitcoin-related retail products or to include bitcoin in institutional portfolios like pension funds. 1 (Full disclosure: I own bitcoins and other cryptocurrencies.)
The concern of bitcoin skeptics is that it's a Ponzi scheme. The concern of true believers is that absorbing bitcoin into the global financial system would destroy its value. Neither fear factored into regulatory decisions. The CFTC focused on whether futures clearinghouses could deliver what was promised to traders. LedgerX does this by holding 100 percent collateral.
Cboe and CME will use cash settlement.
The CFTC did not seem too worried about whether investors could buy and sell bitcoin at settlement prices. The SEC concentrated on the trustworthiness of the settlement prices. It noted that bitcoin liquidity is fragmented among mostly unregulated exchanges, and subject to manipulation, insider trading and other abuses. Moreover, the regulated exchanges that proposed to trade the bitcoin ETF did not have surveillance-sharing agreements with bitcoin exchanges. 4 The SEC is expected to relent on this issue and allow registered bitcoin products. 5
If regulators smile and clearinghouses operate without problems, we'll find out what happens when cryptocurrency prices are exposed to real money. The market capitalization of all cryptocurrencies is $182 billion, but that probably represents only a few billion dollars of actual investment. 6 There are large holders who would like to reduce their exposures at current prices, and retail and institutional investors who would like to buy in. If tens of billions of dollars come into cryptocurrencies from long-term, passive holders, it will add stability and liquidity to the market. But the price at which current holders' supply matches institutional investors' demand could differ from today's prices. 7
Here's how to think about that: Suppose Satoshi Nakamoto, instead of inventing bitcoin, created an island the size of South Carolina 8 in a temperate region of the Pacific Ocean. Most land is held in large blocks by the first inhabitants and a few people who bought below $10 per acre. Recently, though, small lots have sold at $6,400 per acre. 9 On that basis, the entire island is worth $107 billion. But until outside investors commit tens of billions of dollars to buy and develop large portions of the island, that $107 billion is paper wealth only. And, outside investors are only likely to buy in size if regulatory questions are resolved.
In this world, the CFTC has allowed exchanges to trade land derivatives but the SEC has refused to approve registered investment products based on the real estate agent reports, for fear of manipulation and other market abuses. 10
I suggest three plausible scenarios.
First, the SEC digs in its heels and institutional money stays leery of bitcoin. 11 In some ways this makes bitcoin more valuable, but only to a subset of people, and the cryptocurrency will likely remain illiquid and volatile.
Second, the SEC relents and global regulators start treating bitcoin like a commodity, but there isn't interest from long-term, passive investors. Bitcoin becomes like a penny stock, subject to pumps and dumps. CME and Cboe would lose interest. 12
Third, the SEC relents and, let's say for argument's sake, $50 billion flows in from long-term, passive investors over the course of 2018. Bitcoin prices might go up or down as a result, but the new prices would be real in a way the current prices are not. Stability and liquidity lead to more use, which leads to more stability and liquidity. Bitcoin becomes a standard financial commodity, and a useful part of the global financial system. 13
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Adventurous people are already doing these things, but not in significant size, and mainly outside the U.S.
If you enter into a contract cleared at LedgerX, the dollars or bitcoin necessary to satisfy your claims at expiry are already sitting at the clearinghouse.
Cboe using the closing auction at the Gemini exchange in New York, regulated by the NYDFS, CME using Crypto Facility in London, regulated by the UK FCA.
The SEC specifically refused to approve the Gemini auction (the one the Cboe intends to use) as too small, too opaque and not adequately regulated; but it also cast doubt on whether a broader index of the type the CME intends to use would be acceptable. From reading the SEC order, it appears that the SEC would have no problem with a bitcoin ETF or other registered product that obtained exposure through LedgerX (which had not been approved by the CFTC at the time the SEC order was published).
More accurately, that expectation has been widely reported. I know of no official source or reliable unofficial source for it.
The rest of the currencies are held by founders, miners or other people who acquired them at very low prices.
Guessing from the small volumes that trade, much of which is done by short-term, active speculators and some of which is done by users insensitive to price, is not very reliable.
The number of acres in South Carolina is approximately equal to the number of bitcoin.
And a lot of the sales are back and forth among an aggressive group of real estate agents and speculators.
Meanwhile, some residents on the island oppose all outside investors. They want the place developed for people who live there, not for non-residents to play financial games. Other people say the island doesn't really exist and want to protect investors from giving their money to con artists.
This could be followed by further legal discouragement, keeping bitcoin distinct from mainstream finance.
This has happened not infrequently in the past to various futures contracts, and the exchanges drop them. LedgerX would have a niche business primarily from traders trying to monetize volatility.
To the delight of some and the disgust of others.
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Robert Burgess at email@example.com