The CBOE Futures Exchange commenced trading of Bitcoin Futures last night – albeit with a temporary website crash – following a week that saw Bitcoin soar to over US $17,000 at one point. (Click here to access CFE Bitcoin Futures trading data.) In addition, a sixth exchange regulated by the Commodity Futures Trading Commission – Nadex – announced plans to begin trading another Bitcoin derivatives contract on December 17.

Last week, FIA – the exchange-traded derivatives industry organization – also published a letter it wrote to CFTC Chairman J. Christopher Giancarlo expressing regret that no "proper" public discussion and input had occurred prior to CFE, CME Group and the Cantor Exchange self-certifying Bitcoin Futures derivatives on December 1. According to FIA, “[a] more thorough and considered process would have allowed for a robust public discussion among clearing member firms, exchanges and clearinghouses to ascertain the correct margin levels, trading limits, stress testing and related guarantee fund protections and other procedures needed in the event of excessive price movements.”

Prior to launching its Bitcoin Futures, CFE announced that it had set its base initial margin requirement for hedgers and Trading Privilege Holders at 40 percent of the contract’s notional value using the daily settlement price. Initial margin for speculators was established at 44 percent of the contract’s notional value. CFE noted that brokerage firms were authorized to impose higher requirements.

CFE also said it would permit block trades in Bitcoin Futures beginning 6 pm ET on December 17 with a minimum threshold of 50 contracts. Exchange of Contracts for Related Position transactions are also authorized, but all spot Bitcoin positions must be transacted through the Gemini Exchange – the same exchange whose official auction price will be used to set the final settlement price of expiring CFE Bitcoin Futures.

Nadex proposes to offer Bitcoin spreads that will be cash-settled contracts within a floor to ceiling range. Under Nadex’s contract – which appears likely to be marketed largely to retail clients – if Bitcoin’s price exceeds the ceiling, the value of the contract remains at the defined maximum and if Bitcoin’s price drops below the floor, the value of the contract remains at the defined minimum.

Nadex’s Bitcoin spreads will derive their pricing data from the Terabit Index published by the TeraExchange. This index incorporates prices from nine spot Bitcoin exchanges. (Click here for details.) Nadex is both a CFTC-registered designated contract market and a derivatives clearing organization. Nadex previously offered cash-settled Bitcoin binary options beginning in 2014 that it delisted in December 2016.

Chicago Mercantile Exchange Bitcoin Futures are scheduled to launch on November 17 for trade date November 18.

(Click here for details regarding the December 1 self-certification by CME, CFE and Cantor, as well as background on derivatives contracts of those exchanges, as well as of LedgerX and the TeraExchange in the article “Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivatives Contracts” in the December 3, 2017 edition of Bridging the Week. Click here for a discussion by senior CFTC executives regarding Bitcoin, the Commission’s self-certification process for new derivatives contracts, and some insight into the CFTC’s deliberations leading up to the three exchanges’ December 1 self-certification.)

Compliance Weeds1: Legal and Compliance staff supporting firms' trading or facilitation of trading by third parties in cash-settled-Bitcoin futures should ensure their understanding of each of the terms of the new contracts – which may be quite different from one another – and consider among other matters at least the following topics:

  1. How adequate are the firm's disclosures related to unusual characteristics of Bitcoin futures (e.g., that margin requirements may routinely increase when a customer's long positions increase in value. This is because initial margin will be set, on some exchanges, as a percentage of total contract value)? Do the firm's disclosures adequately describe unusual conditions the firm may have imposed on customers trading Bitcoin futures (e..g, no naked short positions allowed, no give-in trades permitted or a premium to exchange-minimum margin required)? Has the firm considered highlighting exchanges' authority, if applicable, to set market prices unrelated to market activity under extraordinary circumstances? Is the firm's customer agreement adequately drafted to authorize the firm to take actions it may deem warranted should Bitcoin futures experience extraordinary volatility?
  2. In connection with exchange for related position transactions, what is a related product to a Bitcoin futures contract that has a reasonable degree of price relationship? Generally, the related position component of an EFRP transaction must be the cash commodity or a by-product, a related product, or an over-the-counter product that has a "reasonable degree of price correlation" to the relevant futures contract (click here, e.g., to access CME Group Rule 538C). Consider what other cryptocurrencies or forked versions of Bitcoin might be regarded as reasonably correlated and the time frame for assessing this. Last month, FCStone Merchant Services LLC and INTL FCStone Financial, Inc., affiliated companies, agreed to pay a collective fine of US $280,000 to resolve an enforcement action brought by the CFTC related to EFRP transactions executed by FCStone Merchant for its own account between December 2013 and March 2014. The firms were sued by the CFTC when FCStone Merchant entered into EFRPs involving CME-traded Canadian Dollar futures and physical canola seed. These transactions, said the Commission, were entered into by FCStone Merchant to help a client manage its financial inventory storage costs associated with canola production and currency risk. However, explained the CFTC, because the two components of the purported EFRPs did not have “a reasonable degree of price correlation,” they did not constitute appropriate EFRPs under the applicable CME rule. (Click here for background in the article, "Trading Firm and Broker Affiliate Settle CFTC Enforcement Action for Trading Firm’s Alleged EFRP Transactions With Insufficiently Correlated Futures and Physical Legs" in the November 19, 20916 edition of Bridging the Week.)
  3. What is a reasonable price of a block trade involving Bitcoin futures (when permitted)? Generally, prices of block trades must be "fair and reasonable" (click here to access, e.g., CME Group Rule 526D). Consider what is a fair and reasonable price when the futures markets may be extraordinarily volatile and the different spot markets in Bitcoin may be showing very different last prices and bid/offer spreads. In 2016, ​JSC VTB Bank (VTB), a Russia-based bank, and VTB Capital PLC (VTB Capital), a UK-based bank that was ultimately 94% owned by VTB, were sued by the CFTC for engaging in block trades with each other contrary to CME Group rules because the prices of their block trades were not fair and reasonable. This was despite the block trades' prices reflecting the midpoint between the prevailing bid-ask spread of related swap contracts at the time when relevant CME futures contracts were illiquid. (Click here for details in the article, “Futures Block Trades' Prices at Midpoint of Related Swaps Bid-Ask Were Not Fair and Reasonable Says CFTC in Enforcement Action” in the September 25, 2016 edition of Bridging the Week.)
  4. How should an account be liquidated when a client defaults in a margin payment related to positions in Bitcoin futures or under other circumstances? Keep in mind that exchanges typically prohibit the entry of orders with reckless disregard for the impact on the marketplace (click here to access, e.g., CME Group Rule 575D). Earlier this year, Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the Chicago Board of Trade and the Chicago Mercantile Exchange to resolve two disciplinary actions against it for the way it liquidated futures positions of its customers that were under-margined. According to the exchanges, on multiple dates between October 2014 and March 2015, Saxo employed a liquidation algorithm that automatically entered market orders for the entire amount of an under-margined customer’s positions. It did so, said the exchanges, without considering market conditions. As a result, claimed the exchanges, on at least three occasions on the CBOT and two occasions on the CME, the liquidation caused “significant price movements.” ​(Click here for background in the article “CME Group Settles Disciplinary Action Alleging that Automatic Liquidation of Under-Margined Customers Positions By Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition of Bridging the Week.)

​It is better for firms to systematically think through these and other potential issues now rather than later.

My View: Last week, many clearing firms were scurrying to determine whether they would permit clients to trade Bitcoin futures and what margin requirements and/or other restrictions would apply. There appeared to be no uniform response. Sadly, however, no matter what protective measures any individual clearing firm took, it would be at risk at a clearing house because of the protective measures another clearing member might not take. This is because, when cleared transactions are leveraged and risk is mutualized, no matter how cautious any one clearing firm may be, it is exposed to the risk of default of other clearing members who may not be nearly as cautious – particularly in connection with the trading of a likely very volatile product like Bitcoin futures. This is why FIA has historically (as well as last week) advocated that clearinghouses expose an appropriate amount of their own capital to its default waterfall (i.e., have “skin in the game”) to ensure that the consequences of default are shared appropriately between clearing members and clearinghouses. Appropriate skin in the game by clearinghouses helps ensure that clearing members continue to act responsibly, and that clearinghouses only process products that would not expose them to too high risks.

Compliance Weeds: The Terabit Index that will underlie Nadex’s new Bitcoin spread contract derives its prices from nine spot Bitcoin exchanges: BitKonan, Bitfinex, Bitstamp, HitBTC, Independent Reserve, itBit, Kraken, LakeBTC and OKCoin. None of these exchanges are subject to functional federal regulation (e.g., subject to trade practice surveillance requirements) and only one, itBit, has a New York virtual currency license (click here for a list of firms currently possessing a NY “BitLicense.”) On August 11, Bitfinex announced it would cease accepting accounts from individual US persons, noting, among other reasons, “[w]e anticipate the regulatory landscape [in the US] to become even more challenging in the future” (click here for details). CME and CFE Bitcoin futures contracts will also ultimately settle to prices derived from non-functionally regulated spot Bitcoin exchanges, some of which likewise do not possess a NY BitLicense.