Hitting the right spot with future contracts

The continued growth of futures markets for crypto assets is an important step in the evolution of the asset class, as it moves from the periphery into mainstream financial markets. Cash-settled futures pose significant risk to market markers and end investors, creating a compelling business case for a physically delivered alternative.

The intrinsic merits of crypto assets have not changed in the years since they first appeared: the peer-to-peer model offers a completely frictionless way to transact with minimal involvement of third parties. As the product matures and becomes more widely accepted, it stands to bring efficiencies to any sector that requires electronic payments and greater access to financial services.

A basic spot market doesn’t satisfy everyone, however, and among institutional investors there has been rising appetite to trade futures as a more capital-efficient alternative that requires less initial capital investment. Futures give investors the opportunity to trade on expected price moves and generally incur lower fees because there is less direct handling of the assets involved.

The development of bitcoin futures has gained momentum in recent years, with regulated markets CBOE Global Markets and CME Group both launching their own cash-settled futures products to great fanfare in December 2017. Meanwhile crypto-trading platforms Bitcoin Mercantile Exchange (BitMEX) and OkEX have become significant pools of bitcoin futures liquidity.

However, the majority of bitcoin futures are still offered only on a cash-settled basis, meaning that upon contract expiry, the investor will receive or pay the difference between the contract price and the indexed price. Cash-settled futures may be relatively straightforward to execute, with no physical exchange of assets involved, but they are prone to increased risk of price slippage and manipulation.

When trading cash-settled futures in traditional markets, liquidity providers will typically buy or sell spot contracts at or close to expiry to offset the impact of the futures. If it becomes difficult to do this accompanying trade or there is unexpected slippage, they face the risk of losses or reduced profits, and there have been concerns that the indices to which contracts are linked can be manipulated to move futures prices.

In a physically delivered bitcoin future, these risks are reduced. A seller would deliver bitcoin and receive cash, while a buyer would deliver cash and receive bitcoin in return. At expiry, the contract holder would simply pay or receive the price difference, but the underlying asset – bitcoin – actually changes hands, and the product is much harder to manipulate as a result.

Among market participants active in bitcoin, there is strong demand for an alternative to cash-settled futures

Bitcoin futures may still be a fairly new product, but there is no reason why lessons cannot be learned from traditional futures, where more than 90 per cent of volume currently takes place in physically delivered, rather than cash-settled, products.

This is because investors and hedgers naturally want trades to behave in a transparent and economically predictable way, but this is much more difficult in a cash-settled future, where the spot price can be more easily manipulated to affect the outcome. The economics of a physically delivered futures contract are more predictable, making it an attractive alternative for liquidity providers and investors.

Among market participants active in bitcoin, there is strong demand for an alternative to cash-settled futures. As a spokesperson for proprietary trading firm DRW put it recently, products indexed to a spot exchange or related auction are “inherently flawed due to the constraints that currently exist on these spot exchanges”. As a result, DRW and Cumberland, its bitcoin subsidiary, have publicly advocated the development of a physical futures contract.

Despite the widespread availability of cash-settled futures, some exchanges have recognised the associated challenges and risks. Intercontinental Exchange has been a notable dissident, with chief executive Jeff Sprecher telling a conference audience in December that he was in no rush to “settle against an index on a lot of exchanges that are not particularly transparent”.

At Coinfloor, we recognised the inherent problems with cash settlement and our subsidiary, CoinfloorEX, launched the very first physically delivered bitcoin futures exchange, based in the British Virgin Islands, in May 2018. It is still early days, but we are already seeing broad-based interest as market participants welcome the advent of a more transparent, reliable alternative to cash-settled futures.

There are challenges associated with physical delivery, of course, including the tightening of margin requirements after delivery, when investors must transition from a leveraged position to being fully collateralised. We have set this cycle over a seven-day period and have worked to ensure liquidity and tight two-way pricing continues throughout.

If liquidity providers and investors can get to grips with these processes, they stand to yield huge benefits. Given the more robust nature of physically delivered bitcoin futures and the reduced susceptibility to manipulation, liquidity providers should be incentivised to quote tight prices that will be more attractive to investors and commercial users of futures, creating a virtuous circle that will in time boost liquidity and volume.

With increased volatility in bitcoin in recent months, it is only a matter of time before the market moves en masse towards physical settlement. Not only will investors be able to absorb price swings better than with cash-settled futures, but physically delivered futures offer a more transparent alternative that will pose less systemic risk to this burgeoning market.