If the world caught crypto fever in the last few months of 2017, nowhere was this more evident than in The Loop—the windswept section of downtown Chicago housing its two biggest commodities exchanges. Cboe Global Markets’ Chicago Futures Exchange (CFE) and Chicago Mercantile Exchange (CME) operator CME Group were racing against each other to roll out their own futures contracts on bitcoin, the cryptocurrency wunderkind that had been toppling price records all year. 

The growth in the value of the digital asset, which had ceased being a possible payment mechanism in favor of being a speculative instrument some time before, was stunning—when the CME announced its futures contract in October, it surged past the $6,500 mark. By the time Cboe won the race and launched its futures contract on December 10, it was creeping toward an all-time high of $19,000, which it would hit a few days later.

Although the immense growth in bitcoin’s value was a recent development, Cboe says it had been looking at the space for well over two years, before it decided to pull the trigger on launching a futures contract. Part of the reason for that was its existing relationship with Gemini, a digital currency exchange (DCE), which would eventually provide the basis for the contract’s pricing. “It was pretty apparent to us, once we announced our partnership with Gemini in August 2017, that there was a huge amount of interest in bitcoin at both institutional and retail levels,” says Michael Mollet, director of product development at Cboe Global Markets.

For CME’s part, the exchange’s managing director and global head of equity products, Tim McCourt, says its own launch is in line with the CME’s tradition of expanding to new and innovative markets through its tried-and-tested focus on risk management. “We had been watching this space for some time, and we launched the product because of increasing client interest in cryptocurrencies and the performance of our indexes,” he says. “We aimed to provide investors with transparency, efficient price discovery, and risk transfer capabilities.”

However, creating new products in a new asset class, which was so notorious for its volatility that institutional money had until that point largely stayed away, was no small feat.

Deep Discussions

While others had dipped their toes in the crypto waters before when it came to developing a derivatives layer for the asset class—LedgerX, for instance, had received approval from the US Commodity Futures Trading Commission (CFTC) to operate a swap execution facility (SEF) and a clearinghouse for bitcoin options earlier in 2017, and TeraExchange had experimented with crypto contracts for some time before that—full-blown futures contracts were a different kettle of fish. Both CFE and CME engaged in an intensive period of discussion with regulators about all elements of the contract, from how it would be margined and settled through to the construction of its pricing mechanism. “This is an evolving market, and we needed to work closely with customers and regulators to launch the futures products,” says McCourt. “As the market continues to change, we continue to work with customers and regulators.”

The process of market education took several months for Cboe. “We embarked on this process with the Commodity Futures Trading Commission (CFTC) in July 2017; we shared a draft of the product we wanted to list and answered their questions,” Mollet explains. “All the while, our development team was engaging market participants, from the market-maker level to bank futures commission merchants (FCMs). It’s just been a whirlwind of conversations with a whole spectrum of users, educating them about the product itself and what they are getting exposure to.” 

For Cboe, however, the most challenging part was designing the product. Mollet explains that bitcoin has some unique features that they had to take into consideration, such as the way the contract settles, the price that would be used as a settlement value, as well as how it would be sized. “Designing the settlement process and building understanding around that for people was a challenge,” he says. “The process we use to settle the bitcoin future is analogous to what we do in the volatility index (VIX) futures market. Even though the VIX Index is a widely followed number and people can tell you exactly what the settlement print is, they may not know the mechanics of how it’s calculated.” 

Deeply Divided

However, traditional market participants were deeply divided about the contracts, and began making it abundantly clear that they were not happy with how the products had been rolled out. Rather than going through a public comment period, the exchanges had moved swiftly to get their contracts in place, exercising their rights as self-regulatory organizations (SROs) to certify their own products as fit for trading, following the consultation period with the regulator.

Bank FCMs, in particular, were not amused. Many bank CEOs had been publicly scathing about cryptocurrencies during bitcoin’s intense bull run, with JPMorgan CEO Jamie Dimon famously calling the cryptocurrency a “fraud,” and stating that he would fire any trader foolish enough to get caught up in it. The launch of the futures contracts proved to be a tipping point for many—Goldman Sachs and Morgan Stanley quickly issued a general ban on bitcoin trading after CME declared its intention to offer the contracts, but the strongest reaction came from the Futures Industry Association (FIA), which predominantly represents FCMs.

On December 7, the group published an open letter to CFTC chairman J. Christopher Giancarlo, sharply criticizing the way in which these contracts had been rolled out, while raising concerns about how collateral funds collected for bitcoin futures trades were being commingled with the wider default funds at major clearinghouses for more stable products, wrote FIA CEO and president Walt Lukken, himself a former chairman of the CFTC during the 2008 global financial crisis, in the letter.  

“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,” Lukken wrote. “The recent volatility in these markets has underscored the importance of setting these levels and processes appropriately and conservatively.”

In response, Giancarlo said the CFTC had “limited statutory authority” to oversee the cash markets underlying the futures contracts, but added that he had instructed agency staff to review the process of self-certification. 

There was perhaps a misunderstanding or miscalculation among bitcoin investors about what the futures markets would really bring to bitcoin.

Nicholas Colas, founder, DataTrek Research.

Despite these concerns, however, some firms decided to support the new contracts. Even Interactive Brokers, whose CEO, Thomas Peterffy, had been a vocal critic in the media about bitcoin, decided to offer long and short trading in the contracts—with the latter attracting an eye-watering level of initial margin. ABN Amro has allowed limited access, while other investment banks, such as UBS, announced that they were going to wait until the first settlement was concluded. Retail brokers such as ETrade and Ameritrade have also allowed clients to trade the instruments, although many demand high margin levels. “Eventually we had to move to the independent FCMs,” Mollet says. “The challenge there was to get people comfortable with the risk management of the product.”

McCourt adds that institutional investors were hesitant because they are accustomed to trading in a highly regulated environment. “While people may see the potential in trading bitcoin and similarities between bitcoin and other products, trading on the physical bitcoin side of the ledger is pretty much unregulated,” he says. “That gives many institutional investors pause because they have fiduciary responsibilities to their customers, so they’re not going to look to trade a product that doesn’t have some regulatory safeguards around it.”

When Cboe’s futures contracts launched on December 10, they immediately tripped circuit breakers at the exchange. On that first day, the breakers kicked in twice, and the websites of both Cboe and Coindesk, a popular crypto news site, crashed shortly after trading began. CME’s futures had a more modest launch the following week, in part due to their construction—while Cboe’s contracts reference one bitcoin, CME’s cover a lot size of five. CME’s pricing is also drawn from a number of digital currency exchanges via its CME CF Bitcoin Reference Rate, which averages the price across four of the top DCEs. It was a strong start for the futures contracts, even if volumes proved to be initially tepid. Unfortunately, the launch also coincided with the end of bitcoin’s bull run and the beginning of the sharpest decline in dollar value of the cryptocurrency’s short history.

Bitcoin Breaks

By the New Year, the price of bitcoin was, to put it bluntly, in free fall. From the heady heights of $19,000 per coin reached on December 15, it had plummeted to under $14,000. Then, on January 17, the first Cboe contract expired at $10,900, almost a third below the initial price of $17,000. Nine days later, on January 26, CME’s contract expired at the same price.

Bitcoin continued to freefall after that, dropping briefly to under $7,000 on February 5 before recovering slightly to just under $10,000. At the time of writing, CME’s one-month futures price was hovering around $9,300. “My working theory is that the peak of bitcoin’s price coincided almost exactly with the launch of the futures,” says Nicholas Colas, bitcoin expert and founder of DataTrek Research. “There was a lot of excitement in the bitcoin community to have a more traditional financial contract and access point besides than just the underlying blockchain,” he continues. “In retrospect, that enthusiasm was misplaced, because it obviously did not help the price go up further. There was perhaps a misunderstanding or miscalculation among bitcoin investors about what the futures markets would really bring to bitcoin.” 

Colas says that the offering is nevertheless significant because before that, institutional investors had no real way to trade cryptocurrencies in ways that felt comfortable.

Rival Offerings 

The performance of the futures contracts has, however, not scared off potential rivals. In December, when Cboe and CME were preparing to roll out their contracts, Waters reported that Nasdaq was also considering the launch of its own one-month contracts, although these would draw their price from over 50 DCEs.

Despite bitcoin’s dramatic nosedive, Nasdaq CEO Adena Friedman reaffirmed in an interview with CNBC on January 24 that the exchange was still exploring the possibility of its own bitcoin contract, which would trade through its NFX futures exchange and clear through the Options Clearing Corporation.

Bitcoin prices have been highly volatile, but we don’t expect this market risk to materially affect CME’s or Cboe’s creditworthiness, given the small volumes involved and strong risk management at the central counterparty clearinghouses.

Moody’s Investors Services

Other pieces of the bitcoin landscape have been coalescing, aimed at encouraging more institutional involvement. Coinbase, which runs the GDAX exchange, one of the largest DCEs, announced that it would be launching a custodian service specifically for digital assets in January. The firm also announced that it had partnered with Chicago-based Trading Technologies (TT) in order to offer TT’s full suite of professional-grade trading and hedging tools to participants on GDAX. 

“They came to us asking for access to a cash crypto platform. This need derived from a combination of the consistent, and seemingly endless, low volatility, low-interest rate environment which was impacting their core trading businesses,” says Rick Lane, CEO of TT. “They viewed trading these spot cash markets as an opportunity to find the edge they might be missing in traditional markets, but they lacked the professional-grade tools and platform to access these markets and couldn’t trade the type of size and volume that they were used to.”

Lane says that TT is in the process of enhancing some of its front-end features on its platform to be more bitcoin-friendly. “For example, this is the first time TT has ever supported fractional quantities; you can’t buy a half of a wheat futures contract or .00002 of a wheat futures contract, but with cryptocurrencies you can,” he explains. “We’ve had to adapt our technology both from a front-end perspective as well as from an underlying tools perspective to support fractional quantities.”

Dark Forces

Senior figures at both the Cboe and CME remain sanguine about the contracts’ prospects. Part of the reason for the lack of lift has been the continuing reluctance of banks and asset managers to engage with the instrument. During a meeting of the CFTC’s Technology Advisory Committee on February 14, CME president Bryan Durkin broke down the participation rates for the contracts, saying that 27 percent of the product’s volume has been attributable to market-makers, with the remainder customer volume. Of that, the buy side represented around 15 percent, proprietary traders around 70 percent, and banks a little over 1 percent.

The CME also argues that, in terms of the product design, the risk-management functionality is also working as planned. “The average daily volume in 2018 is 1,382 contracts,” says CME’s McCourt. “We have continued to see a narrow basis between bitcoin futures and the cash market, which demonstrates efficient price discovery. We saw open interest in all initial four expiries.” 

Cboe’s Mollet says the market is nascent, given that it was just the first contract and that bitcoin will rise again. “That result was not surprising to us. Our expectation wouldn’t be that those guys would be there on day one,” he says. “They’re more dependent on larger liquidity pools than a retail user, so it’s going to take time for them to get in. But the volume numbers were probably more heavily skewed to the retail audience at the outset than they normally would have been.”

The exchanges also received a boost from Moody’s Investors Services on February 14, which said that the risk from the instruments was moderate at current levels, and that it would not affect the credit ratings of either company.

“Bitcoin prices have been highly volatile, but we don’t expect this market risk to materially affect CME’s or Cboe’s creditworthiness, given the small volumes involved and strong risk management at the central counterparty clearing houses,” the firm said in a sector report.

Other forces may be at work, however, which could weigh heavily on bitcoin’s volatile nature. According to DataTrek Research’s Colas, the next 12 months will be the most interesting period for the bitcoin futures trading space, as it will be a time of real transition and in many ways difficult for cryptocurrencies. 

“They rose to prominence very quickly, their asset price rose very quickly last year, and the regulatory side of things didn’t progress as quickly and only now are governments really beginning to investigate cryptocurrencies and understand how they should be regulated,” he says. “You’re going to see a lot more regulation and a lot more talk from regulators and that dialogue is necessary. That also means that they’re going to frighten certain groups of people to not buy and sell cryptocurrencies, people who until today are exploiting bitcoin’s vulnerability.”