As bitcoin tripled in price to emerge from its first crypto winter, and as the last expiry of the Chicago Board Options Exchange’s (CBOE’s) cash-settled bitcoin futures expired, contracts of the same style offered by the Chicago Mercantile Exchange (CME) soared to a record $508 million in May. But over the last year, a different method of connecting regulated institutions to nascent bitcoin spot markets has brewed within other exchanges: futures contracts that settle in bitcoin itself. 

This summer, both ErisX and LedgerX received green lights from the Commodity Futures Trading Commission (CFTC) to launch this new type of product. Bakkt, which was created by the Intercontinental Exchange (ICE), already launched user-acceptance testing for bitcoin-settled futures on July 22, with the promise to more broadly roll out the new platform by the end of the year. Though this marks a necessary step toward maturity for bitcoin as an asset class, traders, investors and the exchanges themselves still have some hoops to jump through when it comes to navigating the technological and regulatory landscapes of bitcoin-settled futures. 

Regulation

“Institutions have been pretty nervous [about bitcoin exchanges], and I would say somewhat rightfully so,” says Hunter Merghart, head of US operations at Bitstamp, Europe’s largest and oldest regulated cryptocurrency exchange. “There’s an open question of how secure are these exchanges? How secure is my crypto? Am I even allowed to trade on these from a mandate perspective?”

Crypto trading has largely resided within a hazy legal realm for institutional players, particularly in the US, but for many, the siren call to jump onboard has been loud and clear. Merghart says he sees a handful of occurrences that gave rise to cash-settled futures at CBOE and the CME, such as the need to hedge or short cryptos. He adds that from a counterparty-risk perspective, trading on some of the more unregulated exchanges might not have fit into mandates, but a futures product just might.

“Do people really need the regulatory clarity of these exchanges? At this point, probably not.”

Hunter Merghart, Bitstamp

He says the goal of offering bitcoin-settled futures is to try and create a spot market in “a very regulated environment.” By the product’s nature, custody is paramount, and given that the exchanges are paddling through mostly uncharted waters, clients have to be very confident they will carry out warehousing duties in the right ways. 

And while an ICE-backed exchange like Bakkt or TD Ameritrade-supported ErisX can offer more familiar levels of institutional oversight and security, Merghart sees the unregulated or semi-regulated exchanges abroad as even bigger competitors than the spot markets. From a margin and collateral perspective, he adds, exchanges outside the US can garner leverage and hedge their books at a much lower cost.

“Do people really need the regulatory clarity of these exchanges? At this point, probably not,” he says. “Maybe in the coming months as regulators in the US start to clamp down on leverage, margin and who can trade what on what exchanges … [but] right now it feels a little bit like it’s the cart before the horse.”

Technology

Though they might have to compromise on price, traders hope to capitalize on the more advanced technologies that these exchanges can offer. One person who is calling bitcoin-delivered bitcoin “a massive game-changer” is Joe Piotrowski, COO of Mercury Digital Assets, a Chicago-based technology and solutions provider for over-the-counter (OTC) cryptocurrency execution.

“The problem with the spot market is you have to individually fund your account, and then all of your assets are completely at risk at ‘Exchange X,’” Piotrowski says. “But by allowing a clearing firm now to manage like they do in the traditional market … it helps to mitigate counterparty risk.” He predicts bitcoin is still at least a year away from establishing a “stable-ish” market, but as more reputable, regulated exchanges offer more products and options, institutions can expect to see less of the “old-school spot markets, where everything is completely unregulated, no rules, poor technology, all web-based.”

Most of the startup exchanges, he says, are just not up to the test. He recalls a string of volatile days in June, in which several of the major exchanges went down, leaving him without access to the platform he uses for more than 24 hours.

“[They] just couldn’t handle the volume,” he says. “In the capital markets, we deal with that kind of volume all the time. These guys got it, and it crushed them. Along with regulation and the product, technology needs to go in lockstep. A better example of how immature the technology is, is when some of the largest exchanges in the crypto world, with billions of dollars, can’t keep up on a high-volume day.”

But they are catching up, however incrementally. As it stands, Piotrowski says the problem is that exchanges are using technology built in-house by people who don’t fully understand high-frequency trading and exchange technologies. To compensate, he’s seeing more and more of the exchanges recruit old colleagues of his from the capital markets space. Because it’s a race, the choice ultimately comes down to deciding where it makes sense to partner with tech vendors, and where to rebuild entirely.

“In my experience, rebuilding internal systems like this can be a political nightmare, which hinders progress,” he says. “I think exchanges, if they’re smart, will start to take a look and be honest with themselves about how fast they can get to institutional-grade technology. … Likely the answer is not to build it themselves.”

Exchanges

Robert Thrash, COO at ErisX, is one of those poached from the sell side, having worked at Barclays Investment Bank from 2007 to February of this year. He likens building a futures exchange to building a bank from scratch. Creating the clearinghouse function is a massive endeavor, not just in terms of technology, but operations, licensing and controls, he says.

“The regulators we worked with are very thoughtful about every single aspect of both the underlying asset class itself, as well as how they view the impact of introducing derivatives clearing into that asset class,” Thrash says. “One of [their] primary concerns is the integrity of your client asset and the process by which you manage client money.”

Since receiving its derivatives clearing organization (DCO) license from the CFTC on July 1, ErisX is continuing to work out its collection of expiries and contract specifications. At the same time, Thrash says the exchange is building out and investing in “bread and butter” technologies that can match market participant orders and support an order book and matching engine. They have yet to announce a launch date for their bitcoin-settled futures product.

LedgerX received its DCO license in June, and co-founder and chief officer of risk and operations, Juthica Chou, a high-frequency trading vet from Goldman Sachs, says one of the larger issues with cash-settled products is that they don’t allow support for institutional funds and players, and there is too much uncertainty around how those products settle.

“When we settle and clear transactions, all of those transactions are on our internal ledger,” she says. “We don’t have to touch the blockchain system on all of those transactions. The way we do it is that the derivatives settle, [and] they will be credited to the account.” 

As an example, if a trader buys 50 bitcoin futures, they will get 50 bitcoin credited to their account and will be able to withdraw that bitcoin to their own wallet at any time. “But it’s only upon that withdrawal that we actually touch the bitcoin blockchain,” Chou says.

She echoes Thrash’s point that the clearing level is the space ripest for innovation for the futures market.

“Once you start taking bitcoin as collateral, that’s where you have at your disposal programmable collateral in a way that wasn’t really possible before—24/7, 365,” Chou says. “That’s where I could see new ways of thinking about clearing because, traditionally in the US, clearing is predominantly done through US dollar transfers and through the banking system.”

Chou compares the notion of programmable collateral to smart contracts—self-executing contractual states stored on the blockchain—which tie together logic and algorithms to collateral without the need for any third party or intermediary.

Good as Gold?

Thrash says it’s not so much uncertainty about cash settlements that’s prompting the migration to physical ones, but about getting a better tradeoff. In a cash-settled futures contract, you reduce the delivery costs, while a bitcoin-delivered contract provides hedging efficiency. For investors that want to short bitcoin, clearly the best position would be to have the asset, and the ability to deliver it, he says.

“I think bitcoin is superior to gold because it provides a fixed supply of all of the things that people like in a commodity.”

Juthica Chou, LedgerX

“The relationship between holding the spot asset, being able to deliver and the settlement price is immutable,” Thrash says. “The delivery itself is the mechanism by which the price is set. That level of transparency makes it a more efficient hedging instrument because it directly links the underlying market to that of the future settlement.”

As a hedging instrument, bitcoin may see a shiny future, not unlike another familiar inflation-agnostic asset. LedgerX’s Chou sees the comparison of bitcoin to gold as not quite exact. On one hand, bitcoin is at the mercy of news cycles and public perception in a way that gold isn’t, as gold has a centuries-long track record that makes it more immune to such things. However, Chou thinks the asset has the capability to outpace its counterpart.

“I think bitcoin is superior to gold because it provides a fixed supply of all of the things that people like in a commodity,” Chou says. “On top of that, it’s actually useful for other things as a method of a payment. You can transfer it really easily. It’s fungible. It’s more practical as a means of payment than something like gold, which is typically [locked up] in the Federal Reserve.”

For investors looking for uncorrelated returns, it’s an interesting asset to look at, says Bitstamp’s Merghart. “Everything I’ve seen in the space in the last two years, more and more people are thinking about [bitcoin] in that perspective,” Merghart says. “Similar to how you would view gold or an early-stage startup is kind of how people view crypto in their portfolios.”

The most interesting drama to play out in all of this, though, might be to see how a currency, engineered in rebellion against global finance and banking systems, fares as those same systems push to adopt it as one of their own. Particularly as exchanges race to invent new ways to provide custody, the irony there almost refuses to be overlooked—that bitcoin’s purpose was to restore the control of money to owners. What was perhaps once an angsty teenager, may very well be maturing into a formidable adult—loss of idealism included.