The adoption of futures contracts on Bitcoin: A new era of cryptocurrency

According to the Financial Times, 31^st October 2017, the Chicago Mercantile Exchange (CME) is expected to offer cash-settled futures contracts on Bitcoin by the end of 2017. CME, the world’s largest exchange by market value, has offered futures contracts on agricultural products, metals, energy, equity indexes, foreign exchange rates, interest rates, real estate, and even weather. With the increasing popularity of cryptocurrencies, the CME has finally decided to enter into the unregulated digital asset market. Futures contracts on Bitcoin may help investors to either hedge or speculate on the future price of Bitcoin. Because almost all futures contracts are cash-settled in CME, traders do not need to actually deliver Bitcoin.

In a traditional centralised banking and economic system, central governments control the supply of mainstream currencies. Bitcoin, the icon of more than a thousand existing decentralised cryptocurrencies, is controlled by computer algorithms. Since Bitcoin was invented in 2009, its price has experienced a great level of volatility. Most sharp rises and drops in Bitcoin prices are due, among others, to the fragility in the Bitcoin system, information asymmetry in its reputation and investors’ overreaction to news. Given the current low interest rate environment, active investors are looking for assets like Bitcoin that are inherently volatile.

The introduction of futures contracts on Bitcoin offers investors a tool to hedge their positions and enhance their risk management practices. This is particularly important given the incredibly volatile nature of the underlying asset. Furthermore, futures contracts may ease the short-selling constraints on Bitcoin and in turn facilitate the entry of sophisticated institutional investors in the Bitcoin market. Not surprisingly, the announcement has generated a lot of investor’s attention. With the expectation of more trading activity from institutional investors and traditional financial firms in the Bitcoin market, we observed a big rally in Bitcoin’s price, from $6,100 on 30^th October to above $7,000 on 7^th November.

Several questions remain though. First, it is not obvious what the margin requirement of such futures contract would look like. This is important because of the high volatility of the asset. Margin requirements can have an impact on the liquidity of the futures contracts. Second, it is not entirely clear what the regulatory framework will be. In 2015, the Commodity Futures Trading Commission declared bitcoin a “commodity”. Given the large fluctuations observed in this market and the concern that the main motive for trading cryptocurrencies is money laundering, the regulatory framework will play an important role. Even economists who advocate a completely free market would agree that an efficient regulator may help mitigating the externalities in the market. Third, Bitcoin itself, as the underlying asset, still involves several major hurdles such as storage security, the possibility of two Bitcoins existing and the overall maturity of the market. As the futures contract may leverage up the risk of underlying assets, any potential investor investing in the Bitcoin futures contract should remain cautious. Finally, it is well-known that Bitcoin lacks a single source for the Bitcoin price index. The proposed Bitcoin futures contract will be cash-settled and based on the CEM CF Bitcoin Reference Rate. Whether the CEM CF Bitcoin Reference Rate is an appropriate benchmark price index for Bitcoin is an argument destined to last for a long time. Find out more about Dr Yeqin Zeng's research.

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