Lanre Sarumi is the CEO of Level Trading Field, an interactive online platform for professionals in the finance industry.
"Study the past if you would define the future." – Confucius
Confucius shares a trait with Satoshi Nakamoto: no one knows if their most famous work was authored by one or multiple people.
Regardless of who came up with the quote above, it is sage advice and so to understand what the introduction of bitcoin futures on the Chicago exchanges means for the cryptocurrency, let's start with history.
Before there were "futures" contracts there were "forward" contracts. Before there were forward contracts, there were gentlemen's agreements. Before there were gentlemen's agreements there was simply "show up in the market with your harvest and hope you can sell everything at your desired price."
All four of the above still exist today. The "show up at the market with your harvest and hope you can sell everything at your desired price" is self-explanatory. The other side of the trade is "show up at the market hoping a merchant is there to sell you what you want at the price you want it."
The problem with conducting business this way, besides the mouthful of words, is that you risk not finding a desirable counterparty and thus losing money. To fix this problem, the gentleman's agreement was created.
In the gentleman's agreement, two counterparties agree on a time, place and price in the future to trade with each other. The problem with the gentleman's agreement was that it required two gentlemen willing to honor the agreement.
The absence of one or more of the required gentlemen usually led to lawsuits.
However, the courts usually threw out the cases because it was hard to convince a judge that you had a binding agreement with just a selfie of you and your counterparty shaking hands. (OK, they probably didn't call them "selfies" back then, but you get the idea.) To solve this problem the forward contract was created.
The forward contract is a legally binding agreement between two counterparties to trade a given asset at a future (forward) date and a given price. It allows one party to seek relief from the court if the other party does not live up to their part in the agreement. While showing up with a nicely typed and signed document is a lot better than a selfie of two people smiling in better times, it has one problem. The defaulting party could be broke. Since broke parties generally do not pay their debt, the other party essentially loses.
To fix this problem, the futures contract was developed.
The futures contract is pretty much the same as the forward contract with some slight differences. The main difference is that an exchange stands as a guarantor to both counterparties.
The bitcoin futures contract set to launch Dec. 18 at the CME is a cash-settled contract. This simply means that on the date of expiry, no actual bitcoin will be traded but a cash value will be credited to one of the parties depending on the final settlement price.
If the contract was first traded at $12,000 and the price of the CME bitcoin index goes to $14,000, the seller is on the hook for $2,000. Should the seller decide to flee and not fulfill his or her obligation, the exchange will step in and make the buyer whole.
Goodbye, going to court with legal contracts or selfies. Goodbye, getting on your donkey and hulling bushels to the harvest market. Ok, you use Uber instead of a donkey and you traded bitcoins instead of corn, but you get my point.
Before you start thanking the exchanges for their selfless service and asking how many ETH tokens you can send them in appreciation of their kindness, here is the thing: they get paid.
In ice cold fiat cash, no cryptos here.
They call it an "exchange fee." That is expected of course, but here is another thing, the exchanges don't really take all the risk of defaults.
They have other entities called "futures clearing merchants" that shoulder a good portion of the risk. For their service, clearing merchants also take a fee. They call it, you guessed it, a "clearing fee."
Exchanges must be regulated. After all, they are now essentially the counterparty to every transaction and could, in fact, default themselves.
In the U.S., they are regulated by the Commodities Futures Trading Commission (CFTC) and not the Securities and Exchange Commission (SEC), despite the word "Exchange" in the latter's name. Why these agencies of government are separate is probably a good subject for an article, just not this one.
But here is an interesting thing. The CFTC is the regulatory body for futures exchanges, but it essentially outsourced a lot of the work to a self-regulatory association established by the exchanges, The National Futures Association. Like most people, the folks at the NFA don't work for free. By now you know what is coming... they get a fee.
In the case of Bitcoin futures, the CFTC has washed its hands very clean and is leaning on the exchanges and NFA to self-certify and self-regulate the Bitcoin futures market.
Remember when I said the exchanges don't take all the risks and they have the clearing firms shoulder some of the risks? Well, the clearing firms are no fools, they also pass on some of the risk to firms called introducing brokers. Introducing brokers, of course, collect a "brokerage fee."
Now if you think brokers are the last fool, then think again. There is one last party in this chain, the trader, you.
Yes, did you think because you pay exchange fees + clearing fees + NFA fees + brokerage fee you would be let off the hook? Hahaha, ROFTL, give me a moment let me gather myself.
I'm back. You see, when the exchanges said they would stand as guarantor to both sides, what they really meant was they would ask their friends at the clearing organization (sometimes a subsidiary of the exchange, not to be confused with the clearing merchants) to put their hands in both counterparties' pockets every day to make sure they don’t abscond when the market goes against them.
You may be able to trade the bitcoin cash market anonymously, but you cannot do the same with futures.
So, if two counterparties trade a Bitcoin futures contract for $12,000, the clearing organization will calculate the value of the contract every day using a price they call "settlement price." For the CME, the settlement price is determined from an index, the Bitcoin Reference Rate (BRR). The BRR is calculated using the market prices from certain exchanges.
As of today, there are four exchanges in the CME index, Bitstamp, GDAX, Kraken and itBit. The Cboe, which launched bitcoin futures trading Sunday, uses the price from the Gemini exchange. If the settlement price is $11,900, after the first day, the clearing organization takes $100 from the buyer and gives to the seller. If the settlement was instead $12,100, the opposite happens: The clearing organization takes $100 from the seller and gives it to the buyer.
This mark to market process is performed every trading day.
By so doing, the exchange essentially protects both sides, and itself, from having to deal with massive losses that can accrue over days. The clearing organizations don't really interact directly with most traders except the self-clearing firms. They perform the "hand in pocket" routine with clearing merchants. Long before the clearing organization takes money from the clearing merchants' pockets, the clearing merchant would have notified the broker and the trader who must have made a deposit with the clearing firm.
How much deposit is required? The exchanges, CME to be specific, created this magical tool to measure the intraday volatility of every commodity futures contract. It's called SPAN, short for standard portfolio analysis of risk.
SPAN does some intensive computation not unlike the computer from "The Hitchhikers’ Guide to the Galaxy," Deep Thought.
Just like Deep Thought, SPAN spits out a magical number, but in this case that number isn't 42. In fact, it's different for every contract. The number is used by a lot of brokerage firms to determine how much of the risk the trader will shoulder. They call it initial margin. This is the amount a trader must deposit before he can trade a given contract.
In the case of a brand new contract like the bitcoin futures contract, where SPAN has no historical futures data to calculate the margin number, the exchanges go back to their "Deep Thought" computer for a number. For CME, Deep Thought says initial margin should be 35%. Cboe's computer says 30%.
So that's it right? Not really.
Focus on the first word of the term "initial margin." The margin you deposit is just to "initially" get you started. If you immediately start making money from your trade because you followed the secret to trading, "buy low, sell high" then you are fine.
If your strategy doesn’t follow that simple concept and the value of the futures contract you bought or sold causes the initial margin to fall below a certain value called the "maintenance margin," then you will be getting a call to post additional funds into your account. If you fail to do so, then the broker, clearing firm, or exchange will close out your position and whatever is left in your account will be used to offset your losses.
The above is essentially a high-level synopsis of the futures market as well as an introduction to how account management and setup work. The process is the same whether the account is set up to trade oil, wheat or bitcoin. I will be posting additional articles on futures contracts in general and bitcoin futures contracts in particular.
Market miniature image via Shutterstock
The leader in blockchain news, CoinDesk strives to offer an open platform for dialogue and discussion on all things blockchain by encouraging contributed articles. As such, the opinions expressed in this article are the author's own and do not necessarily reflect the view of CoinDesk.For more details on how you can submit an opinion or analysis article, view our Editorial Collaboration Guide or email email@example.com.
FuturesCME Groupbitcoin futuresCBOEFutures Industry Association
Bitcoin Price Jumps by 11% to Reach One-Month High Above $6.9k
Bitcoin, the world's largest cryptocurrency by market capitalization, jumped by 11 percent on Monday, pushing prices above $6,900 for the first time in a month.
CoinDesk's Bitcoin Price Index shows
Price of 'Stable' Cryptocurrency Tether Tanks to 18-Month Low
UPDATE (10/15, 7:50 PM EST): Representatives from Tether have released a statement, attributed to chief compliance officer Leonardo Real. The statement comes hours after the USDT price fell below its
PBoC's Digital Currency Chief Departs to Lead Securities Clearing House
The former architect of China's central bank digital currency (CBDC) initiative has left the position to head the country's central securities clearing house.
Yao Qian, who founded the Digital Curr
Bitcoin Price Spikes But Bull Reversal Is Still $1K Away
Bitcoin (BTC) spiked 11 percent Monday, likely due to a sell-off in tether (USDT), but a bullish reversal is still not confirmed, technical charts indicate.
The leading cryptocurrency jumped to a 2
US City Mulls Roll Out of Tougher Rules for Crypto Miners
Plattsburgh, New York, is considering bringing in stricter requirements on commercial cryptocurrency mining farms operating in the city.
Patrick McFarlin, a councilor of Plattsburgh's Common Counci
Crypto Exchange OKEx Lists 4 New Stablecoins
Malta-based cryptocurrency exchange OKEx has announced that it is adding four U.S. dollar-pegged cryptocurrencies to its platform for trading.
Rolling out the new additions over Monday and Tuesday,
Binance Pauses Tether Withdrawals After Denying Delist Rumor
Crypto exchange Binance, the world's largest by volume, suspended withdrawals of the tether (USDT) stablecoin Monday morning during what it called a period of heightened activity.
Sony Builds Digital Rights Management System on a Blockchain
Japanese electronics giant Sony has developed a new blockchain-based digital rights management system that may see commercial rollout.
According to a press release from the firm Monday, the system