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Bitcoin futures: Everything you need to know

Despite the (well-founded) protests of JPMorgan, Citigroup and other Wall Street brokers, bitcoin futures are set to go live Sunday evening at 6:00 p.m. EST on the Cboe Futures Exchange (CFE). Next Sunday, December 17, the CME Group (CME) is expected to launch its own bitcoin futures.

Currently, bitcoins are mainly traded on one of the many “cash” exchanges that exist around the world — even the largest of which has been subject to outages. Though bitcoin derivatives already exist (LedgerX just launched in October), bitcoin futures are expected to eventually bring the liquidity and stability demanded by large institutional traders and small retail traders alike.

What happens to the price of bitcoin once bitcoin futures begin trading?

First, the price of bitcoin futures will affect the prices on the cash bitcoin exchanges, and vice versa. Speculators will arbitrage the different prices, buying on one and selling on another, pocketing the difference. This isn’t very easy to do when bitcoin is moving fast and exchanges are crashing left and right. We’ll likely see one or more bitcoin “flash crashes.” But over time, the prices will roughly be in line.

And as bitcoin exchanges mature, become more reliable and robust — with the futures contracts become more liquid — this “arbing” will bring all the bitcoin prices much closer in line with each other. That will take time. (There’s also a non-zero chance that the whole thing comes crashing down, but that probability is pretty low.)

Mock Bitcoins are displayed in Berlin in this January 7, 2014 file photo. REUTERS/Pawel Kopczynski
Mock Bitcoins are displayed in Berlin in this January 7, 2014 file photo. REUTERS/Pawel Kopczynski

Critics may argue there’s a bit of tail wagging the dog here, with the futures market influencing the cash market prices. But it’s not uncommon for derivative markets (which include futures markets) to become bigger than the underlying commodity or asset. (This is the case for gold, crude oil and nearly all currencies.) The total value of all bitcoins (or its “market cap”) is about $250 billion, which is chump change for Wall Street. It’s easy to envision bitcoin derivatives becoming greater than the underlying cash market some day (the number of bitcoins theoretically being limited to 21 million).

Will bitcoin “shorts” crash the price of bitcoin?

Futures contracts allow traders to bet on a market moving in either direction by “going long” or “going short.” Aside from a few small bitcoin derivative markets, there’s currently not an easy way to short bitcoin. One question is: If it becomes easy to bet on bitcoin’s price decline, does that increase the chances of a bitcoin selloff, or even a crash? Or, might we see the opposite, where pent up money on the sidelines finally enters the bitcoin futures market and bids up the price of bitcoin?

The answers aren’t so simple. Unlike the stock market, futures markets are a zero-sum game. For every long there is a short. For every winner, there’s a loser. Every dollar of one trader’s profit is a dollar lost by another trader. If someone wants to bet big that bitcoin is going down — say, by shorting 1,000 bitcoin contracts — there needs to be one or more traders willing to take the opposite side. That liquidity may not be there from Day One. As the futures market grows, large institutional money will increasingly influence the price of bitcoin. If bitcoin derivatives become larger than the underlying cash market for bitcoin, Wall Street’s opinion will have an outsized effect on bitcoin prices. That might be bullish or bearish.

What’s the next step after bitcoin futures?

Bitcoin futures are only the start. The Holy Grail for bitcoin bulls is a U.S. bitcoin ETF listed on a major exchange, which would truly bring the cryptocurrency to the masses. For better or for worse, having bitcoin exposure in a 401(k) isn’t that far off. The Winklevoss brothers (who are partly behind the new CFE’s Cboe Bitcoin Futures) have tried unsuccessfully for years to register a bitcoin ETF with the Securities and Exchange Commission. The SEC’s main objection has been the lack of a transparent pricing mechanism — that the bitcoin market is too easily subject to manipulation.

Venture Capitalists and Bitcoin investors (L-R) Barry Silbert, Jeremy Liew, Fred Wilson, Cameron Winklevoss and Tyler Winklevoss are sworn in before speaking at a New York State Department of Financial Services (DFS) virtual currency hearing in the Manhattan borough of New York January 28, 2014. REUTERS/Lucas Jackson
Venture Capitalists and Bitcoin investors (L-R) Barry Silbert, Jeremy Liew, Fred Wilson, Cameron Winklevoss and Tyler Winklevoss are sworn in before speaking at a New York State Department of Financial Services (DFS) virtual currency hearing in the Manhattan borough of New York January 28, 2014. REUTERS/Lucas Jackson

Each of the two new bitcoin futures contracts will be priced (or “settled”) on proprietary indexes that are themselves based on the cash market for bitcoin (see below for further details). If these indexes prove robust enough for futures trading and settlement, the thinking is that the SEC will eventually allow them to price a bitcoin ETF. That’s at least a year away though, according to most industry insiders.

Where are bitcoin futures traded?

The futures market, not unlike the stock market, is organized around exchanges. Clearing brokers are members of the exchange, and customers trade through their brokers. The Commodity Futures Trading Commission and the National Futures Association regulate the futures markets.

The CFE and the CME are two different exchanges. The CME is the world’s largest futures exchange, and over the years has acquired many competing exchanges, including the CBOT, the NYMEX and the COMEX.

The CFE is the futures arm of the Chicago Board of Options Exchange, which is the largest stock options exchange in the U.S. The CFE is small — so small that, besides the new bitcoin futures, it only offers a few futures contracts, all of which are based on volatility indexes, such as the VIX “fear index.” It’s perhaps fitting that the CFE is the first out of the gate with futures contracts for bitcoin — a market that just capped the most chaotic and volatile week in trading of any market in recent memory.

Who will be trading bitcoin futures?

Not the customers of many large brokers, which are standing aside to see what happens before they let their customers trade bitcoin futures. Futures brokers as a whole, as represented by the Futures Industry Association, have been quite critical of bitcoin futures, particularly the rushed manner in which they’re being brought to market.

The FIA, which represents brokers from Chicago to New York to Hong Kong, penned an open letter to the U.S. futures watchdog Thursday morning, urging further study and testing before bitcoin futures go live. The futures clearing exchanges, like the CFE and the CME, are set up such that the brokers are ultimately on the hook for customer losses if they can’t pay. Several brokers, including Bank of America Merrill Lynch and Citigroup, will not allow their customers to trade bitcoin futures just yet, according to Fox Business. Others are reserving the privilege of trading for select clients. All of this calls into question just how much liquidity will be available.

Nevertheless, some brokers are embracing bitcoin futures. TradeStation has set up a “Cryptocurrency Knowledge Center”, and has published a side-by-side comparison of the contract specifications for the CFE’s Cboe Bitcoin Futures and the CME’s Bitcoin Futures.

The bottom line is that, at least initially, trading might be dominated by smaller retail traders, resulting in less liquidity. Veteran trader and author John Netto isn’t concerned, and he says he’ll be trading bitcoin when they open Sunday night. Netto says, “I’m not in a [cash] bitcoin position or looking to move serious size to where liquidity could be an issue.”

What happens when the futures contracts expire?

This is perhaps the biggest area of concern for traders, exchanges and regulators.

Both the CFE and CME bitcoin futures contracts will be cash settled. That means you won’t get delivered a bitcoin if you’re long, and you won’t have to deliver a bitcoin to the exchange if you’re short. This avoids a potentially huge problem for the exchanges, which would have to warehouse bitcoins with Fort Knox-like security if they weren’t cash settled. Most traders won’t hold until expiration and will either “roll” their position into the next month, or simply close it out prior to expiration.

However, the exact price at which the futures contracts are settled is an area ripe for manipulation and fraud because the contracts are ultimately based on what’s happening on the cash bitcoin exchanges. Both futures exchanges are taking great pains to ensure a smooth settlement process, with contingency plans if there are market disruptions. Everyone will be closely watching what happens on the expiration dates, the first of which is Wednesday, January 17.

How are bitcoin futures priced?

Bitcoins trade on over 100 exchanges worldwide, and prices between exchanges can vary widely — especially when the markets are moving fast. That’s a principal concern for regulators, brokers and traders alike because the price at which futures contracts are settled when they expire are based on those exchange prices.

In a separate process, each day, the futures exchanges assign their futures contracts a final closing settlement price for that day. Unlike the monthly settlement, the daily settlement is not directly based on the underlying spot bitcoin exchanges. It’s a weighted average of the trades made on the respective futures exchanges in the final minute of trading each day. That final minute ends at 4:15 p.m. EST for Cboe Bitcoin Futures and at 4:00 p.m. EST for CME Bitcoin Futures.

The final settlement price to be determined when bitcoin contracts expire each month is much more complicated because it needs to be tied to the cash (spot) market. Figuring out that price can mean the difference between millions of dollars for bitcoin traders.

The CFE and CME are going about this price discovery process differently. The CFE settlement price for Cboe Bitcoin Futures is the official auction price for bitcoin in U.S. dollars at 4:00 p.m. EST on the Gemini Exchange, which is owned by the Winklevoss brothers. If there’s a trading disruption, a contingency plan will go into effect, which is spelled out in detail on the CFE’s Cboe Bitcoin Futures specification page. The CFE publishes the current futures contract prices as well as the Gemini Exchange bitcoin price with a 10 minute delay on its website here.

CME Bitcoin Futures will be based on the “CME CF Bitcoin Reference Rate (BRR),” which aggregates bitcoin trading activity across major bitcoin spot exchanges between 3:00 p.m. and 4:00 p.m. GMT (10:00 a.m. to 11:00 a.m. EST). These prices, as well as the futures contract specifications can be found on the CME’s website here.

How much money do you need to trade bitcoin futures?

Brokers are playing it very safe when it comes to bitcoin futures, which will have significantly less leverage than any other futures contract. This limits the potential for trading losses that customers can’t pay (a broker’s worst nightmare). The short answer is you’ll need to put up about half the money of the current bitcoin price to control one contract. Some brokers are requiring more.

To enter a position (either long or short) in any futures contract, the exchange and broker require an amount of money called “initial margin.” To hold a contract from then on, a lower amount called “maintenance margin” is required.

Typically, margin requirements are only a fraction of the full value of the contract, which creates substantial leverage. For instance, each eMini S&P 500 futures contract requires initial margin of $4,950, while the contract is worth $132,700 (based on Friday’s closing price). In this case, the margin is only about 3.7%, which means the contract has leverage of 27 times, or 2,700%. Some brokers have reduced “day trading margin” requirements, which can increase leverage to over 10,000%. (This is why many traders lose their shirts in the futures markets).

The S&P 500 trading pit is pictured from overhead at the Chicago Mercantile Exchange in Chicago, Illinois in this late 1980s handout photo. REUTERS/CME Group
The S&P 500 trading pit is pictured from overhead at the Chicago Mercantile Exchange in Chicago, Illinois in this late 1980s handout photo. REUTERS/CME Group

For Cboe Bitcoin Futures, the CFE requires initial margin of 44% of the prior day’s settlement price, and 40% for maintenance margin. But many brokers are demanding more, which is their right since they’re potentially on the hook for customer losses. TradeStation is requiring 66% initial margin (maintenance margin is 60%), which delivers leverage of only 150%.

This relatively low leverage is a good thing. If it proves to be too little or too much, the exchanges and brokers can increase or decrease margin requirements at any time, as they see fit.

What are the fees to trade bitcoin futures?

In addition to margin, traders must have money in their accounts to pay fees to both the exchange and their broker. The CFE is waiving transaction fees for its Cboe Bitcoin Futures for the month of December. After that, customers will pay $0.50 per side. Entering a position and closing a position are each considered a side, so a customer trading 10 Cboe Bitcoin Futures contracts (after December) will pay $5.00 per side, or $10 total to the exchange. Sometimes prices are quoted in what’s called a “round turn,” which is double the “per side” rate because it includes both sides — the entry and the exit of the position.

The customer’s broker also charges a fee, which can range from $0.25 to $3.00 per side ($0.50 to $6.00 per round turn), depending on the type of futures contract and how much volume the customer trades.

How do bitcoin futures exchanges deal with extreme volatility (i.e., circuit breakers and trading halts)?

Both the CFE and CME will employ circuit breakers and trading halts, which engage automatically when the price of bitcoin on the exchange has moved a given amount. Unlike most futures contracts, there is no maximum daily limit that price can move for CFE Bitcoin Futures.

Each exchange has its own circuit breaker thresholds and procedures. On its bitcoin futures page, the CME links to this page for price limit guides, but there is no bitcoin contract listed. (Presumably, it will be updated as we get closer to the December 17 launch date).

For the CFE’s Cboe Bitcoin Futures, there will be a 2 minute trading halt if the price of moves 10% above or below the prior day’s settlement. After trading commences following such a halt, there will be a further 5 minute halt if the price trades 20% above or below the prior day’s settlement. The CFE retains the absolute right to change these procedures at its discretion. Accordingly, the 2 or 5 minute halts could be extended (or even shortened) if the exchange thought it necessary to protect market integrity. Full details may be found here.

Anyone who follows bitcoin knows these huge swings are common. Since May 1, the 10% circuit breakers would have been triggered 35 times (18 times on upward price movement, 17 times on downward price movement). On September 15, the 10% circuit breakers would have been triggered in both directions. Over the same period, the 20% circuit breakers would have been triggered 4 times (3 times on upward price movement, 1 time on downward price movement).

Bitcoin futures — the nitty gritty details

The CFE’s Cboe Bitcoin Futures will trade under the base symbol, XBT. Similar to crude oil futures, there will be one XBT futures contract for each month of the year. The “front month” contract will initially be January, which will be traded under the ticker XBTF18. The “F” represents January and the “18” stands for the contract year, 2018. February and March contracts will also be traded under the tickers, XBTG18 and XBTH18, respectively.

Each month, the XBT futures contract will expire two business days prior to the third Friday of the month at 3:45 p.m. EST. The January contract expires January 17, 2018. Bitcoin traders will be closely watching to guage how smoothly the final settlement is priced, which is based on the underlying spot bitcoin exchanges.

Each Cboe Bitcoin Futures contract represents one bitcoin. Each point equals $1, and the minimum price movement is $10. Traders are limited to owning or controlling 5,000 contracts (either long or short), and this limit drops to 1,000 contracts 5 days prior to the final settlement date of an expiring contract.

CME Bitcoin Futures will represent 5 bitcoins. Each point will be worth $5, and the minimum price movement will be $25. Termination of trading for an expiring contract will occur on the final Friday of the contract month at 4:00 p.m. London time (11:00 a.m. EST).

What happens if there’s another bitcoin fork?

Wow. You got this far, so we’re really gonna get into the weeds. According to the the fine print here:

FORKING: A hard fork in a blockchain is a permanent divergence from the previous version of a blockchain, and nodes running previous versions will no longer be accepted by the newest version. This essentially creates a fork in the blockchain, one path which follows the new, upgraded blockchain, and one path which continues along the old path. Generally, after a short period of time, those on the old chain will realize that their version of the blockchain is outdated or irrelevant and quickly upgrade to the latest version. In the simplest terms and as it relates to Bitcoin futures, a hard fork is similar to a spinoff into a new instrument. CME is developing a hard fork policy for capturing cash market exposures in response to viable forks. The policy may involve cash adjustments to position holders or listing additional related futures that are also issued to position holders. CFE is developing a hard fork policy for capturing cash market exposures in response to viable forks. The CFE policy is not finalized.

That’s it. Nothing more to see here.