Streetwise Professor

December 4, 2017

Bitcoin Futures: What? Me Worry?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:53 pm

The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.

Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.

So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.

If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.

Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg today:

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.

Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.

Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:

“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”

Petterfy has expressed worries about weaker FCMs in particular:

“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”

He has recommended clearing crypto separately from other instruments.

These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.

Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.

As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).

Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.

Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.)  The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.

This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?

(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)

What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.

Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.

All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.

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  1. While barriers to entry are indeed low (as witnessed by the proliferation of alt-currencies), the network effects that Bitcoin and Etherium have built up seem to be very strong so far. As the prof says, it will be interesting to see hot it evolves…

    Comment by Hiberno Frog — December 5, 2017 @ 8:39 am

  2. I think you overestimate the willingness of sophisticated investors to go against such a strong trend, especially when the asset is volatile. Even if you time the market near perfectly, being a week or two early could plausibly give Bitcoin enough time to double (or worse) while you are short, and leave you ruined even though the thesis was correct.

    Comment by Ryan — December 5, 2017 @ 9:39 am

  3. I read that a million tonnes a month of coal is burnt to support the BTC network. If you transact a fraction of supposed total value of bitcoins its price crashes. What kind of asset is it where you can’t get out?

    Nobody can explain what a bitcoin is for. It is a ponzi scheme.

    Comment by Green As Grass — December 5, 2017 @ 9:56 am

  4. Good sense from the Professor.

    Comment by Thomas Jefferson — December 5, 2017 @ 11:53 am

  5. “Campfire horror stories”? You prove that academics have no business pontificating and being pundits for financial print or TV. You must clearly have no trading experience to dismiss Peterffy’s concerns so easily.

    Your quote in FT Alphaville is evidence enough:
    “I looked at the data, and found that a 20 per cent initial margin, which is huge, by the way — crude oil is on the order of 4 per cent — would have covered 99 per cent of the price moves in 2016-2017.”

    Wow, so it covers 99% of past moves, so it’s safe? What’s that saying about past performance? Were you also saying that it was impossible for housing prices to fall back in 2006 because “it never happened before” and so a diversified pool of mortgage backed securities failing was never going to happen? Very typical for an academic to dismiss tail risks and have no understanding of second order effects.

    A futures seller MUST deliver the goods at expiration of the contract. In this case, if cash settled, that seller MUST pay whatever price Bitcoin happens to be at that point. Bitcoin has no tethering to reality. It is tethered to what someone else will pay for it and it is in very limited supply. The upper bound of its price is massive and futures sellers can go bust very easily.

    Comment by Michael Burry — December 5, 2017 @ 8:36 pm

  6. There are other things baked into the Bitcoin price. One is scarcity. There is a limited supply. The counterbalance is bitcoin is infinitely divisible .00000000000000000001 Bitcoin. If you look at it purely as a medium of exchange, the Professor’s points are spot on. If you think that it’s not just a way to transact but a new technology, the price might make more sense. Is Bitcoin/Blockchain a new TCP/IP? Which chain will dominate?

    New companies are always met with disbelief. The best investments at early stages are where really dumb stupid ideas intersect with “hey if it worked it would be pretty cool.” Bitcoin/Blockchain looks like one of those ideas.

    I can make a lot of bearish reasons not to own, buy or utilize Bitcoin. The bullish ones can be made but they aren’t being made by a lot of the fanboys out there. I spoke with an entrepreneur who asked me what I thought of the price. As a trader I told him rallies like Bitcoin had are unsustainable. Historically, we can go far beyond tulip bulbs and look at any new technology to see bubbles. However, you only see bubbles in the rear view mirror. If Bitcoin is truly in a bubble, shorting it on the futures market is a way to take advantage and if it’s a bubble, very few people will short it.

    If you are interested in getting some sort of foothold on the reasons blockchains and crypto will be big, read the book The Business Blockchain. It’s a primer and will get you to think. When I look at industries like titles, title insurance, blockchain puts them out of business. If I look at others I can see where crypto/blockchain solutions would be far more efficient than the current ones. I also see a big potential for blockchain in government. In my state of Illinois, embracing blockchain could make government a lot more efficient displacing a lot of patronage workers which would be great for citizens. Blockchain voting solutions could stop voter fraud.

    It’s also important to remember these are very very early days in crypto. Yes, there is a lot of largesse when it comes to ICOs. It’s like the internet in 1997. How do you pick a winner? We are probably not even at the point where pitchers and catchers are reporting for Spring Training yet-much less play the top inning of a game.

    In the entrepreneurial community, we are just starting to see coders switch from coding in Java to coding for blockchain. The high price of many of the cryptos is driving that. Irrational exuberance is bringing them into the market-now we will see if some companies can be built to make them stay.

    At we look at a lot of crypto companies. We haven’t pulled the trigger yet but we are actively seeking out something cool. Personally, I pulled the trigger on and it’s winding its way through the process. If you are disciplined, and understand markets there are opportunities to be had. They will be outsized.

    Comment by Jeffrey R. Carter — December 6, 2017 @ 9:12 am

  7. Thomas Peterffy

    Comment by vfk45 — December 6, 2017 @ 12:21 pm

  8. Infinitely divisible-block chains must contain a lot more data than I thought.

    Comment by pahoben — December 6, 2017 @ 3:34 pm

  9. The closest thing I have read for a plausible argument supporting bitcoin is Andolofatto’s crypto as safe asset theory:

    Still I think it is a bit of a stretch.

    Comment by Dan in Euroland — December 6, 2017 @ 4:37 pm

  10. […] friend Professor Craig Pirrong wrote about Bitcoin futures here.  He says, “If I’m right, BTC is ripe for shorting. Traditional means of shorting […]

    Pingback by Bitcoin Futures Are Coming. Are You Ready? | Points and Figures — December 7, 2017 @ 5:28 am

  11. […] at after, its marketplace rate could plummet as University of Houston professor Craig Pirrong set it in a recent site publish, “relatively little volumes of buys or product sales could shift the […]

    Pingback by Killer Whales Could Be Controlling the Bitcoin Market | Ethereum Blog — December 11, 2017 @ 11:35 am

  12. […] bitcoin at once, its market price could plummet; as University of Houston professor Craig Pirrong put it in a recent blog post, “relatively small volumes of purchases or sales could move the price […]

    Pingback by Killer Whales Could Be Controlling the Bitcoin Market - Cryptinfo — December 11, 2017 @ 11:53 am

  13. […] “The Bitcoin cash markets are immature and hardly seem the epitome of robustness,” Craig Pirrong, a finance professor at the University of Houston, wrote in a blog post. […]

    Pingback by U.S. Bitcoin Futures Climb in First Day of Trade – Flourish Foundry | Business Trading News — December 11, 2017 @ 1:16 pm

  14. […] Cutting to the chase, if Bitcoin is a manipulated market, which may be the case, this week’s launch of Bitcoin futures could eventually pop the bubble and crash the market. Because for the first time, you can have real price discovery from smart money, that can bet big, go short in any size at any price where it can find a counterparty, and doesn’t have to worry about counterparty risk, custody with cybersecurity etc. (see also Craig Pirrong.) […]

    Pingback by Virtual Mining Bitcoin News » The Bitcoin crash is coming — December 13, 2017 @ 10:29 pm

  15. @Jeffrey R. Carter

    “In my state of Illinois, embracing blockchain could make government a lot more efficient”

    Do you know if you would be better off as a result?

    “The most important single cause for hope, beyond any doubt, is the incredible inefficiency of government”, [Milton Friedman] told students at the University of Puttsburgh … “If the government were spending the forty per cent of our income that it now spends efficiently, we would long since have lost our freedom”.

    Comment by Ivan — December 15, 2017 @ 4:17 pm

  16. BTC is the perfect ponzi format. Those who jumped in early, are living off the fat of those who come lately. And – when the value gets just right, just high enough – there’s a magical well-timed theft, or loss, or hack. What a surprise! There’s a market for everything I guess. trading costs are who makes the money. Just like the miners suppliers making more than the miners.

    Comment by doc — December 15, 2017 @ 8:10 pm

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