On December 1, three exchanges regulated by the Commodity Futures Trading Commission self-certified new cash-settled derivatives contracts based on Bitcoin. The exchanges – known as designated contract markets (DCMs) – are the Chicago Mercantile Exchange, the CBOE Futures Exchange and the Cantor Exchange.
CME and CFE proposed to offer margined futures contracts related to the price of Bitcoin, while Cantor said it would list fully collateralized binary options based on the price of the same virtual currency. Only CME announced an intended launch date – December 17 for trade date December 18.
Contemporaneously with the three exchanges’ self-certifications, the CFTC issued a press release noting that it had “extensive discussions” with each of the DCMs regarding their proposed new contracts. CFTC Chairman J. Christopher Giancarlo said each of the facilities “agreed to significant enhancements to protect customers and maintain orderly markets.” The CFTC separately noted in a “Backgrounder” also issued on December 1 that its staff had considered the potential risk of default of the three exchanges derivatives contracts on the regulated clearinghouses (DCOs) clearing the products. However, said the CFTC, “[b]ased on analysis of different stress scenarios, staff estimates that any potential impact will not be significant to a DCO.” The CFTC also said that CME had modified its proposed margining in response to discussions with Commission staff. CME observed that, if it had begun trading its Bitcoin futures contract as of December 1, it would have assessed an initial margin requirement of 35 percent of the contract’s notional value.
CME – which plans to self-clear its own Bitcoin futures contracts – will use its proprietary CF Bitcoin Reference Rate for final settlement. The BRR is derived from Bitcoin/US Dollar transactions on selected spot exchanges. Currently, there are four constituent spot exchanges – Bitstamp, GDAX, itBIT and Kraken; however, two more – Bitfinex and OkCoin – may be added later if they satisfy all BRR requirements. (Click here for details regarding CME Bitcoin futures contracts.)
CBOE Bitcoin futures contracts will settle to the auction price of Bitcoin in US dollars on the Gemini Exchange – another spot exchange that trades Bitcoin. (Click here for details regarding CBOE Bitcoin futures contracts.) CBOE Bitcoin futures contracts will be cleared by the Options Clearing Corporation.
Cantor Bitcoin binary options – a form of swap contract – will settle to the Cantor Exchange Cash Market Reference Price, which represents the value of Bitcoin in US dollars at the time of a contract’s expiration. The CECM Reference Price will be determined by Cantor “in its sole and absolute discretion” using publicly available Bitcoin prices from a variety of sources including “widely followed” cryptocurrency spot exchanges and “aggregates, composites or indexes of Bitcoin cash prices,” as well as bids, offers and transactions in the expiring and non-expiring contract months traded on Cantor. Cantor Bitcoin binary options will be cleared through an affiliated DCO – the Cantor Clearinghouse. (Click here for details regarding Cantor’s Bitcoin binary options.)
In its Backgrounder, the CFTC noted its belief that “responsible innovation is market-enhancing.”
In 2014, TeraExchange LLC – a CFTC-regulated swap execution facility (SEF) – began trading non-deliverable Bitcoin forward contracts based on the Tera Bitcoin Price Index. In July 2017, the CFTC approved LedgerX as a SEF and DCO for fully collateralized digital currency swaps. Unlike with CME, CFE and Cantor’s proposed derivatives contracts, LedgerX’s swap contracts may result in settlement in Bitcoin. (Click here for details in the article “LedgerX Approved by CFTC as First Derivatives Clearing Organization for Fully Collateralized Swap Contracts Potentially Settling in Bitcoin” in the July 30, 2017 edition of Bridging the Week.)
According to Coinbase, the price of Bitcoin rose from $9,386/Bitcoin to $11,235/Bitcoin – a 19.7 percent increase – from November 27 through December 3, including a midweek drop from $11,290/Bitcoin to $9,398/Bitcoin – a 16.8 percent decline– between November 29 and November 30 (click here for details).
The National Futures Association issued an “Investor Advisory” regarding futures on all virtual currencies, including Bitcoin. Although noting that the contracts “have certain benefits,” NFA also enumerated a number of potential risks that investors should be aware of, including “significant price volatility.”
Two additional purported class action lawsuits alleging the unlawful sale of securities in connection with the Tezos initial coin offering during July 2017 were filed in the same federal court in California. The allegations in these complaints parallel charges in two purported class action lawsuits previously filed in a California state court and a Florida federal court. (Click here for details in the article “Second Lawsuit Against Tezos ICO Backers Filed; CME Group Schedules Testing of US Dollar Futures Contract Based on Bitcoin” in the November 19, 2017 edition of Bridging the Week.)
The New York State Department of Financial Services (DFS) approved a sixth firm for either a virtual currency charter or a virtual currency license (known as a “BitLicense”) authorizing the firm to engage in virtual currency business activities involving New York or a NY resident. The firm, bitFlyer USA, obtained a BitLicense. Other firms currently authorized to engage in virtual currency business activities involving New York or a NY resident are Coinbase Inc. (including its exchange platform, GDAX), XRP II, Circle Internet Financial, Gemini Trust Company and itBit Trust Company. (Click here for background on the NY BitLicense regime in the July 8, 2015 Advisory “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” by Katten Muchin Rosenman LLP. Futures or swap contracts traded on CTFC-regulated DCMs or SEFs and persons handling such transactions, are subject to CFTC exclusive jurisdiction; click here to access 7 U.S.C. § 2(a)(1)(A).)
Helpful to Getting the Business Done: As a result of these developments, soon there will be three principal ways for US-based hedgers and speculators to gain exposure to Bitcoin:
Buy and sell spot Bitcoin. This can be accomplished by any person by directly trading with another person or by transacting on an online spot exchange, such as any of the enumerated spot exchanges underlying the soon-to-be traded CME or CFE Bitcoin futures contracts. Although, at least in the United States, these exchanges are subject to anti-money laundering requirements of the Financial Crimes Enforcement Network of the US Department of Treasury, they are not subject to functional regulation of their marketplaces by any federal or state regulator. (Click here for background regarding FinCEN’s oversight of persons deemed administrators or exchangers of virtual currency.) Spot exchanges engaging in virtual currency business activities involving New York (e.g., located in New York) or with a NY resident must also obtain a NY BitLicense and comply with prudential requirements mandated by the state’s virtual currency rule. Other state laws may be applicable.
Buy and sell Bitcoin through a Bitcoin deliverable swap contract. This can be done by qualified persons known as eligible contract participants. Currently, Bitcoin-settled swap contracts trade on LedgerX, a CFTC-approved SEF and DCO.
Buy and sell non-deliverable Bitcoin derivatives contracts. This can be done by ECPs through the purchase or sale of a non-deliverable Bitcoin forwards contract on the TeraExchange, a CFTC-approved SEF. It soon will be possible for any person to do this through the new derivatives contracts self-certified on December 1 by CME, CFE and Cantor, all CFTC-approved DCMs. No Bitcoin will pass in connection with transactions in these contracts. These products will solely be cash settled by reference to Bitcoin prices on spot exchanges.
My View: When DCMs self-certify a new derivatives contract, they must confirm that the contract is not “readily susceptible to manipulation.” This requirement derives from CFTC Core Principle 3 for DCMs (click here to access CFTC Rule 38.200). Although acknowledging “concerns” about the price volatility and trading practices of participants on the spot markets underlying the new CME, CFE and Cantor Bitcoin derivatives contracts which the CFTC conceded were “largely unregulated,” the Commission accepted the self-certification by the three exchanges that each of their proposed new Bitcoin derivatives contracts complied with Core Principle 3. According to the CFTC, “We expect that the futures exchanges … will be monitoring the trading activity on the relevant cash platforms for potential impacts on futures contracts’ price discovery process, including potential market manipulation and market dislocations due to flash rallies and crashes and trading outages.”
In March 2017, the Securities and Exchange Commission declined to approve a rule change to the Bats BZX Exchange to list and trade shares of the Winklevoss Trust – which proposed to hold Bitcoin as an asset and track the price of Bitcoin as traded on the Gemini Exchange – the same exchange on whose prices the CBOE Bitcoin futures contract will be based. In denying Bats BZX’s application, the SEC concluded that the exchange’s proposal did not support a finding that “the significant markets for Bitcoin or derivatives on Bitcoin are regulated markets with which the [Bats BZX Exchange] can enter into [a] surveillance-sharing agreement.” The SEC implied concern regarding the integrity of prices of Bitcoin traded on the Gemini Exchange. (Click here to access the SEC’s BZX Order.) Within the last few months, two additional Bitcoin-related exchange-traded funds withdrew their applications to the SEC for qualification, apparently because the SEC’s view on ETFs based on prices on spot Bitcoin exchanges has not changed. (Click here for background regarding REX Shares LLC’s and Grayscale Investments LLC’s investment trusts in the article “Singapore Regulator Joins Other Regulators in Warning Initial Coin Offerings May Impact Local Laws,” in the October 8, 2017 edition of Bridging the Week.)
Potentially, the CFTC’s acceptance of the self-certifications of CME, CFE and Cantor will spur a rethink by the SEC of its views regarding the regulation of trading on at least certain spot Bitcoin exchanges. It seems incongruous that the CFTC could take comfort in the three exchanges’ oversight of activities on at least a few spot Bitcoin exchanges, but that the SEC may still have material concerns.
At some point soon, it would also be helpful for the CFTC and SEC to develop a common approach to distributed ledger entries (DLEs) like Bitcoin and Ether. Although the CFTC has determined that Bitcoin is a virtual currency and is properly regulated as a commodity under applicable law, the SEC has separately determined that initial coin offerings may constitute securities requiring registration or an exemption from registration, as well as being subject to other requirements under securities laws and SEC rules. However, in the end, ICOs often result in the same type of DLEs that function as a medium of exchange or unit of account just like the DLEs the CFTC regards as commodities. Moreover, some of these DLEs may be chameleon-like, having principal characteristics of securities at initial creation and principal characteristics of a virtual currency later on. Different approaches to the same type of technology could impede its development and cause regulatory and legal headaches. (Click here for background regarding the SEC’s approach to ICOs in the article “SEC Warns That Digital Tokens May Be Securities” in the August 3 Advisory by Katten Muchin Rosenman LLP.)