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Bitcoin Futures Will Start as Regulators Rush to Catch Up

CME, the world’s biggest exchange owner, and smaller venue Cboe, known for its VIX volatility products, were allowed to offer the products after pledging to U.S. regulators that they comply with the law.

By Rob Urban and Ben Bain

(Bloomberg) --CME Group Inc. and Cboe Global Markets Inc. are poised to offer bitcoin futures contracts, easing the way for mainstream investors to bet big while dragging regulators into a realm skeptics call a fad and fraud.

CME, the world’s biggest exchange owner, and smaller venue Cboe, known for its VIX volatility products, were allowed to offer the products after pledging to U.S. regulators that they comply with the law. CME said its contract will begin trading Dec. 18, while Cboe said it is “operationally ready” and would announce a start date soon. Cantor Exchange, a subsidiary of Cantor Fitzgerald, also will offer bitcoin binary options.

Bitcoin extended gains following the announcement.

The moves are a watershed for Wall Street professionals -- including institutional investors and high-speed traders -- who’ve been eager to bet on cryptocurrencies and their wild swings. But the new products will also spur federal regulation, with the contracts announced Friday subject to oversight by the Commodity Futures Trading Commission. All three exchanges promised to help the agency surveil the underlying bitcoin market.

“Bitcoin, a virtual currency, is a commodity unlike any the commission has dealt with in the past,” CFTC Chairman Chris Giancarlo said in a statement. “We expect that the futures exchanges, through information sharing agreements, will be monitoring the trading activity on the relevant cash platforms.”

Under a process called self-certification the exchanges assured the CFTC that the new products complied with the rules. While it doesn’t technically require CFTC approval, the regulator could have stayed their plans if they weren’t satisfied. Friday’s announcement allows them to go forward.

“The launch of the futures will actually make the market healthier,” Cboe President Chris Concannon said in an interview after the announcement. “It will create pricing equilibrium in the market. Clients who are holding bitcoin now have no way to hedge their risk. These products allow them to hedge, and to take opposing views. More importantly, it brings a wave of regulatory oversight.”

U.S. financial regulators have struggled for years to agree on what, exactly, bitcoin is and what risks it might pose. That’s left its enthusiasts and financial professionals unsure which government agencies might try to police the rapidly growing market. In addition to the CFTC, there’s the Securities and Exchange Commission, the Internal Revenue Service and the Treasury Department’s FinCEN, which tracks illicit payments.

The CFTC declared in 2015 that it would treat bitcoin as a commodity. “But the IRS says it’s property, the SEC said now some digital currency is a security, and FinCEN says digital currency is a ‘money-like instrument,’” said Adam White, general manager of GDAX, a cryptocurrency exchange owned by Coinbase. His company is trying to work with all of them, he said, while offering his own definition: “It’s a new asset class.”

The new derivatives will open the door for institutional investors to get into the market, likely pushing the price higher once they start trading, said Naeem Aslam, a chief market analyst at TF Global Markets in London.

“This is going to bring large sum of money in this area,” Aslam said. “It sends the message that the product does have some regulation around it and it is trading on the same exchange where other reputable derivatives are.”

Bitcoin, created in 2009, excited early investors with its potential use as a global currency, free from bank fees and government control. Transactions take place person-to-person around the world -- anywhere there’s Internet access. The cryptocurrency’s price skyrocketed in recent months, surpassing $11,000 this week before paring some gains.

After Friday’s announcement, exchanges and the CFTC will have to keep tabs on that underlying market, according to Jeff Bandman, who until June advised Chairman Giancarlo on financial technology issues.

“It’s well understood that bad actors can take actions in the spot market for a commodity where the reward or payoff is the derivatives market and vice versa,” Bandman, who now runs Bandman Advisors, said in an interview before Friday’s announcement. “This would represent a new opportunity for mischief.”

Brian Quintenz, a Republican commissioner at the CFTC, said in an interview in London earlier this week that such venues will have to be vigilant if they list contracts.

They would “take on a significant but a very, in my view, positive role in ensuring manipulation is not occurring in how they calculate the prices for these futures,” he said. That “can bring some regulatory oversight on their own” to bitcoin, he said.

There are other ways the new futures could spur more vigorous oversight of the cryptocurrency. The contracts, for example, could make it easier to create an exchange-traded fund tied to bitcoin -- even after a previous attempt was knocked down.

That could enlist the SEC. In March, the agency rejected a bitcoin ETF proposed by Tyler and Cameron Winklevoss -- the co-creators of the Gemini exchange -- saying necessary surveillance-sharing agreements were too difficult given that “significant markets for bitcoin are unregulated.” Cboe will base its XBT futures on the Gemini Exchange’s bitcoin auction price.

On Thursday, a top SEC official weighed in. David Shillman, associate director in the agency’s division of trading and markets, said a strong bitcoin futures market could make the regulator more comfortable approving bitcoin ETFs.

Many mainstream investors and their brokers -- lured by bitcoin’s meteoric rise this year -- wouldn’t mind some government oversight to head off potential abuses.

“The problem with the futures contracts is they are regulated derivatives that are based off underlying trading in unregulated markets,” Richard Johnson, a market-structure analyst at Greenwich Associates who specializes in blockchain, said before Friday’s announcement. “That does create a potential problem.”

Ever since digital currencies began emerging, U.S. regulators have faced a big dilemma: The laws that empower watchdogs and delineate their areas of responsibility were written decades ago when money was minted on paper, companies turned mainly to the stock market for capital, and commodities came from farms, mines or wells. Many authorities have held back, studying what to do.

CME Chief Executive Officer Terrence Duffy sped up that process in October when he disclosed his plan for futures. His announcement of an imminent product caught some CFTC officials by surprise, according to three people with knowledge of the matter.

Exchanges like CME, which profit from increased trading volumes, can approve new futures contracts themselves. Still, CME and Cboe conferred with the CFTC while crafting terms for their products. The agency said they made a number of adjustments. CME, for example, increased its margin requirement for the contracts.

At the SEC, Chairman Jay Clayton has warned that initial coin offerings -- which are also backed by the blockchain ledger technology that underpins bitcoin -- are probably ripe with fraud.

Earlier this year, the SEC cautioned that in many instances the offerings are essentially securities that must be registered. In November, the SEC warned that celebrities who endorse ICOs risk running afoul of securities laws if they don’t disclose their compensation.

“Most people believe that bitcoin is not a security,” Clayton said this week. “The question is, jurisdictionally, where does the SEC fall. The various regulators are thinking about it. There are jurisdictional issues around bitcoin and bitcoin trading and where it’s taking place.”

The Federal Reserve, meanwhile, is taking a cautious approach. Federal Reserve Chair nominee Jerome Powell has said bitcoin isn’t big enough to affect monetary policy. And Randal Quarles, who was confirmed in October as the Fed’s first-ever vice chair responsible for regulating banks, has said authorities should keep a close eye on digital currencies, slowly adopting useful innovations if deemed safe.

The problem among regulators is that they each have roles with bitcoin, but that there’s too little coordination, said Justin Slaughter, a former top aide to a CFTC commissioner who now consults on financial technology and regulation as a partner at Mercury Strategies.

“It’s been very scattershot, it’s been somewhat confused,” he said.

--With assistance from Silla Brush, Matt Robinson, Brian Louis and Camila Russo.To contact the reporters on this story: Rob Urban in New York at [email protected] ;Ben Bain in Washington at [email protected] To contact the editors responsible for this story: Jesse Westbrook at [email protected] ;Nick Baker at [email protected] David Scheer

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