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Bitcoin Futures and Big Banking

How do bitcoin futures work and why is there hesitation from big banks?

Bitcoin has smashed through many barriers in 2017 hitting extraordinary highs making the cryptocurrency a household name. Riding on this excitement are the launch of bitcoin futures. The first U.S. bitcoin futures started trading Sunday, December 10th, on an exchange run by Cboe Global Markets Inc., while CME Group Inc. plans to launch a rival contract on Dec. 18 at its Chicago Mercantile Exchange.

The creation of a bitcoin futures market allows investors to place bets on the price of bitcoin and whether that price will rise or fall in the future. In the most technical sense, it is not trading bitcoins; it is a way to place a bet on the price of bitcoin if it rises in the future, as the investor will receive the cryptocurrency at the price within that contract. Investors can also short bitcoin with bitcoin futures if the price of bitcoin falls.

This is a big deal. Investors are able to trade futures through their brokers using methods such as etrade or interactive brokers. Large trading firms trade futures all the time. By offering these services for bitcoin through futures contracts, there is less of a hurdle to trading bitcoin than trading through a wallet service.

This begs the question: why are not all the big banks jumping aboard?

Bitcoin is currently classified as a commodity. As such, bitcoin trades under a commodity futures contract, much like gold or oil. The Commodities Futures Trading Commission (CFTC) has stated that bitcoin is a commodity unlike any the commission has dealt with in the past. A futures contract on a cryptocurrency is completely new to many in the world of Wall Street and to regulators. Since it is so new, everyone is figuring out how to classify bitcoin, how to trade it, and the appropriate regulations that apply to bitcoin futures.

The role that the banks play in the futures market is very specific. Most big banks serve as a brokerage or clearing house for futures contracts. This means they are not betting on bitcoin themselves. Instead, they are allowing customers to place those bets. The need for a broker arises because futures exchange cannot be accessed directly by investors; investors must use a broker.

To trade bitcoin futures, investors need to set up a futures brokerage account and put some cash in it. This is called margin by futures traders, and it is the key to making those leveraged bets that can result in either profits or losses. The broker handles a certain amount of cash and each day the broker gives the investor money depending on whether the investor gained or lost money for the day. Most importantly, the broker is on the hook if the client loses money and goes broke.

Since bitcoin’s volatility serves as a major concern for brokers and those trading futures, banks are trying to figure out how to manage their own risk in this process and how much capital to require their clients to put up. They also need to answer: who they will allow to trade bitcoin futures? These questions are complicated given bitcoin’s extraordinary volatility.

As a rule, the more volatile a certain futures market is, the more conservative the broker will be about who it lets trade the contract and how much money the client is required to put up as collateral. The exchanges also maintain a certain minimum requirement for investors regarding how much they need to put down to trade the contract. The brokers usually top this requirement up a certain amount.

Every futures contract has its own minimum margin requirement. Exchanges demand greater margin for more volatile contracts, which forces traders to put more cash down if they want to place riskier bets. For instance, to buy or sell CME’s main crude-oil futures contract, traders must post about 4% of the value of the contract. For natural gas, it is about 8%. Bitcoin is so volatile that CME is requiring traders to post 35%.

This means the banks are all doing this calculation, with some being more aggressive than others. Three big banks, Bank of America, Merrill Lynch, and Citi Group, will not be offering their customers bitcoin futures trading given the inherent risk they see within bitcoin futures trading. Those offering bitcoin futures are offering some built-in protections given bitcoin’s volatility. For instance, both CME and Cboe will have circuit-breakers for their bitcoin futures that freeze the market if it swings up or down 20% in a day.

All this implies banks are trying to stay within a certain framework in which they can manage the risk and activity that is associated with bitcoin futures. For the institutions interested in bitcoin – and even those that are cynical of bitcoin – there will be a learning process as they try to maintain due diligence with the launch of such an exotic offering.

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