Bitcoin continues to create a good deal of lively news flow. The start of this year saw the launch of bitcoin futures by the Chicago Mercantile Exchange and the CBOE Futures Exchange (CFE). It also saw the price of the underlying plunge from a high of $17,135 in early January to $6,914 on February 5 – it has since recovered to above $11,000 – but the news underlies just how volatile and uncertain the latest horse in the commodity stable can be.
The launch of the futures contracts was surrounded by controversy, and not just because of bitcoin’s infamous volatility; critics also pointed out the contracts were based on prices at only a few bitcoin exchanges, which are largely unregulated and open to possible manipulation. Most recently, Cumberland Mining, the bitcoin subsidiary of DRW, told the CFTC that cash-settled futures could leave the contracts vulnerable to manipulation, and only physically-settled contracts should be accepted. And the critics have been joined by many leading futures commission merchants.
Before the contracts were launched, the FCMs were making their concerns public; both exchanges had set high initial margin rates for the contracts – 27% at the CME and 33% at the CFE – and raised them even further before launch to 47% and 44% respectively. Many FCMs believed even this was too low, and introduced their own top-up margin requirements for their customers.
They now argue that the process through which the contracts were approved for trading – self-certification – was rushed through by two exchanges desperate to match each other, and that it left the clearing members taking risks they had never been given the chance to discuss. The exchanges have pushed back, saying a formal process of allowing FCMs to comment on new contracts before they are approved would be an unnecessary burden for the industry. Regulators seem divided on the issue, but it is possible bitcoin could be the trigger for an overhaul of how risks are handled at for-profit central counterparties.
Most CCPs currently follow the same sequence of payments after a member default – known as a default waterfall. The defaulting member’s margin payments and contribution to the shared default fund go first. Next, the CCP itself pays out a tranche – its ‘skin in the game’, intended to provide it with an incentive for cautious risk management – and then the other clearing members’ parts of the default fund are paid out. If all that isn’t enough, the CCP can levy additional contributions from its members.
But the size of a CCP’s contribution varies greatly among CCPs. Recent research even suggests two tranches rather than one might be preferable. Gauging the correct size of CCP contribution is far from easy. Too small and it has no incentive to improve its risk management as the clearing members will absorb most of any loss (this is the situation some members say applies to the bitcoin futures at CME and CFE). Too large and the cost of capital will make fees prohibitive, and the incentive for clearing members to help take on portfolios to reduce the impact of a default will be lessened.
It would be ironic if, after all the hype and anxiety, with opinions ranging from “massive fraud” to “the birth of a new financial system”, bitcoin’s most lasting legacy turned out to be a slightly safer central clearing mechanism. But it would certainly be a better end for the bitcoin story than many fear.