CBOE’s Bitcoin Futures: LIBOR Fixing Scandal 2.0?
Disclaimer: I am a cofounder of CoinAlpha, a company that manages blockchain-native, quantitative cryptocurrency hedge funds that, amongst other currencies, trade Bitcoin. This discussion is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding a course of action.
We stand on the eve of a major milestone in the history of Bitcoin and digital currencies. Within a few hours, the Chicago Board Options Exchange (CBOE) will open the trading of Bitcoin futures. Not long thereafter, the CME Group will launch its own futures, with Nasdaq following suit in 2018.
These events are a testament of the increasing mainstream acceptance of digital currencies. Prices have surged on the optimism that these futures will for the first time enable the $139 trillion institutional asset base to access the cryptocurrency asset class en masse. This optimism is compelling, as the cryptocurrency market has posted outsized returns and offers an attractive new alternative for asset managers to diversify and optimize their portfolios.
But in all the excitement of the run up in Bitcoin over the past week, mixed with ongoing debates into how the the opposing forces of enabled institutional access versus “one of the greatest shorting opportunities ever” will play out, the mechanics of the futures themselves largely went unnoticed.
As someone who previously spent many years in investment banking structuring various types of financial derivatives and poring over their minute details, I note some concerns with the CBOE Futures.
Issues with the CBOE Bitcoin Futures Contract
Payment terms for futures, as with all other financial derivatives, are determined by reference to a pre-determined index. In the case of the CBOE Bitcoin Futures (CBOE Bitcoin Futures specifications), the reference rate for the price of Bitcoin is an auction rate published by Gemini Trust Company, a major New York-based cryptocurrency exchange.
Initially, I wasn’t surprised because I knew that Gemini was one of the only exchanges that even had an official price fixing. But the more I started to think about this, the more troubling it became.
How can an exchange which has barely over 1% of the Bitcoin market volume, be used to set the price of a potentially major Bitcoin futures contract?
This is eerily reminiscent of a major financial scandal that I witnessed firsthand in the traditional finance world: the LIBOR fixing scandals that were uncovered during the 2008 financial crisis and had allegedly occurred since 1991.
Background to the LIBOR Scandals (Wikipedia)
LIBOR (London Interbank Offered Rate) is an interest rate set by leading banks in London based on the average rate at which each bank quotes to lend money amongst each other. While its use for interbank lending is a fundamental element of the financial system, LIBOR is used as a reference rate for $350 trillion of commonly used derivatives in the market, such as interest rates swaps, cross currency swaps, in addition to various types of loans, including mortgages and company loans.
A conflict of interest (no pun intended) therefore arises because these very same banks setting the LIBOR rate are also parties to trillions of dollars of other financial transactions whose own value and payments depends on that very rate.
For example, a bank could quote a low interest rate for LIBOR even though they could potentially lose money on interbank lending, but could profit materially on their other derivatives transactions with their clients. Ultimately, big banks were prosecuted for this and ended up paying billions of dollars of fines.
Problem: a coterie has exclusive influence over the outcome of financial contracts in which they stand to gain depending on that outcome
This problem is even more pronounced in the cryptocurrency market due to (1) clear delineation between the “physical” market (Bitcoin) and the derivatives market (CBOE futures), (2) cryptocurrency market segmentation, and (3) limited liquidity of the cryptocurrency market.
Gemini Price Auction Mechanics
As mentioned above, as of writing, Gemini exchange garnered only 1% of all Bitcoin transaction volume over the past 24 hours. Granted, it is the weekend and the exchange was down several hours today (which itself can be regarded as another red flag), but even on normal trading days, its market share of volume is relatively low.
Even more surprising and what most people probably do not know, participation in the actual Gemini price auctions themselves is diminutive. Below is a table of recent fixings from this past week:
Source: https://gemini.com/auction-data/
Admittedly, to date, these fixings have not really been used for anything substantial, as far as I know. Nonetheless, this raises concern as the reference rate to be used for setting the CBOE Bitcoin Futures settlements was recently set by as little as 0.02 units of Bitcoin (or around ~$233.62)! On the Friday before the launch of the CBOE Futures, participation in the auction peaked for the week, but even then, participation only amounted to 245 Bitcoins (~$3.73 million).
Participation in the auction is open to Gemini customers only, which leads to another fundamental problem. If institutions are to use futures to access the Bitcoin market, would they knowingly enter into these contracts whose settlement terms are set by Gemini account holders only? Accounts holders which are less likely to be major financial institutions such as themselves, and are more likely to be small hedge funds? This is on top of the fact that the volume seen on the Gemini exchange represents only a relatively small portion of the market.
In addition, there is a wide variance of Bitcoin prices across exchanges due to market segmentation. Prices currently range from $13,247.40 to $14,250, representing a 7.6% price differential, from the top 16 most active exchanges (note that 16 was chosen only so as to include Gemini):
Source: https://coinmarketcap.com/currencies/bitcoin/#markets
This exchange segmentation exists for a number of reasons, such as the difficulty of setting up different exchange accounts, exchanges being globally distributed with different investor bases, and limitations on trading across exchanges due to the difficulty of moving fiat currencies (e.g. US Dollars) between exchanges.
This means that the Gemini Bitcoin price can easily diverge from the broader Bitcoin market, even if only during the time of the rate fixing. Again this opens up the Gemini Bitcoin price for manipulation.
Theoretical Example of How This Could Be Exploited
It would be all too easy for a hedge fund to exploit the CBOE Bitcoin Futures. A hedge fund that trades on the CBOE could realize arbitrage profits as follows:
- Buy Bitcoin in Gemini and push prices higher: given the low liquidity in Gemini, a hedge fund could put in a large buy order in Gemini, pushing prices higher and driving the value of the futures higher
- Short position in CBOE Futures: enter into a short position in the Bitcoin futures that references the higher price
- Close the position upon expiration of the futures: the hedge fund could dump its Bitcoin in Gemini immediately before the price fixing, pushing the price lower in the auction, benefiting the payout on its Bitcoin futures
This is possible because of the limited liquidity in the Gemini exchange and the ease of moving prices with a relatively small amount of Bitcoin.
What Does this Mean for Bitcoin Futures?
Investors looking at the CBOE futures as a way to access Bitcoin should best proceed with caution. I would expect any informed institutional investor who has done its homework would probably stay away, at least for now given their mechanics and the current state of the market.
It’s more likely that the early participants in these futures will be speculators looking to take advantage of a new way to monetize Bitcoin price volatility and are less motivated by fundamental investment thesis.
New investment will definitely be coming in; it just may not be from whom you expected or hoped it would come.
