Bitcoin Futures, Part 2

It was a tight race between CME and CBOE to be the first one to list BTC futures, but CBOE turned out to be a winner. Bitcoin futures will start trading on CFE platform this Sunday, Dec 10, at 6pm EST.

According to Reuters, CME is scheduled to list futures 8 days later, on December 18th.

The margin information is also available now - but in short futures will offer about 2x leverage. To me this seems quite tame comparing to other bitcoin changes, but roughly in line with what I expected for CBOE or CME.

Bitcoin Futures

While news have been dominated with upcoming launch of CME bitcoin futures, I would like to remind readers that shorting is available on most major bitcoin exchange, and futures are available on major platforms like Bitmex, OKCoin, and Deribit.

In a more recent news, if you want to go with a more established exchange two Swiss banks listed certificates that trade pretty much like futures, on SIX Swiss exchange

link1

link2

I am not familiar with details of the contracts, so cannot offer comparison between them, but there are certainly a lot of options if someone wants to bet against bitcoin.

Bitcoin and Volatility, Part 3

Yesterday Russel Rhoads wrote an article comparing recent VIX and Bitcoin volatility. I am reposing a table that summarizes his findings:

But even though daily volatility of the two is at about the same level, it is a different type of volatility. While VIX moves quite a lot from day to day, over the long periods of time it stays in a relatively narrow range. Bitcoin on the other hand is volatility over the short term, and over the long term. 

To illustrate the difference I will create a plot of term structure of volatility - how historical volatility evolves as a function of interval. So the first point in the plot will be annualized volatility calculated from one day returns, the second point will be from 2 day returns, etc. 

The first chart pictures the term structure of VIX's historical volatility. What we see is that short-term volatility is high, and long-term volatility is low. This makes sense because this is what we actually observe from the time series, they appear to be mean-reverting (we're not saying necessarily that mean-reversion is the driving process), just that positive moves are likely to be followed by more negative moves, and negative moves are likely to be followed by more positive moves, keeping the index in a range.

The second chart is one for BTC USD rate I downloaded from Coindesk. What we see in the chart is just the opposite - volatility is increasing as function of time interval. Such behavior is common for trending time series, where positive moves are likely to be followed by more positive moves, and negative moves are likely to be followed by more negative moves.

So, if we were to extrapolate the historical behavior of these time series, and extend the charts beyond 100 trading days, we can make the following (and I'm sure quite imprecise) predictions: in a year from now 1 std move in VIX will be 30% ( 9.7-17.7 ), while 1 std move in BTC will be 190% ( 1,200-53,000 )

These forecasts are not serious forecasts, they just illustrate what some of the patterns we observe in the time series imply about future events. 

Bitcoin and Volatility, Part 2

Apparently Thomas Peterffy was not swayed by CME Group's Terry Duffy phonecall, and published an open letter to CFTC in today's issue of the Wall Street Journal (also available on IB's website)

In the letter, Mr Peterffy proposes to isolate Bitcoin futures clearing funds from all other deposited funds to prevent financial contagion. I think this risk is something that can be addressed with higher (maybe even 100%) margin requirement for bitcoin futures, but it is more important to understand why one of the top leaders of derivatives trading is not buying this argument.

The letter presents several arguments, which I will quote in a different order than they appear in the letter.

1 - "Instituting daily price move limits on cryptocurrency derivatives does not solve the problem. In a runaway upward market for example (like the silver market in the 1980’s caused by the Hunt brothers), the futures price gets locked limit-up day after day with little or no trading and the short sellers are unable to cover, leading them (and potentially their clearing firms) to ruin."

I completely agree with the statement, and daily (or whatever the time interval) trading pauses just buy time, and do not prevent clearing firms from going bust. However in this respect XBT futures are no different from other products - trading halts mitigate risk, they don't eliminate it. So I don't agree with this argument.

2 - "Margining such a product in a reasonable manner is impossible. While the buyer (the long side) of a cryptocurrency futures contract or call option could be required to put up 100% of the value to ensure safety, determining the margin requirement for the seller (the short side) is impossible. "

This is no different from other products as well - the seller of ESZ7 contract also faces the same, potentially unlimited risk, if S&P 500 index goes to 20000. And yet, you can as easily short futures as buy them. So I disagree with the second argument as well.

3 -  "There is no fundamental basis for valuation of Bitcoin and other cryptocurrencies, and they may assume any price from one day to the next. This has been illustrated quite clearly in 2017 as the price of Bitcoin has increased by nearly 1000%. "

I would argue that one person's fundamental basis is another person's bs, and people disagree about fundamental valuations of different products all the time. In fact the very reason why markets exist is because people disagree on valuation. And just like other futures products, XBT futures "may assume any price from one day to the next." Do stocks have fundamental basis? In 2017 the stock of Polarityte, Inc. ticker symbol COOL, rose about as much as bitcoin. Disagree with the third argument.

4 - "Cryptocurrencies do not have a mature, regulated and tested underlying market. The products and their markets have existed for fewer than 10 years and bear little if any relationship to any economic circumstance or reality in the real world. "

This is a "we don't know enough about bitcoin to understand the risks" argument, since 10 years ago we did not have any cryptocurrencies at all. However there is a regulated market, or at least as regulated as FX spot market. Also bitcoin market is a tested market - there are numerous exchanges offering spot, futures, and even options trading. The leverage offered is typically 2x or even 3x, although I think it is too generous.

Even the point that market is not mature is not quite right with me. How long does it take for a market to mature? How would we know? Bitcoin is few months away from it's 9th birthday, and in 2022 we will celebrate bitcoin bar mitzva and declare it a mature market?

We will have to wait and see how this all will play out, but this is certainly very exciting to have a completely different asset class to be listed on a major exchange.

They said what? Bitcoin and Volatility

As CBOE and CME both racing to list bitcoin futures we see some surprising statements from leaders of financial industry. In a recent interview Thomas Peterffy was quoted as being very scared that abrupt moves in bitcoin could bankrupt smaller clearing firms, jeopardizing the entire structure of the markets. Unfortunately, the full quote is unavailable (if you find it, please email me) but what Barron's article implied seems very strange. While margins across the board are relatively low, it is unreasonable to expect them to be low for a completely new product in a completely new asset class. Clearing houses would not change the same margin (in%) for Eurodollar (low vol) and VIX (high vol) futures, and BTC futures are certainly going to be the most volatile of all products listed so far in the history of mankind (both spot VIX and BTCUSD have spot vol of about 100%, but VIX is mean-reverting so long-term vol is much lower) I expect that margin requirements of BTC futures will be highest we've ever seen, simply because clearing firms, large or small, don't want to go bankrupt, and will change rates they decide to be appropriate for the level of risk their customers take.

Another surprising quote comes from Terry Duffy: "I’m not going to let it go to zero" Well, I'm sure Mr Duffy is a very influential person, but he is not in a position to influence the market. So I watched the video where he elaborates on the trading halts that CME implements across products would apply for Bitcoin futures as well. So, not literally "I’m not going to let it go to zero;" more like "I’m not going to let it go from $7K to zero in a second"

Updated: Blockchain Real-World Applications in Finance

My friend is organizing an event (demo/discussion) on smart contracts. The event is open to U of Chicago MBAs, and readers of this blog. If you're in NYC area, please stop by and say hello in person.

Smart contracts and blockchain technology are transforming capital markets and introducing new opportunities for efficiency and contract design. Join us as we explore this rapidly developing area within the FinTech space. The event will detail a live smart contract example – presented by Ron Papanek – Managing Director of blockchain pioneer Symbiont. Following the demonstration, Emmanuel Aidoo (Director Credit Suisse) and Joe Salerno (CEO Synaps) will discuss current block chain projects that will impact the future of finance.

What Matters for Bitcoin

The other week SEC rejected bitcoin ETF application, causing a sharp decline in bitcoin exchange rate. However after a few days market quickly recovered to pre-decision levels, near all-time bitcoin highs. I offer you some reasons why this is not surprising to me.

Of course if ETF were to be launched that would add significant allocation to bitcoin, and raise the prices. However even at this point in time there are plenty of convenient, completely legal and legitimate ways to purchase bitcoins. ETF would only add a convenience factor, however with a cost of trusting third parties - which would not be the case if you were to buy and store bitcoins directly.

Second, a number of financial instruments tied to bitcoin already exists (see this article for a comprehensive list) and if one is adventurous enough to allocate to bitcoin, one if probably ok with doing it outside of conventional US-ETF framework.

However what set bitcoin prices lower over the last weekend was a dispute of sorts about future of bitcoin - the bitcoin core vs bitcoin unlimited. I am not a specialist, but will try to explain it to the best of my understanding. Imagine you have a software upgrade that is not compatible with the previous version - that is pretty much the issue. The switch is called "hard fork" - hard meaning not compatible. The split in version is somewhat like a split in a political party - it is subadditive: two best scenarios for the value of bitcoin are if everyone stays with core, or if everyone switches to unlimited. The worst scenario is 50/50 split, where two separate incompatible ledgers coexist. I find this nonlinear behavior to be very interesting.

At this point about 11% of nodes have switched to unlimited according to coin dance. I will be writing more about this as the situation progresses.

End of an Era

Interactive Brokers Group, owner of Timber Hill, announced that they will be phasing out their options market operations (link). This is a really a pivotal announcement, that one of the oldest and most established derivatives market making operators is calling it quits. Other options market makers are not doing great either - earlier KCG announced that they are 'shuttering' their options market making business, and from what I hear other firms PL (DB, MS, Citadel) have been stagnant in the last 4-5 years.

IB mentioned that they are not exiting proprietary trading completely " The Company intends to continue conducting certain trading activities in stocks and related instruments." but I really don't understand what exactly are they going to do. Is there a special dividend in the near future for IBKR? Another part of the announcement is re-balancing of GLOBAL with almost doubling of USD share. Is this a good move to be purchasing dollars at multi-year highs? Only time will tell ...

KCG will also continue options trading, although not market making, and I have not hears of any other players exiting the field.

What does it mean for the market? Will spreads widen, or skews become more volatile? Will other market makers step in and profit from the gap? Or maybe there was really no gap - maybe Timber Hill will disappear with a whimper? If you have any predictions please share them in the comments!