First off, congrats to the CFTC on their approval of Bitcoin Futures! It’s been a long time coming for large institutional investors to enter the space and I hope that tools like futures and options will only continue to mature the space.

The increased opportunities, interest and volume will surely make for a more robust and vibrant crypto-community, but trading cryptocurrencies will never be the same. For all those long time crypto-traders out there, these are some shenanigans to watch out for due to the introduction of this new marketplace:

Large manipulations on price feeding exchanges

Props to CME for making a robust price feed for their contracts. Shame on CBOE for having one auction (Gemini) determine the price. The biggest concern for BTC traders should be large, directional manipulations on price feeding exchanges.

For the CBOE, we can imagine that if someone has a very large long position in derivatives, they could very easily just move the price on the Gemini exchange since the auction volume is a pittance compared to what expected derivatives volume will be. This was likely the point of the contract methodology (to bring more business to the Gemini exchange), however traders should beware of parties willing to take huge losses on their auction bids to manipulate the reference rate on contracts.

The CME uses a robust methodology, however even the LIBOR was manipulated, so we should be under no assumption that any methodology or index can be perfect no matter how large.[1] To summarize, the CME uses data from 4 exchanges over a one-hour period (3 to 4 pm). Each 5-minute block (e.g. 3–3:05) is given a volume weighted median trade price. They then take the average of all of these numbers (12 intervals * 4 exchanges) and get the End-of-day price of Bitcoin. The four exchanges are Bitstamp, GDAX, itBit, and Kraken.

Since they all get an equal weight in the calculation, manipulation will be easiest on the exchange with the lowest volume.

To be fair, this methodology is stellar compared to most futures products (props to Cryptofacilities for setting it up), however one should keep an eye on the open interest in the futures market relative to the volume on these participating exchanges, as a large number could indicate an incentive to try and manipulate the underlying exchanges. We should keep an eye on volume in specific 5-minute price intervals over the 3 to 4 pm EST on these exchanges and watch to see if an increased volume is trying to move the price in one direction or another.

For more on the problems of a cash BTC settled contract, Ledger X had an excellent post.[2]

The big boys coming to the table

Let’s be honest, most current Bitcoin traders won’t be trading futures. At a size of 5 bitcoin per contract, unless you’re one of the Bitcoin millionaires who wasn’t lured by the temptation of some alt-coin, you’ll be sitting on the same exchanges you have been trading on. The problem however is that the institutional clients coming to your spot exchange will completely change the game.

Day traders are almost a thing of the past in futures and stocks. Unless one has a very specific, almost inside, knowledge of an industry, the prop traders (aka high-frequency traders) are just too good. That VWAP mean reversion strategy that has made you a solid over the past year will likely come to a screeching halt. The good news however is that with the introduction of calculated market making strategies, spreads are lower, volume is greater and exchanges are more tightly linked by arbitrage. So, if you’re a hodler, you should welcome this change with open arms.

Circuit breakers and other exchange manipulations

Significant money can be made from flash crashes. These instantaneous drops and recoveries in the market are often due to ‘fat fingers’ (e.g. pushing sell 5,000,000 vs 500,000) and rogue or untested algorithms, however more nefarious intent could always be at play.

When the price on a futures exchanges drops (or increases) too much too fast, the exchange halts. Usually lasting 10 minutes, all orders are cancelled and participants will then resume trading as if it were a new market open. Since most cash markets are more expensive or difficult to manipulate, and much more transparent when it comes to who is purchasing what, these events may become commonplace on crypto markets (can one even compare physical crude oil to bitcoin?). CME market halts are set at a daily price move of 20%, a number not too uncommon in the crypto-currency world. [3]

For much of 2016, leveraged and/or anonymous exchanges in China were the price discovery mechanism for most of the bitcoin market. Although the specific exchanges where CME pulls reference prices from may not be manipulated, it is not hard to imagine one using highly leveraged, often illegal (for US customers) exchanges to manipulate cash prices on the reference exchanges. In semi-good news however, bitcoin portability issues may in a large way limit the arbitrage mechanisms between these exchanges.

Network Usability Issues

This is my biggest fear for the cryptocurrency world. As more institutional money flows into Bitcoin, we’re going to have a world where the vast majority of bitcoin holders, who by law, won’t even be allowed to hold their own private keys (e.g. pension and hedge funds). They will be speculating on the price rising; the usability of the network becomes an afterthought. Concerns are already widespread in the bitcoin world as to the underlying ‘use’, however creating an entire class of whale investors with no intention to ever use Bitcoin is worrisome.

In addition, prop traders hedging cash vs. derivative vs. the future ETF price will move large volumes through the chain with little concern over the fees that will be miniscule solely in comparison to their profits. Fees may skyrocket to hundreds or even thousand dollars and the world will turn again to central clearing houses such as DTCC or a new player in Coinbase. All BTC will move in name only as paper once again moves around a warehouse and the hope of a truly decentralized currency or store of value will fall to a different cryptocurrency.

Conclusion

In the end, I applaud the CFTC for their approval of Bitcoin futures and options. Allowing the free market to work is almost always the best solution and the fear of volatility or a new asset class should be no reason to throw existing law out the window. There are however serious concerns about how well this new asset class will fit within our regulatory structure as well as an even bigger question of whether our regulatory structure helps to protect the end users of the commodity. New options for trading digital assets in the form of decentralized exchanges, trustless optionality on contracts and fully anonymous derivatives contracts are blooming on decentralized networks. The revolution away from centralized exchanges and clearinghouses is coming, however take heed in the meantime of the potential seismic shifts in our community that are about to take place due to this sure to be massive new derivative product.

[1] CME Methodology http://www.cmegroup.com/trading/files/bitcoin-reference-rate-methodology.pdf

[2] https://ledgerx.com/how-do-we-fix-this-long-winded-thoughts-on-the-challenges-of-cash-settled-futures/

[3] http://www.cmegroup.com/education/cme-bitcoin-futures-frequently-asked-questions.html