The 5 issues to consider before trading bitcoin futures

Greg Dwyer, head of business development at BitMEX, a bitcoin derivatives exchange based in Hong Kong, talks with Business Insider executive editor Sara Silverstein about what investors should know about trading bitcoin futures. Following is a transcript of the video.

Sara Silverstein: Help me understand how these bitcoin futures are going to work. Your betting on a future price of bitcoin. What is the underlying, what’s the reference point, how do they decide? I’ve seen a lot of different bitcoin prices every single day.

Greg Dwyer: There are two main contracts being launched. There’s the CBOE and the CME which is coming out a few weeks later. The CBOE is pricing against the Gemini auction which settles at 4 p.m. eastern time. Whereas the CME is looking at a more broad, diverse index comprising of four exchanges. That’s going to be referenced at 4 p.m. London time.

Silverstein: So explain to me what are the issues for having an underlying like bitcoin that isn’t something that’s regularly traded on an exchange.

Dwyer: Well first of all is the fact that bitcoin trades 24/7. Whereas these contracts are only going to be trading basically 24/5. They’re closed for the weekend plus they have these trading limits in place of 20% — hard limit up and down. So potentially we could see no trading occur. If there’s a 20 percent move over the weekend. And it opens that limit up on Monday and then no one’s going to be able to open or close positions until the following day.

Silverstein: Which is likely.

Dwyer: Right, so this also introduces, I believe, five other concerns given the fact that this does not trade like a regular, say, stock on an exchange, such as the NYSE. Market manipulation, also there’s potential of systems overloading. There’s potential of DDoS attacks, there’s hard forks, and finally the way that these contracts are margined.

Silverstein: So Market manipulation, how does that work?

Dwyer: So let’s take the CBOE contract for example. This is one exchange which compromises a relatively small amount of bitcoin dollar-traded volumes globally. So there are concerns that they could be priced — adverse price movements — due to this illiquidity. Or some bad actors in the space trying to move the price at settlement. The CME contract being more diversified on four exchanges alleviates this problem a bit.

Silverstein: And what about the DDoS attacks? What is that?

Dwyer: DDoS basically means that you’re trying to take down a system by overwhelming it with a large amount of traffic from various sources. We’ve seen various exchanges this week become partially unusable because they’ve been subject to DDoS. So this could be a large issue going into settlement and we see DDoS happening on these exchanges thus making settlement unlikely.

Silverstein: And what about the margin? How concerned are you about the fact that your margin requirements are going to be in cash versus like on the BitMEX exchange people are holding their their margins in bitcoin. So if you have a short position and bitcoin goes up by 10X. Then all of a sudden your margin requirements go through the roof and if your margin’s held in bitcoin, you’re covered. But if it’s held in cash that that’s not the case.

Dwyer: Exactly, it’s not easy to cash out bitcoin from an exchange and thus use to cover your unrealized losses on your short position. So this is going to introduce a very interesting element in to how the prices are actually going to evolve for the forward structure of the futures curve.

Silverstein: Explain to me what the system overload issue is.

Dwyer: Recently we’ve seen a number exchanges have performance issues. With the run up to $19,000, we saw a number of exchanges collapse under the pressure. They crashed and they went down for half an hour to a few hours. Other exchanges had issues whereby you couldn’t submit orders or if you could, you weren’t getting fills back until several minutes later. As we get more institutional money coming in and arbitrage across the various exchanges between spot, futures and so on, we should see more and more flow coming in. And this presents a real problem for exchanges — how are they going to handle with this increased amount of volume. Over the past year, we’ve seen volumes go up from 80 times. And I imagine that they are going to increase by another 10X before the end of the year.

Silverstein: So explain to me what happens if your underlying forks, because this is not something we see with any other futures contract.

Dwyer: So there needs to be clear guidelines as to how the futures exchanges are going to handle this. They could think of the fork as potential dividends that they reinvest. So, in fact, the Nasdaq has come out stating that they’re going to treat this as a reinvestable dividend and they’re going to look at the prices of some of the parts. Now from what I understand CME and CBOE haven’t come out with any clear guidance yet as to how they’re going to treat the fork. And this is a real issue because some exchanges might be listing the original bitcoin, under the same name bitcoin, whereas you might have some other exchanges listing the new chain bitcoin as bitcoin. So now you have different types of bitcoin being traded, but still under the same term — “bitcoin.” So as a futures exchange where they’re trading bitcoin futures, this presents a problem in pricing the contract. So they need to come up with clear guidelines as to how they’re going to solve this problem, which they have not as of yet.