CME Group Crypto Futures: Prudent Risk Management in the Flight to Crypto Quality
As the digital asset market skyrocketed in value and influence in late 2021, 2022, in stark contrast, was defined by a series of market events underpinned by structural issues that quickly spread into nearly every area of the industry – and beyond.
The market turmoil of 2022 shall be remembered with the collapse of Terra Luna and its stablecoin UST, and later the bankruptcy filings of Three Arrows Capital, Voyager, Celsius Network and BlockFi. To end the year, the failure of FTX, including the contagion that occurred as a result, has gone down as of one of the largest cases of fraud in U.S. history. Over the year, bitcoin prices made consistent lower lows, resulting in a prolonged bear market sentiment.
Fast forward to 2023, we are now dealing with a series of significant market-moving events driving inflation to multi-decade highs. Perhaps most notably, the pace of interest rate hikes in the U.S. has dampened the bond portfolios of banks, wiping out capital buffers – earmarked by the recent banking failures of Signature, Silvergate and Silicon Valley Bank.
Prudent Risk Management
In the wake of the collapse of prominent crypto firms and contagion concerns, the starting point for cryptocurrency investment decisions should center on risk management…and then risk management again.
Turbulence in the broader crypto market has increased the understanding, appreciation and use of CME Group’s Cryptocurrency futures and options for a number of key reasons. First, our regulated product suite continues to offer deep liquidity and price discovery with growth in both volume and open interest.
Since the launch of Bitcoin futures just over 5 years ago in 2017, and Ether Futures in 2021, CME Group’s transparent rules, regulations and operational controls have helped to consistently allow customers to manage cryptocurrency risk against rapid price swings.
Dynamic circuit breakers are in place in crypto futures and options markets and serve as the primary market protection as prices swing up or down, preventing markets moving too fast, too quickly, while also allowing price discovery to continue even amid rapid price fluctuations throughout the trading session.
Position limits protect customers against concentration issues and prevent snowball issues. Further, a market surveillance program monitors, detects and reviews for potential manipulation and other abusive practices in the Central Limit Order Book.
CME Clearing uses a SPAN model to determine the margin required to cover at least 99% of anticipated price changes for a product over a given liquidation period. Cryptocurrency futures products are cash-settled futures contracts and, as such, margins are set in line with the volatility and liquidity profile of the product and are fiat-based amounts, affording market participants greater predictability regardless of price fluctuations. Market participants are also able to net margins between CME Group Cryptocurrency products, all of which fall into the CME Group base futures & options guaranty fund.
Deep Liquidity and Price Discovery
Time and time again, with volatility in the underlying crypto markets, we see a migration of investors moving from crypto native platforms to CME Group. This was seen on November 8, 2022, and the days that followed the FTX collapse with record futures volume, and again on March 13, 2023, with the failure of Silicon Valley Bank, where the CME Group suite of Cryptocurrency futures once again proved their use case and saw their best trading day of the year, exceeding 90,500 contracts (representing more than $4.6 billion in notional traded).
With uncertain and volatile markets, the ability to borrow and go short spot crypto has dried up. As such, CME Group has become the venue in which institutions can effectively and efficiently gain short exposure. This underscores the role that our regulated futures marketplace plays for the industry in terms of continuity of risk transfer and price discovery.
Source: CME Group
Moving forward, the concept of segregated funds shall be truly appreciated by investors. What sets our diverse suite of deeply liquid, regulated crypto futures apart, is that they are cash-settled contracts. With a U.S. dollar-settled contract, the barriers to entry are reduced allowing for a broader and more diversified client mix. Exposure to the underlying asset can be achieved without having to set up a wallet, establish custodial accounts or deal with other security concerns such as insurance on wallets.
As a regulated derivatives exchange, CME Group maintains segregated customer accounts at both the clearing house and clearing firm levels. This is a direct requirement under the CFTC regulations for futures trading and clearing. CME Group’s Clearing House becomes the buyer to every seller and the seller to every buyer and guarantees the clearing and settlement of transactions on the exchange. Additionally, the availability of inline credit controls provides clearing firms more granularity in managing risk and there are no auto liquidate risk or clawback risk as may be seen on some of the unregulated crypto derivatives platforms.
Index Choice Matters
CME Group Cryptocurrency futures settle on the last Friday of every contract month to the Bitcoin Reference Rate or Ether-Dollar Reference Rate. Both are regulated benchmarks under European Benchmark Regulation and have expert oversight committees. The reference rates are published daily at 4:00p.m. London time and are derived from bitcoin-dollar or ether-dollar transactions from six leading cryptocurrency spot exchanges.
The reference rates were designed so that the methodology is transparent, observable and discrete. Each reference rate is calculated daily between 3:00pm to 4:00pm London time where the hour is divided into 12, 5-minute periods. At each period a weighted median is calculated. The average of those 12 observations is the respective reference rate for that day. The use of medians reduces the effect of outlier prices from any exchange. The volume-weighting of medians filters out multiple small trades that may otherwise dominate. The use of 12 partitions means influencing the rate would require trading during multiple partitions on several exchanges over an extended period, which would prove costly and there is no over reliance on any one exchange. Due to these design choices, the index has demonstrated to be reliable in times of high market volatility.
As more participants start trading in both spot and derivative markets we see the development of a highly interrelated ecosystem, bringing the price discovery that’s happening in the futures in alignment with the cash markets. It could be said that last year’s events might actually accelerate the next wave of institutional crypto adoption, rather than impede it. In line with growing interest, we have expanded our product suite to include right-sized Micro Cryptocurrency futures contracts, options on futures, Euro-denominated Bitcoin and Ether futures, and several order types such as Basis Trade at Index Close (BTIC) or Trade at Settlement (TAS) on crypto futures that provide trading price certainty and help institutions and sophisticated crypto traders manage risk efficiently – more choice, more precision, and more accuracy.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
CME Group futures are not suitable for all investors and involve the risk of loss. Full disclaimer. Copyright © 2023 CME Group Inc.