Over the years, we have documented numerous examples of conflicts of interests at the major, for-profit stock exchanges.  We understand that exchanges are public companies and they need to grow the bottom line.  But in their quest to increase shareholder wealth, they have often cut corners and introduced products which have advantaged their largest customers at the expense of long term investors.  

With the explosion of cryptocurrencies this year, the exchanges are once again chasing profits and throwing caution to the wind.  We’re talking about bitcoin futures and the race by the futures exchanges to trade the product first. On Sunday, December 10th, Cboe (the parent company of BATS) announced that they will be the first futures exchange to begin trading bitcoin futures.  The CME and Nasdaq have also announced that they will begin trading bitcoin futures in the coming weeks and months.  These three exchanges are racing to be the exchange with the most liquidity and they don’t seem to care about the dangers that exist in the underlying bitcoin market.

CFTC Warning

We have followed this story very closely, not because we are crypto currency experts, but because we see a market structure problem that could potentially affect many investors.  The problem lies in the unregulated bitcoin markets.  The CFTC noted this problem when they issued a statement last week on the self-certification of bitcoin products:

Market participants should take note that the relatively nascent underlying cash markets and exchanges for bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority. There are concerns about the price volatility and trading practices of participants in these markets. We expect that the futures exchanges, through information sharing agreements, will be monitoring the trading activity on the relevant cash platforms for potential impacts on the futures contracts’ price discovery process, including potential market manipulation and market dislocations due to flash rallies and crashes and trading outages. Nevertheless, investors should be aware of the potentially high level of volatility and risk in trading these contracts.”

This harshly worded warning reminded us of what the Surgeon General requires that cigarette makers place on a carton of cigarettes.  We think the CFTC was most likely lobbied hard by the exchanges to allow them to trade bitcoin futures.  However, the CFTC seems to know that there are serious manipulation problems at the underlying exchanges and they don’t want to be responsible for surveillance of these markets.  We think they agreed to allow self-certification but issued the stern warning to try and keep their hands clean if something goes wrong. 

Surveillance Responsibility

So who is responsible for monitoring the underlying bitcoin markets?  According to the Cboe , they will have an information sharing agreement with Gemini, one of the bitcoin exchanges:

Cboe Options has entered into an information sharing agreement with Gemini that provides CFE with the ability to access Gemini Exchange trade data for regulatory purposes, including in connection with the surveillance and regulation of trading in XBT futures on CFE’s market.”

While this might provide some surveillance for manipulative activity, Gemini is only one of dozens of bitcoin exchanges that operate around the world.  Who will be monitoring the other underlying bitcoin exchanges? The answer is no regulatory authority will monitor and cross-surveil all of these markets.  

The Underlying Market Dangers

We are not the only ones that are concerned about bitcoin futures and their underlying markets. Yesterday, ICE CEO Jeff Sprecher, questioned these markets.   According to the WSJ,  Sprecher “suggested that the underlying exchanges where bitcoin is traded are “not particularly transparent” and that it was premature to use them as the basis for a new futures contract.” Sprecher also questioned who would be participating in the bitcoin futures contracts and implied that the futures might just be a vehicle for large holders to unload their positions.  The WSJ noted:

“Mr. Sprecher said the bitcoin market was currently dominated by buyers, not sellers, and it was unclear who would short bitcoin when given the chance.  Bitcoin sellers, including “algorithmic guys”, could seize upon the launch of futures to exit big bitcoin positions, the ICE CEO said.”

Sprecher and ICE did the right thing by not rushing to list bitcoin futures. Reuters quoted Jeff Sprecher as saying:  ““We didn’t think it was obvious to rush out a product and be first and settle against an index on a lot of exchanges that are not particularly transparent.”  We agree.

Regulators and policy makers need to wake up before the cryptocurrencies get buried deeper and deeper into US markets and investors portfolios.  They need to start asking tough questions and figure out the potential risks before it’s too late.