Headline: The Futures of Crypto

Date: 3/26/2022

Body:  OK, I have to make a confession.  From time to time, I become scared by how many people are piling into crypto.  But I was absolutely terrified when I read about cryptocurrency futures markets.

Why does this scare you (me) so much?

Let’s break down both parts, cryptocurrency and futures.  First of all,  cryptocurrency is really not based on well, anything  (There  seems to be a perverse bit of pride on this matter too.)  Usually, when a fiat currency bounces around, you can look at the industries within that nation to see their fortunes ebb and flow with the value of currency. But, with a cryptocurrency, there is no such industry to look for a correlation.  This is scary point #1.  Said a different way, “Bitcoin and other cryptocurrencies have already sucked an insane amount of money from the real economy,” said Bart Naylor, financial policy advocate at the consumer group Public Citizen. “Enabling more gambling under the banner of the SEC debases what’s supposed to be the gold standard of world securities markets oversight.” Scary point #2 is the futures. 

In the beginning, futures markets were a good idea, in that they helped to moderate risk.   For instance, an airline might offer a futures contract to an aviation gas distributor.  By executing this deal, the airline gets a definite price, and the distributor gets assured cash.  Both parties have to give up the possibility that prices could drift in the direction of their benefit.  (Farmers often trade uncertainty in  a similar way.)  But, when you are speaking of cryptocurrency, the benefits obtained and fees to be paid are both undefined, so the trading of risk cannot be accurately estimated.  Since this derivative is now not effectively trading risk, what is the investor doing?   Effectively, they are now going to a casino.  This is the crux of my concern.

Another thing that caught my attention is the amount of leverage that investors are given.   (Leverage means debt.)   in 2019, an offshore exchange was allowing up to 125 times for leverage.   They have moderated to only allowing usage of 20 times, but this is itself very worrying.   As you might remember, the housing crisis was triggered by leverage, allowing up to 30 times leverage.  But, these were large institutional investors, and even with their experience, they also went to excess and nearly bankrupted the American  public.  Allowing for 20 times leverage for normal investors seems rather dangerous to me.  Please recall also, that these futures contracts are extremely complex instruments, and unless the investor does exhaustive research, one can easily be misled.

Is there a case for trading cryptocurrency futures?

Well, yes, sort of.  Some assert that the futures market is regulated by the Commodity Futures Trading Commission (CFTC) and this governmental involvement might make institutional investors less squeamish.  Their argument is that with the larger investors inside, the smaller investors might derive a smoother ride.   But this looks somewhat doubtful to me.  They go on to argue that because futures contracts are settled in cash, there is less risk.  I am also somewhat dubious of this logic too, because of the extreme volatility of cryptocurrencies.  There is also a self-certification process for many of their procedures and, with the majority of exchanges being in other countries, I don’t have a lot of faith in the accuracy of self-certification programs under the CFTC.

Are there Special Considerations when considering futures contracts for cryptocurrency?

The futures market is well-developed.    But, the futures market surrounding cryptocurrency is  embryonic.   So, there are a few concerns that are special to this neighborhood of the futures market.   Therefore, it is unlike other futures trading for other asset types. Here are some special considerations that you should contemplate while trading bitcoin futures.

  • The bitcoin pricing model seems to resemble the model for the futures contracts, and this is good.  Bu, the futures market appears to be much more illiquid, not allowing investors the quick exit they might be forced to make.
  • The regulatory environment for cryptocurrency futures appears cloudy.  Even though the U.S. is making efforts to investigate this and regulate it properly, most of the exchanges are located offshore, and beyond U.S. Law.
  • Derivatives were developed to hedge risk.  (For example, one might be forced to make a deal in a foreign currency and the derivative was there in case the foreign currency was substantially devalued.  You lose money on the deal, but you gain a little on the derivative, mitigating the loss.  With cryptocurrency futures, the “underlying asset”  is the same as the one being hedged, so there is no protection being afforded by the derivative.

Rest assured, your mature, deliberate Federal Government is moving with all due speed, and all constituencies are working together flawlessly.

Sorry, I guess that might have been a bit too much.  To the surprise of nobody, the different parts of the Federal government are all claiming that they have the most important role in this drama.

As a result, US regulation of virtual currencies has not been too incredibly organized.   Each agency has  been grabbing for a little piece of regulation of cryptocurrency futures:

  1. The Internal Revenue Service (IRS) treats virtual currencies as property subject to capital gains tax.   So, say you bought a tranche of cryptocurrency for $5,000 in Year #1.  At the end of Year #3, you sell that piece of cryptocurrency for $12,000.   You would be taxed on that $7,000 capital gain. 
  2. The Treasury’s Financial Crimes Enforcement Network (FinCEN) monitors Bitcoin and other virtual currency transfers for anti-money laundering purposes.   I work in the Treasury department and there is a huge amount of focus on anti-money laundering (AML) activities.
  3. The Securities and Exchange Commission (SEC) takes increasingly strong action against unregistered initial coin offerings.
  4. The CFTC also has an important role to play.   In 2014, the CFTC declared virtual currencies to be a “commodity” subject to oversight under its authority under the Commodity Exchange Act (CEA).  Since then, the CFTC has taken action against unregistered Bitcoin futures exchanges (BitFinex),

The Verdict

When they started flying their kites and then airplanes, the Wright Brothers must have had some harrowing experiences.  Crashes must have been epic and frequent.   The futures markets for cryptocurrency are quite similar.  But, in this case, we are trying to build the plane that should carry us as we are in midair.  So, I don’t believe that I would recommend this to anybody.






Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

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