Bitcoin futures market share

Ethereum futures started trading on the Chicago Mercantile Exchange (CME) today, Feb. 8, 2021. How successful will this contract be?

We can get our clue from looking at the performance of bitcoin futures, launched on Dec. 18, 2017. Three years later, CME has an embarrassingly small market share in bitcoin futures: about 1% of total volume and 19% of open interest. Majority of bitcoin futures trade on non-regulated exchanges in Asia and Europe which are off-limits to US investors. How come that the CME, the derivatives market goliath, has found it so hard to compete against upstarts that can’t even serve CME’s core constituency?

The CME would like you to believe that the reason stems from lack of regulation in Asia. The truth is different and much more dangerous for the CME. Their fundamental problem is that their business processes are stuck in the 19th century while their crypto competitors are taking advantage of 21st century technology.

Have you ever wondered why futures trading, unlike stock trading, starts early in the morning and ends early in the afternoon? Is it just because commodity traders are by nature early risers, all bright-eyed and bushy-tailed? Not by a long shot. To understand why, we have to make a detour into the mechanics of futures trading.

Futures are fundamentally different from stocks in that no money changes hands at the time of the trade. When you sell 100 shares of Acme stock at $10, you get $1,000; when you sell 1 contract (5,000 bushels) of May soybeans for $10 per bushel, you don’t get $50,000 upfront. A future contract is an agreement to receive (or deliver) the underlying commodity on a given date for a set price. No money changes hands at the time of trade. Now, of course, there is a problem. If the price of soybeans goes up, the seller may be somewhat disinclined to deliver at the contract price, and, conversely, if the price goes down, the buyer may get antsy and look for ways to welsh on his commitment.

That’s where margin comes in. In stock trading, margin is simply a loan secured by assets in the client’s account. In futures trading, margin has a different meaning. It is a deposit guaranteeing the performance of a contract. The underlying idea is that the margin amount is higher than the profit that either side could make by reneging on the contract. Both sides of the trade have to put up initial margin, and then they have to top it up periodically as the spot price moves so that the posted margin is always higher than the cumulative loss from the contract.

The mechanics of margin posting dictate the rhythm of futures trading. Since 1865, when futures trading launched on the Chicago Board of Trade, the floor closed for trading at 1:15pm. Closing price of the session was used to calculate new margin requirements and runners were dispatched to customers’ offices to notify them of the new margin amounts before banks closed. Customers then had until 7.30am the next morning to come up with margin funds. If they couldn’t, their positions would be liquidated during exchange opening at 8.30am. Hence, the traders’ days started early and ended early.

Fast forward 150 years to the present. Much has changed in the business of futures trading: pits have closed, trading is electronic, and trading hours have expanded to 24 hours per day, 5 days per week (even electronic trading shuts down between Friday night and Sunday night). But the fundamental mechanics of margin stayed the same. Margin is still calculated once per day, based on closing prices, and liquidations are delayed to the next opening session.

This slow pace of margin collection causes problems for trading of instruments with high volatility. Prices for bitcoin and other cryptocurrencies can easily move 10-20% in the time between two trading sessions. Exchanges are exposed to the risk of collecting insufficient margin based on old prices. They mitigate their risk by setting margin requirements for bitcoin at much higher levels than for other futures contracts. CME set their bitcoin margin at 35% of the value of the contract, versus less than 10% for soybeans and less than 2% for US Treasury notes.

Could CME speed up its margin calculation and collection cycle? Unfortunately, that depends on the US payment processing infrastructure. Unlike Europe and Asia, whose bank payment systems are capable of guaranteeing settlement in less than one hour, the US banking system can only move money within one business day. CME can’t demand margin payment on a cycle that is shorter than that.

And here is where the new crypto competitors are eating CME’s lunch. Because they do not use the legacy payment systems, they can speed up their margin collection cycle and and reduce the amount of margin needed. An extreme example is BitMEX, a futures exchange operating from Hong Kong. Its margin engine recalculates all margin positions for every single customer (of which they have millions) after each tick, several hundred times per second. Comparing its margin engine with CME is like putting a Saturn rocket next to a horse drawn carriage. They are not even in the same century. No wonder that BitMEX can offer its customers 1% margin (100x leverage) on crypto trading. If CME offered 100x leverage on Treasury notes (let alone anything more volatile), they would go under within a month. By the time they recalculated and collected the margin, it would already be insufficient.

From the perspective of the user, high margin requirements are a cost. Margin ties up capital that could be used elsewhere and reduces the return on investment. If the user has a choice between two venues, one with a higher margin requirement and one with a lower margin requirement, the lower margin will always win. The only reason that CME has any bitcoin trading volume at all is because regulations ban US investors from utilizing overseas crypto derivatives exchanges. If US investors had a choice, they would flee from CME.

It’s hard to imagine a realistic scenario where the CME overcomes the disadvantage of their obsolete technology and catches up with their crypto competitors. It is much easier to imagine a scenario in which the crypto exchanges, capitalizing on their superior technology, expand beyond crypto into traditional financial derivatives trading. The only obstacle is the cost of regulatory compliance, and the leading crypto exchanges are amassing billion dollar war chests. The next 10 years are going to be very exciting.