One of the hottest topics recently unfolding around Bitcoin is whether or not the SEC will approve a Bitcoin ETF; both Bitwise Asset Management and VanEck currently have open applications at the SEC and there has been quite a bit of speculation surrounding this decision. In denying previous applications, the SEC has commented that the price of Bitcoin is too easily manipulated on unregulated exchanges and the proposed funds have not met the requirements under the Exchange Act Section 6(b)(5).
The sentiment expressed by the SEC certainly has merit, as the illiquid nature of Bitcoin, coupled with the many unregulated overseas exchanges, can make Bitcoin susceptible to manipulation and ensuring the stability of the underlying assets of any ETF rightfully helps protect individual investors. When you combine these factors with the recent allegations that a huge percentage of volume on Bitcoin exchanges is manipulated or completely fake, you can begin to see how complex this topic is for any regulator.
Additionally, earlier this week one cryptocurrency risk manager claimed that crypto derivatives are inappropriate for retail investors. He cited counter-party and valuation risk, as well as the general complexity of derivative products, even going so far as to say that aside from sophisticated, financial experts, everyone else should completely stay away from cryptocurrency derivatives.
At LedgerX we are very cognizant of the complexity of these issues, specifically Bitcoin price manipulation and the speculative nature of derivatives, however these are not new problems and our platform has already tackled them in a number of ways. Specifically, all transactions on LedgerX are physically settled as opposed to cash settled and LedgerX requires all trades to be fully collateralized prior to execution. Now, you may be asking yourself what does “physically settled” and “fully collateralized” actually mean….
In 2015 the CFTC made the decision to classify Bitcoin as a commodity, similar to oil or gold. When you purchase an option on a traditional commodity like oil, that trade is settled on a cash basis. That means that if you hold a crude oil call option with a $60 strike price and a barrel of oil is $65 at expiration, you would receive the difference in actual dollars – thankfully so, because I don’t think many of us have use for an actual barrel of Crude being delivered to our front door. Exchanges can settle those trades in cash because it’s relatively easy to get an accurate price on Crude at any given time to settle a trade. That’s not necessarily the case with Bitcoin as it’s traded on so many different venues. In order to solve that issue, we settle our trades “physically” which means when you trade on LedgerX, if you purchase a $4,000 call option on Bitcoin and at expiration Bitcoin is at $4,500, you receive an actual Bitcoin, removing a lot of the risk around spot price manipulation.
Now, you may be thinking, where does the Bitcoin received by the buyer come from in the above example? That’s where LedgerX’s fully collateralized model comes in. If a participant wants to sell a call option (betting that the price of Bitcoin will go down), they must have a Bitcoin in their account at the time of sale, which LedgerX then locks until the call option is either exercised or expires. If the option expires out of the money for the buyer, the seller keeps the premium and their Bitcoin. If the option is exercised, the buyer receives the seller’s actual, physical Bitcoin. This ensures that the buyer and the seller of the option can easily settle the trade.
Full collateralization also serves another purpose for LedgerX by helping us prevent manipulation as Participants on our exchange cannot use margin to purchase swaps or options. This limits the possibility of a single person placing a large order on margin to influence the price of Bitcoin and in turn the price of their open options position.
Lastly, LedgerX has developed a set of risk parameters in our Surveillance system to continually monitor all order entry and trade activity electronically and alert the LedgerX management and compliance team of any anomalies on our Exchange. This allows for real-time monitoring of any manipulative or suspicious behavior, but also gives LedgerX staff the opportunity to take immediate action should a parameter be breached either intentionally or in error.
Price manipulation of Bitcoin on unregulated exchanges is a legitimate concern for everyone in the Cryptocurrency space, and when combined with regulatory uncertainty, unsubstantiated volumes, and security concerns, can explain why investors may be apprehensive when it comes to investing in derivative products. To combat that uncertainty, LedgerX has created the stable trading environment that investors demand by structuring the rules of our exchange as illustrated above, without compromising the availability and liquidity of our derivative products.