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What is Bakkt and Bitcoin futures contracts?

Bakkt
Table of Contents

Introduction

The long-awaited Bakkt bitcoin futures contracts went live on September 22nd.  If you’ve tuned into crypto news over the last few months then you’ve certainly heard Bakkt mentioned quite a bit. Now that the dust has settled, let’s take a look at Bakkt in detail and what it means for the overall crypto space.

Bakkt is a bitcoin futures exchange and digital assets platform which was founded in 2018 by the Intercontinental Exchange (ICE). The ICE is the parent company of the New York Stock Exchange (NYSE) and owns a number of other regulated exchanges and clearing houses. 

The company is headquartered in Atlanta, Georgia, and the CEO is Kelly Loeffler, the former Chief Communications & Marketing Officer at ICE.  A former Coinbase executive Adam White also joined as COO.  Bakkt’s mission statement,  according to their website, is to “expand access to the global economy by building trust in and unlocking the value of digital assets.”

Bakkt is big news because it’s the first physically-settled bitcoin futures contract. Bitcoin futures traders can now place bets on physically settled derivative products. To understand the significance of this we’re going to give an overview of futures contracts and review the Bitcoin futures market in a bit more detail.

What are Futures Contracts?

Future contracts, or just futures for short, are a type of derivative instruments. It is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Futures contracts are standardized to facilitate trading on a futures exchange such as Bakkt. This is one of the key differences between futures and forward contracts.  Forward contracts are not standard; the quantity and spec of the asset are specific to the deal and so they are non-transferable on an exchange 

The buyer of a futures contract is taking on the obligation to buy the underlying asset when the futures contract expires. Sellers are taking on the obligation to sell the underlying asset at the expiration date. The futures contract, as we know it today, evolved as farmers (sellers) and dealers (buyers) began to commit to future exchanges of commodities for cash. For example, a wheat farmer would agree with the dealer on a price to deliver 5,000 bushels of wheat at the end of June. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs in advance so it was a win-win. From this beginning in commodities, the market expanded and cash-settled financial futures are now a convenient way for traders to hedge and speculate.

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leverage 4386208 1280

What about margin?

Buying on margin means using borrowed funds. Margin trading is an important concept in the traditional markets and has spread to the crypto space. 

“Leverage” and “margin” refer to the same concept. So, when we talk about 5x or 100 x leverage, we could equally say that the margin requirement is 20% or 1% respectively. It’s the skin that the trader needs to have in the game. There are two margin requirements in futures: Initial margin and variation or maintenance margin. 

An initial margin can act as a guarantee. In the example above there might be an initial margin required by both the buyer and seller of the wheat futures contract. Maintenance margin is the amount of margin that is needed to maintain a position and is always less than the initial margin. 

Futures contracts are marked-to-market,  so depending on the price of the contract, the buyer might receive what is known as a “margin call”.  This means the trader must either deposit more money in the account to bring it back up the maintenance margin or sell some of the assets held in the account.   If a margin call is not met, a broker may close out open positions to bring the account back up to the minimum value. This helps minimize the risk of default by participants in the trade.

What about settlement?

Futures contracts are settled in three different ways.

Closeout

If a trader is long a futures contract, they can take a short position in the same contract. Similarly, if they are short a futures contract, they will take a long position in the same contract to close out the position.

Physical delivery

If the trader doesn’t close out the position before expiry then the futures contract will be settled by physical delivery or cash settlement. With physical delivery, the underlying asset or commodity is delivered. For example, bushels of wheat, digital currency or even cartons of eggs.

Cash settlement

With cash settlement, there is no need for physical delivery of the contract. Instead, the contract can be cash-settled. The margin accounts are marked-to-market on the final day of the contract and cash is transferred from one trader’s account to the other.  Cash settlement saves on transaction costs and is the preferred option for most traders.

What about clearing?

Clearing houses provide important clearing and settlement services for futures traded at an exchange. They act as a highly capitalized neutral counterparty between every buyer and seller. This helps ensure trust in the system.  Its main role is to make certain that the buyer and seller honor their contractual obligations. Key responsibilities include settling trading accounts, clearing trades and collecting and maintaining margin.

The key players in the futures market

There are three main players in the futures market: hedgers, speculators and arbitrageurs.

Hedgers use futures contracts as a form of protection or “hedge”  from price changes. It involves taking an offsetting position. Speculators use the futures market with the hope of making a profit quickly.  Bernard Baruch, put it well when he said: “A speculator is a man who observes the future, and acts before it occurs.” The arbitrageur on the other hand looks for risk-free profit through the difference in prices between futures and spot prices.

History of Bitcoin futures

Bitcoin futures contracts have been around for a while, but before the regulated players entered the market, they were only available on crypto derivatives exchanges as unregulated assets. BitMEX for example offered bitcoin futures in 2015 and other players such as Kraken and Binance have recently followed suit. Binance futures opened for business in September and they have already seen massive volumes of 300 million in a month , which is a third of the spot market.

Regulated bitcoin futures first opened for trading on the Cboe (Chicago Board Options Exchange) futures exchange in December 2017 –  near the all time high of bitcoin. Cboe was then followed swiftly by it’s competitor the CME (Chicago Mercantile Exchange) in the same month.  Cboe recently decided to exit the bitcoin futures market with the last contracts trading in June of this year. We now have physically settled bitcoin futures available from Bakkt and others such as LedgerX joining the market.

Proponents say that bitcoin futures bring greater liquidity and efficient price discovery to the ecosystem. It’s also a useful mechanism for those looking to hedge against the risk of price fluctuations as mentioned already. In addition, trading in bitcoin futures is useful for countries that have banned bitcoin trading as futures are not treated as bitcoin itself. The futures contract gives them exposure to bitcoin, without ever having to take delivery of the digital asset.

What is Bakkt and why is it important?

Bakkt is primarily designed for institutional investors and is one of the ”on-ramps” for institutional capital. In other words, the big players with deep pockets like pension funds, mutual funds, hedge funds, investment banks and bitcoin miners. Bakkt offers a daily and monthly futures contract with the monthly contract going 12 months out. This allows traders to see where the price is going and miners can also begin to hedge their operations. 

 

Bakkt is an end-to-end regulated marketplace for the price of bitcoin. You can store in a federally regulated custodian, trade on a regulated exchange and clear in a registered clearinghouse. This is an important step to allow institutional capital to move into the digital asset market,

 

Bakkt is working with leading organizations like the Boston Consulting Group (BCG), Microsoft Corp. (MSFT) and Starbucks Inc. (SBUX). Starbucks is an interesting one and there have been suggestions that Starbucks will accept crypto payments in the future. 

 

How do Bakkt Futures work?

Contract types

As mentioned, there are currently two contract types available to trade – a daily and monthly contract. The daily contract has a size of 1 bitcoin and as the name suggests it is settled daily. The monthly contract has a size of 1 bitcoin also and is settled monthly. Minimum block trade size is 10 contracts.

Contract Workflow

Bakkt futures contract workflow is documented in detail here and is similar to the process for traditional futures.  

The clearing member posts required margin in USD or US Treasuries at the ICUS;   a CFTC-regulated Derivatives Clearing Organization (DCO). If the trader decides to take delivery instead of rolling the contract at expiry, then the clearing members communicate the delivery intentions. For a long position, the trading participant sends USD to the clearing member. For a short position, the trading participant sends bitcoin to the Bakkt Warehouse. The Bakkt Warehouse processes bitcoin delivery and bitcoin is moved from the short to long future holder’s account. ICUS processes USD from long to short holder’s account. 

The ICE announced tentative margin requirements recently  Per the notice, the initial hedge requirement for daily and monthly futures contracts is $3,900. The speculative initial requirement for both contracts is $4,290. Speculative requirements are for those accounts that are speculating on the price move on bitcoin through futures contracts. The notice further reveals that the inter-month add-ons for both the contracts will vary between $400 and $1,000 for the hedge rate and between $440 and $1,100 for the speculative rate. ICE also clarified that the margin rate will vary within the range depending on “the expiration date and the difference in expiration dates of contracts.”

As contracts trade over time, there then becomes a maintenance requirement in order to keep your position open. Depending on which way the market movements, this position may require you to allocate more funds to cover the margin. More information can be found here.

Settlement

As mentioned, the settlement process is what makes Bakkt bitcoin futures different to CME. The bitcoins are actually delivered on the specified date, unlike other bitcoin futures products that are cash-settled.  Bakkt has created new protocols specifically established for managing the security and settlement requirements of digital assets like bitcoin.

Clearing

Trading is done using a registered clearing member. The clearing member clears the Bakkt bitcoin daily and monthly futures through the ICE clearinghouse. A clearinghouse acts as a central counterparty for every trade.

Bakkt Warehouse

The Bakkt Warehouse is operated by a regulated entity and includes the security and software system that stores and delivers bitcoin associated with trading the Bakkt bitcoin Daily and Monthly Futures. 

According to Adam White

“The Bakkt Warehouse was built using the same institutional grade infrastructure, operational controls, and security protections that support the world’s most actively traded markets, including the New York Stock Exchange”

Bakkt’s warehouse is insured up to $125,000,000.

Custody

Bitcoin held at the Bakkt Warehouse will be secured in a combination of “warm” and “cold” wallets. As stated by Bakkt, the vast majority of customer funds are stored offline and safeguarded by robust operational controls. There will be a “fee holiday”, through June 30th, 2020, for bitcoin stored at the Bakkt Warehouse that is associated with the Bakkt Bitcoin Daily and Monthly Futures.

Regulation

Bakkt prides itself on being a fully regulated environment. Bakkt Holdings, LLC, is licensed by the state of New York to provide custody of bitcoin and is a qualified custodian under applicable laws. The company is registered with the Financial Crimes Enforcement Network (“FinCEN”) and regulated by the New York State Department of Financial Services and the CFTC.

Bakkt vs CME

Bitcoin Futures Market Statistics

Volume

In May 2019, the CME had it’s highest volume of bitcoin futures trading in a single month. The volume in the month reached 268.18K, which equates to over 13k contracts a day, or 65k bitcoins. The highest trading day was on May 13, when a volume of 31k  contracts (155K bitcoin equivalent) was traded. As you can see below, this resulted in a massive 13.8% increase in the price that day.

Now, if you compare May 13th to September 24th you’ll see less volume was traded, but the 24hr drop in price was a massive -14.53%.

With Bakkt and others joining the regulated futures market, it’s expected that overall bitcoin futures volume will increase.

Open interest

Open interest (also known as open contracts or open commitments) is the total number of outstanding contracts that have not been settled. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered to be  ‘open’.

Open interest is an important indicator, but it can’t forecast price action.It is a measure of the flow of money into a futures market. Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market. 

Recently the open interest in CME bitcoin futures rose by a record 643 contracts in a single day, representing an inflow of additional money. For more on open interest we suggest you read this.

Conclusion

It was unrealistic to think that Bakkt would go-live and instantly explode bitcoin futures volumes. It is an important step in the evolution of the digital asset ecosystem and brings key new on-ramps for institutional investors. It will facilitate greater price discovery, enable more sophisticated risk-management and give a further push to bitcoin as an accepted asset class.

 

Next up for bitcoin might be exchange-traded funds (ETFs). Even with the recent SEC rejection of the Bitwise bitcoin ETF, it’s only a matter of time before one gets approved. The institutional capital is knocking at the door. Watch this space.

For more on bitcoin futures contact us as info@boinnex.com

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Bryan

Bryan

Based in Ireland, Bryan is the founder and CEO of Boinnex. He has worked for almost a decade as an IT Project Manager contracting across finance, banking, insurance, tech, and healthcare industries. He found his way into the crypto space in 2017 when he started a contract role with IOHK — the dev company behind the Cardano blockchain. Since then, he has continued to be actively involved in different projects in the crypto and blockchain space. He enjoys learning, writing, and sharing knowledge about all things crypto.

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