Putting on My Broker Hat About Bitcoin

John Lothian

John Lothian

Executive Chairman and CEO

Everyone is asking about bitcoin. A journalist called and asked to interview me. A magazine called and asked me to write something. A brokerage firm chief risk manager called to ask me my opinion about bitcoin and bitcoin futures. Two weeks ago, a former employer I have not seen in 10 years called me out in Coindesk.com for my bitcoin qualms. At the dinner table my son Robby opened up about owning not just bitcoin, but bitcoin cash, ether and monero. This is a full-fledged mania.

As I was driving home last night and thinking about bitcoin (as opposed to walking and thinking about it or sitting at my desk and doing the same), I asked myself what would John Lothian the broker think of bitcoin.

John Lothian the broker loved new products. He would often be the broker who first traded a new product at his firm or even clearing firm. He loved innovation and new markets and new customers coming to manage risk, or assume it.

However, John Lothian the broker was also John Lothian the risk manager. He was John Lothian, the customer default fund. By that I mean that when customers failed to meet margin calls or left uncollected debits, the funds would come from my commissions.

If my commissions would not cover it, then they would come from the firm’s commissions, impacting the pay of other brokers. Sometimes we would be able to negotiate with the clearing firm to delay repayment, or segregate the impact to just the defaulting broker. But at the end of the day, all the money the firm had up and all the commissions were the first line of defense for defaulting customers.

Thus, when I looked at the new product, I would always look at the risk to the client, to me and to the firm. One particular new product stands out, and represents an alternative market structure for futures exchanges to manage bitcoin risk.

In the 1990s, the CBOT unveiled CAT futures options. These were options on an index for catastrophic insurance claims. Think hurricane insurance. The risk profile of the product was one day you could be great, with no claims, and the next the contract could be maxed out at full claim. It was a very binary sort of risk. And it could take months for claims to come in, so the settlement was very long.

But the way the CAT options were traded was the most interesting, and I am not talking about the quotes on a chalkboard by the men’s room on the CBOT trading floor. CAT options traded like the reinsurance market and traders would buy or sell levels or layers of risk as represented by vertical call spreads. If you sold the 20-40 call spread, you were collecting a premium just as a reinsurance company would for taking a piece of a risk pool. They were on the hook if claims reached the 20 percent level, but maxed out at 40% of the contract’s value.

What was great about this approach was there was no unlimited risk. There were no futures contract to short, there were no uncovered options with unlimited risk. Every risk was defined.

The contract was designed by Richard Sandor and Associates, and the clients I found were referred by his firm, which could not take these brokerage clients for some reason.

John the broker would not have personally offered trading in bitcoin futures at a brokerage he owned, or one he worked at. He would have referred clients interested in trading bitcoin futures to some former colleague he did not like so much. Yes, he had enemies even in those days.

Leaving the third person, let me say that I believe crypto-assets will have a big impact on our industry in the coming years. I don’t know the form it will take, but I strongly suspect we will be managing this risk.

So it is important we get it right. I would like to suggest we are moving a little too fast towards launching bitcoin futures this year. It reminds me too much of the little pig who built his house out of straw.

We need a house made of brick and steel. We need more open dialogue between exchanges and brokers about this, with the regulators also involved. We need more education for brokers, clients, regulators and the public at large. This is too big an opportunity to get wrong. Imagine for a second a financial crisis caused by cryptocurrencies and you have to testify before the U.S. Congress as to why an exchange or clearinghouse needed to be bailed out. Not a pretty picture for the industry.

In the piece that I wrote for the magazine that approached me, I said bitcoin futures have two risks to manage. The first risk is that of the miners. They need to hedge or sell their inventory. Futures would be helpful for that. The opposite side of the trade is those interested in using bitcoin as a credit default swap or currency default swap. This could also be classified as money laundering, which may be illegal in some countries, but not necessarily immoral.

Rather than using gold for this currency or credit default function, something done for centuries, individuals can now use bitcoin and its decentralized structure to move money out of local currencies into bitcoin, and then out of the country and into another currency. And they don’t need an armored car or secret hiding places to do it.

This was a bit a of a revelation to me, as I had previously maintained there was no true economic use for bitcoin from the long side other than as a speculative trade. I give a big nod to the technological replacement of gold that bitcoin represents as a swap, regardless of the legality or morality of such trades.

However, this makes bitcoin’s function that of a swap, not a future. And since it has the unique risk profile of a swap, it should be treated as such. I recommended to ICE’s Jeff Sprecher many years ago that I did not want CDS cleared with my sugar.

He smartly built a bespoke clearinghouse for CDS to reside, segregating its risk from his futures business.

Perhaps the exchanges offering bitcoin futures should take the advice of Interactive Broker’s Thomas Peterffy, someone richer and smarter than me, and give clearing brokers a choice whether they want exposure to this new asset class or not.

And speaking of FCMs, if I were going to build a bitcoin house of brick and steel, I would be reaching out to the FCMs and building a consortium of cryptocurrency exchanges with them. Bitcoin exchanges look to me a lot like FCMs. They don’t really look too much like exchanges to me.

FCMs will convert your dollars to other currencies. They have listed bids and offers for FX conversion for client held funds. So why not launch a consortium group of 10 or 20 FCMs with subsidiary bitcoin exchanges using common technology? The prices from the exchanges could be combined to create a broad-based bitcoin index from trusted parties.

The other thing this does is allow for physical delivery of bitcoin, so you could have a physically delivered contract instead of a cash settled. It would also create a situation where you could have a bitcoin loan business, so traders could borrow it and actually short (physical?) bitcoin.

This would solve a big problem in the cash market, which is largely asymmetrical. But these moves would take some time.

I think the first step is to create the bitcoin futures options market and only allow vertical spreads. John the broker would feel OK with trading those. John the broker would also realize he was the reinsurance company for the rest of the spread risk and ask traders to put up the full value of the risk. This would allow client, brokers, executives and risk managers to sleep better.

If people want the full action of bitcoin, they are going to trade the OTC market. We are in the risk management business. The risks of bitcoin are not those of just the client, but also the brokers and the industry at large.

This approach would restrict gains but also restrict risk to traders, firms and brokers. And margins would allow for a greater number of traders to participate as high futures margins would be eliminated. The principal trader firms in favor of bitcoin have lots of expertise in options trading. It would also allow for a potential volatility product to be developed. Bitcoin VIX, anyone?

And then, when the FCM exchanges are built, the regulations are set and the market is better educated and more comfortable, futures could be offered.

That is what John the broker would have told any exchange that asked.

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