Before the CME embarked on this idea of doing a Bitcoin futures market, one of the fundamental things you need for a futures market is the ability to have a consistent predictable publicly audited reference rate, meaning a price. A price both every 30 seconds, as well as, a point price once a day that you use in order to underpin the legal contracts that a part of the futures exchange. So if two people are disagreeing on what was the price of Bitcoin yesterday, they need a way to answer that is essentially non-reputable, that they're both bound too. The Chicago Mercantile Exchange therefore started this process by building these two reference rates.
The Bitcoin reference real-time index which is a spot price which updates every 30 seconds is published on traditional trading fees like Bloomberg and Reuters, places like that. That allows a trader from anywhere in the world to answer a question, what is a Bitcoin price today to a high degree of certainty. The other one is a point price which is every day at 2 PM central. Which is based on the average of sum amount of time, so it's a moving average taken at a point in time that's considered the daily rate. The CME has an oversight committee which is responsible to create and oversee the application of the rules regarding which exchanges are used to pull data about the current Bitcoin price.
These rules were created during an open public consultation that involved not only publishing the minutes of all of their meeting with three independent experts that have nothing to do with the CME. These rules are simple, one of them being, you have to publish a price consistently and not stop publishing a price. Out of these rules came that system. You have to understand that this is a cash-settled market, that means that nobody holds actual Bitcoin, which means that for the CME to operate this market, for every short position they have to have a corresponding long position and both have to be capitalized in US dollars against the CME. Meaning that the CME customers who have very strict requirements for capitalization have collateral deposited and audited on a daily basis and that collateral can be used to take certain positions, but not too big positions so they don't go over their collateral beyond a certain level and they have to be matched with buyers and sellers.
They also have some trading circuit breakers which ensures if the price of Bitcoin drops or climbs more than 7% they cease trading. Which means at this point in time they'd be ceasing trading three times a day. That's the tolerance of risk they have. Ironically some people that objected to that were the traditional investors in the CME and they said, "this is too risky of an investment to include in the CME," which is controversial because the CME has been in the business of managing risk for 200 years in trading commodity futures in very risky, very volatile markets. Price of wheat was doing great, then you have a drought that was unexpected, the price of wheat collapses, now you have to pay out billions of dollars to farmers who have taken positions in these futures markets, that's what they were used for. Who is going to short Bitcoin? That's a question we get a lot related to the CME futures. Who the hell would short Bitcoin?
Well, there's a couple of options and I think when trading opened on December 10, 2017, we might see a lot of short activity because a reason why Bitcoin is so volatile is that you can't take a position against it. So if you can't short it, if it starts pumping, the price could really go to extreme heights without any downward pressure. It's unbalanced in that way. So who shorts?
Maybe some traders, maybe some investment banks. They're going to short Bitcoin, they're going to do so at great risk. Just like people who try to short the stock market right now, which is also in a bubble do so at such great risk. The most interesting possibility is that the people that take short positions that take the least amount of risk are minors. You see minors actually hold the underlying asset and since they hold the underlying asset unlike all of the people that are naked shorting, they're not naked shorting and they have the collateral to make good on that option call if they lose the bet without loss, and their risk is not unlimited. So if I'm a minor and I have to pay electricity prices next month but I don't know the price of what Bitcoin will be and I'm earning Bitcoin today, that's a very risky position.
If the price collapses suddenly, I may go out of business not because of profitable but simply because of cash flow. That's not smart business so what we do is take 10% of our Bitcoin and put it in a short position. Now if Bitcoin does collapse it price, that gives us a cushion, it gives us a margin. It actually allows us to recover our losses from a decline in the price so that we can pay profits to investors next month and if we calculate our cash flow and operating costs, we can figure out exactly how much Bitcoin we need to short in order to have a good risk-reward premium, right? Basic market economics.
But if the price climbs tremendously, while everyone else who's shorting is losing their shirt, we're losing on my 10% but we're gaining 90% that we hold, so we can take that position with very little risk and make a lot of money. We expect to see minor participation in a big way in futures markets. Well capitalized, properly managed futures markets. Some people say this brings legitimacy to Bitcoin. We're uniquely allergic to the world, legitimacy, it makes us want to vomit when warmongering, war profiteering bankers create a word legitimacy to criticize Bitcoin.
That takes a lot of audacity. In this case, it's important to recognize the CME is not wall street. The Chicago Mercantile Exchange comes from a 200-year tradition of mercantilism. They are people who trade in actual commodities, these markets trade not just oil but probably their biggest market is wheat, corn, ethanol and hundreds and hundreds of other commodities.
Their primary purpose is to protect risk for producers of these commodities, they're not from the type of wall street mentality that is about printing money out of nothing and creating derivatives on top of derivatives on top of derivatives. We don't think these people are as alien to our culture as many believe.
We've met a few of them, so before we go into bundling all investment bankers into the same category, I think it's important to recognize that. We have no influence or interest in the Chicago Mercantile Exchange Futures Market, we know it's creating a lot of interest. I think the period between December 10th and December 31st is going to be very, very exciting. Twenty-one days of extreme excitement, because the most likely thing that is going to happen is we're going to see a lot of volume.
You think we have volume in Bitcoin now? When you watch a trader eat a sandwich while he presses enter on a 10 billion dollar trade, you realize how small this game is. We're going to have a lot of volume and that’s not bad. In fact, that is the first step to reducing volatility in Bitcoin, that's what we need. Massive liquidity and we're glad it was the CME that did it first.
August 12, 2018
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