On October 9, 2014, the world was told that the first bitcoin derivatives transaction had taken place on a regulated exchange. The groundbreaking event for the bitcoin community was widely publicized as the next step in bitcoin’s revolution. The transaction in question occurred on New Jersey-based TeraExchange, the first federally regulated platform for bitcoin derivatives, trading USD/Bitcoin swaps.
To the bitcoin community, it was an important milestone, since derivative trading is a great way to hedge bitcoin holdings and reduces investment risks. Hopes were high that the trade marked the beginning of a liquid bitcoin derivatives market, and therefore large banks and corporations would all pour capital into bitcoin.
However, almost a year later the U.S. Commodity Futures Trading Commission (CFTC) revealed that the transaction was a wash trade, and prearranged. The story, as promoted by TeraExchange was at best a poor decision, and sanctions quickly followed.
TeraExchange, a multi-asset class platform for trading an array of financial instruments offers bitcoin forwards and swaps. Its provisionally registered as a Swap Execution Facility (SEF), as of Sept 19, 2013, but its application for permanent registration is still pending.
While still on a temporary registration, which is the first step in the process of gaining full compliance, the exchange launched it’s SEF and began offering bitcoin swaps on September 12, 2014. As a provisionally registered SEF, the exchange is required under the Commodity Exchange Act and CFTC regulations to enact and enforce rules prohibiting certain types of trade practices, including wash trading and prearranged trading.
As part of the compliance process, TeraExchange established a rulebook including warnings for all participants.
"No Participant shall create fictitious transactions or wash transactions or execute any such Order with knowledge of its nature.”
— – TeraExchange rulebook
However, a year after their launch the exchange broke its own rules, as well as the CFTCs. The transactions involved the only two firms who were authorized to trade on its SEF. According to TeraExchange the two firms did not know each other, one was digitalBTC, who acts as a liquidity provider for bitcoin swaps on the exchange, and the other was “a hedging counterparty.”
The transactions commenced when an employee of TeraExchange sent an email to one of the two firms, stating that they had "a counterparty who would like to do a trade,” and that "we would like to test the pipes by doing a round-trip trade with the same price in, same price out, (i.e. no [profit and loss] consequences) no custodian required."
“Tera arranged for the two market participants to enter into the transactions.”
— – CFTC
While on Skype calls with the exchange’s employees, the two trading parties obliged, and one entered a bitcoin swap buy order with a notional amount of US$500,000, which was accepted by the second party. Then, just minutes later, an equivalent sell order was executed and accepted, completely offsetting the first transaction.
“The two traders executed a fully offsetting transaction in the Bitcoin swap for the same price and notional amount. As a result, the two transactions constitute both wash trading and prearranged trading.”
— – CFTC
The two trades canceled each other out entirely, as intended. There was no gain or loss, and TeraExchange did not even charge a transaction fee or commission to either party, as they would with a real trade.
Since there were only two market participants authorized to trade on TeraExchange’s SEF, and only one pair of trades executed, this pre-arranged trading did not go unnoticed.
Soon after the trades, the National Futures Association and the CFTC’s Division of Market Oversight separately contacted TeraExchange regarding the two suspicious offsetting transactions. However, both agencies were told by the exchange that the purpose of the transactions was only to "test the pipes.”
The CFTC would have been satisfied with that answer, since it is acceptable for exchanges to test their systems. Unfortunately for TeraExchange, the CFTC saw the press release that TeraExchange issued the very next day, misleadingly claiming the first bitcoin derivative transaction to be executed on a regulated exchange.
On the same day, the exchanges’ then-president appeared at a meeting of the Commission’s Global Markets Advisory Committee (GMAC), and confirmed that trades had occurred in the Bitcoin swap the previous day.
As part of the CFTC’s regulations, it is very important that no pre-operational test trades are publicized as real trades, as it could confuse the public and make the market appear more liquid than it is. While the CFTC has no problem with TeraExchange testing their systems, to ensure they are transaction-ready, the company is obliged to make “it clear to the public that the trades do not represent actual liquidity in the subject market.”
Neither the press release nor the company’s statement by its then-president even hinted that the transactions were prearranged wash sales executed solely for the purpose of testing. The Commission then considered both announcements were made “to create the impression of actual trading interest in the Bitcoin swap,” which is a violation of the Commission’s regulations.
“[The trades] provided an opportunity for Tera to state publicly that trading in the Bitcoin swap had occurred. Tera intended for its press release and statements at the GMAC to create the impression of actual trading interest in the Bitcoin swap.”
— – CFTC
In staging the wash trades and announcing them as real trades, TeraExchange did not just accidentally make the mistake of not enforcing the rules, but instead the exchange spearheaded the violations from the start.
“Tera actively arranged for the two traders to enter into prearranged wash trades.”
— – CFTC
At the time of the CFTC’s recent order, the wash trades were the only transactions executed on the TeraExchange SEF. This shows an extreme lack of liquidity on the exchange, as well as opening up the spot for the first bitcoin swap transaction.
“The October 8 transactions were the only transactions in the Bitcoin swap executed on the Tera SEF as of the date of this Order and provided an opportunity for Tera to state publicly that trading in the Bitcoin swap had occurred.”
— – CFTC
TeraExchange, without admitting or denying any liability, settled with the CFTC. The Order requires Tera to cease and desist from future violations relating to its obligations to enforce rules on trade practices. There was no financial penalty.
This is the second case of the CFTC coming down on a bitcoin derivatives platform. Just a week prior the Commission officially classifying bitcoin as a commodity for the first time, while simultaneously ordering bitcoin options trading platform Coinflip, operating under the name Derivabit, to cease operations.
In such a short amount of time, two bitcoin derivatives trading platforms were sanctioned, attesting the fact that not only do bitcoin derivatives trading platforms need to register, but all trades on them must comply with CFTC regulations.
Thankfully, not all bitcoin derivatives platforms are this careless. LedgerX seems to be taking multiple steps above and beyond those required to ensure compliance. In addition to registering its SEF, they have also applied for registration as a derivatives clearing organization.
The Commission has recently approved the LedgerX temporary SEF registration, but the company has said that they do not intend to launch with only the SEF license at this time. If both registrations are approved, LedgerX would be the first U.S. regulated derivatives exchange and clearing house for institutions to trade physically-settled options on bitcoin.
LedgerX also recently appointed Mark Wetjen to the Board of Directors at Ledger Holdings Inc., the parent company of LedgerX LLC. Wetjen coincidentally organized and chaired the CFTC’s Global Markets Advisory Committee meeting, at which TeraExchange announced its first bitcoin derivative trade.
“Mark brings a unique combination of market acumen, regulatory expertise and discerning interest in the evolution of the bitcoin market.”
— – Paul L. Chou, LedgerX CEO
Nominated by President Barack Obama in March 2011, and later unanimously confirmed by the U.S. Senate, the Honorable Mark Wetjen served as commissioner on the CFTC from October 2011 to August 2015. He also served as the CFTC’s acting chairman for five months and helped craft over ninety CFTC actions.
"I am excited to participate in the evolution of the bitcoin asset class with a firm that is building institutional-grade trading and clearing capabilities under a regulatory framework."
— – Mark Wetjen, ex-Commissioner of the CFTC
With LedgerX taking their current, careful path, the future of bitcoin derivatives still looks bright, despite the actions of a couple of overanxious start-ups.