Recently, the U.S. Commodity Futures Trading Commission (CFTC) announced that it has approved the application of a derivatives exchange and clearinghouse startup, New York based LedgerX LLC, for temporary registration as a Swap Execution Facility (SEF).
“LedgerX would be the first federally regulated bitcoin options exchange and clearing house to list and clear fully-collateralized, physically-settled bitcoin options for the institutional market.”
— – LedgerX website
LedgerX, applied for registration as an SEF and Derivatives Clearing Organization (DCO) with the CFTC on September 29, 2014. The company has said that it requires full approval as both an SEF and a DCO for full operation.
“Our vision is to be a US‐based, US‐regulated platform for options on Bitcoin. The instruments that we’re going to focus on first are physically settled options. This is going to be one of the first ways, in the United States in particular, where the end‐user who exercises a call option can get access to the underlying Bitcoin”
— – Paul L. Chou, LedgerX Co-Founder and CEO
Paul L. Chou’s background as a trader on the Quantitative Cash Trading desk at the investment banking firm Goldman Sachs, saw him responsible for the development, trading and risk management of algorithmic equity trading strategies for both the U.S. and Japanese markets. He believes there is a very big difference between cash settled contracts and physically settled contracts. “You know, I think they both have their use cases. For us, our customers in the course of their business many of them actually need underlying bitcoin (or bitcoin derivatives),” he said
According to Chou, the company is seeing broad demand for a Bitcoin derivatives exchange across several institutional groups, from companies looking to hedge their inventories, trade the volatility, and diversify their portfolios. Large corporations, miners, wallet and payment companies are often looking to hedge their inventories.
Joshua Lim, the Head of Treasury and Trading Operations at Circle Financial sees a need for this service, “for many Bitcoin market participants, physical settling of derivatives is the most appealing way to hedge [their bitcoin holdings.] Miners who produce new bitcoin and merchant processors who accumulate bitcoin and disburse dollars would prefer to actually deliver their bitcoin to settle their hedges; meanwhile, consumer on-ramps like Circle Financial would prefer to receive bitcoin on settlement to be able to deliver it to their own end-customers.”
LedgerX’s bitcoin derivatives contracts are unique as they are fully collateralized and physically settled. No leverage is involved as participants are not able to buy or sell contracts on margin. There is also no risk of default by a market participant or broker as they will be in a traditionally margined clearinghouse.
Before any transactions on the new derivatives platform are cleared by LedgerX, funds must be transferred to the company’s settlement bank account or digital currency collateral must be transferred to an account controlled by the company.
To initiate a transaction, counterparties must each send bitcoins to LedgerX, and if their investment is profitable, they’ll receive bitcoins back in return.
LedgerX uses a multi-signature wallet to hold all bitcoin deposits. It also has extensive security measures to protect participants and their funds from theft, fraud, and hacking attempts. Market surveillance is conducted to detect and prevent manipulation and disruptive trading. The company also implements a position limits program to prevent a single trader from establishing a large,possibly excessively speculative position.
While LedgerX would not be the first CFTC-regulated bitcoin derivatives exchange, it will be the first to offer physically-settled bitcoin derivatives contracts. The first CFTC-regulated bitcoin derivatives exchange, TeraExchange, announced the first bitcoin derivative transaction executed on a regulated exchange on October 9, 2014. However, TeraExchange’s products are U.S. Dollar cash-settled, meaning all trades are settled in USD, not bitcoin.
Following LedgerX’s CFTC applications, the Commission asked for public comment as part of their approval process. Among LedgerX’s supporters was Circle Internet Financial, an active participant in the digital currency market and bitcoin financial service provider, also believes that LedgerX can benefit Circle and other industry participants. Lim emphasized that Circle must maintain an inventory of fiat and bitcoin assets to facilitate “seamless, zero-cost conversions” between fiat currencies and bitcoin for their customers globally 24/7.
Lim advises that, “Just as Circle sees numerous consumer benefits associated with this protocol [bitcoin] — including the ability to send, receive and spend money in a faster, less expensive and more secure manner, we believe LedgerX can use these new technologies to disrupt legacy financial infrastructure by eliminating frictions and intermediaries that stand between institutional market participants who need to hedge risk and the marketplaces where such risk exchanges occur.”
One of the company’s early investors, Lightspeed Venture Partners, which invests in several digital currency companies, believes that LedgerX can provide participants with a safe, regulated platform to hedge risk and invest in bitcoin using cleared bitcoin swaps and options.
“Regulated derivatives exchanges and clearinghouses such as LedgerX will play an important role in the development of Bitcoin markets by providing liquidity and a secure venue for investors to manage short- and long-term risk. Similar to exchanges for financial products, LedgerX will serve the critical role of providing price transparency and a level playing field for market participants to transact.”
— – Jeremy Liew, Partner at Lightspeed Venture Partners
However, not everyone was confident in LedgerX’s applications. A number of issues were raised by [Professor I. Michael Greenberger](http://Professor%20I. Michael Greenberger, Law School Professor of the University of Maryland,), Law School Professor of the University of Maryland, citing that some critical information submitted by LedgerX were not made public or missing altogether.
While agreeing that the development of a regulated market and clearinghouse for virtual currency hedging would be beneficial, Professor Greenberger shared evidence as to how LedgerX’s proposal “incorporates untried elements, deviates from core principles applicable to the proposed registrants and generally raises issues of significant concern.”
Public investor, Michael Green, who claimed to be familiar with both the derivatives and bitcoin markets was pleased regarding the application’s submission. However, he had a list of concerns which he submitted to the CFTC ranging from the involvement of former CFTC Chairman and Commissioner Jim Newsome as the company’s equity holder, director and advisor to inadequate public disclosure.
BitPay’s Co-Founder and Executive Chairman Tony Gallippi, believes the CFTC “should provide regulatory oversight, encourage transparency, and allow the creation of a robust derivatives market for bitcoin”, a common view shared by Landon Thorne, Midas Advisory Group, Inc who cited his belief that “digital currency is here to stay and therefore expect and welcome an appropriate spectrum of regulatory oversight to include a US based digital currency derivatives exchange.”
Once the exchange starts trading, the possibilities for added Bitcoin adoption could be pretty strong. Jeffrey R. Carter, an angel investor and co-founder of Hyde Park Angels, advocates for physical delivery of bitcoin derivatives. While citing that cash settlement is very simple and cheaper to do than physical settlement, he believes that physical delivery would be better for the overall ecosystem. "Physical delivery will cause more accounts to actually be set up and used denominated in Bitcoin," said Carter