Bakkt is launching a pair of regulated physically delivered futures contracts on Friday. The event has been touted by many in the crypto space as the next step to entice institutional money into the market. In this article I'm going to break down what Bakkt is and what effect it could have on the crypto markets.
For better or worse, the US market is the leader in digital asset trading as it's the richest and most developed country in the world. But due to a strong regulatory environment, the rollout of regulated financial products for retail and institutional investors has been lackluster. Since 2014, several companies have been trying to apply for the creation of a Bitcoin ETF, but have been unsuccessful due to the SEC concerns of custody and market manipulation.
This is where ICE or the Intercontinental exchange comes in. They created Bakkt, which is working in collaboration with ICE Futures U.S. and ICE Clear US. Bakkt serves two functions primarily, first, it provides a regulated custody for Bitcoin second it will offer daily and monthly physically settled futures contracts.
ICE is one of the largest providers of futures products in the world. The majority of their futures are energy based, dealing with gas, oil and natural gas. ICE even offers futures on specific tankers for those who want to hedge. By jumping into the crypto markets, ICE is following the CME group, who listed their futures on the 1st of January 2018, at the height of the crypto market.
While Bakkt is not the first to offer physically settled futures, they are the first to offer a regulated futures for available to US investors. Coinflex also created a physically delivered future, but their product is not regulated and unavailable to US traders. I've already covered Coinflex in a separate post and I encourage you to go listen to the podcast episode with Mark Lamb.
Bakkt’s custody is arguably the most important cog in their system. Without regulated custody, questions about the creation of the futures products are a non-starter. It's really hard to develop a custody system meeting the exacting needs of US regulators. Opening a business and storing private keys in a nuclear bunker isn't enough.
Instead, Bakkt needed to focus on reporting, KYC/AML and security requirements. Any Bitcoin deposited in their warehouse must be cleared first by a chain analysis company (ChainAnalysis). Proper reporting must be sent to the IRS, SEC and other three letter departments. The company must also secure their private keys beyond the normal scope of what a normal retail investor would ever dream of.
Bakkt is using a mixture of Hot and Cold wallets to securely store client funds. They are also closely working with Bank of New York Mellon who is assisting them in storing their private keys in secure systems distributed around the world as a redundancy measure.
Bakkt's warehouse opened for deposits on Sept 6.
Just a few days later 95,000 Bitcoins valued over 1 billion dollars were transferred from Huobi to an unknown wallet. It was speculated that Bakkt's newly launched warehouse was the recipient of the coins.
The launch of Bakkt is important because they will provide the first true market for regulated price discovery in the United States. Bitcoin and other cryptos are heavily manipulated and volumes are faked in numerous unregulated exchanges. Bakkt will be the first provider of a derivative product to allow miners, institutions and traders to speculate and hedge the digital asset.
What’s innovative about their futures contract is that at expiration, the contract is settled and Bitcoin is delivered to the buyer at Bakkt’s custody warehouse. This type of settlement ends with physical delivery of the asset instead of cash settlement. As a trader this is very important for me. Currently the CME Bitcoin futures settle in cash, meaning that if I have clients who give me Bitcoin to trade on futures, I can buy futures and then settle at the end of the contract in Bitcoin, rather than in cash, which I would then have to transfer to another exchange and buy Bitcoin with.
Physically delivered futures are the preferred trading instrument for commodities traders. Volume of cash settled futures typically pales in comparison to physical settlement. In the gold market the physical volume is 20 times greater than cash markets. The reason is that the buyers and sellers of these commodities are actual end users who trade for future use, not just to speculate.
Let's go through an example of how Bakkt is used across the entire ecosystem of production and trading. A Bitcoin mining company can hedge price movements by selling a Bakkt future based on their future production to lock in prices and ensure profitability. At expiration, the miners deliver the Bitcoin to the Bakkt warehouse. The counterparty to the contract of the Bitcoin miners can then contact Bakkt and withdraw their Bitcoin to their wallet directly or continue to use Bakkt as their custody provider.
Bakkt futures will compete with futures run by the CME group. The main difference is the CME futures are cash settled. Another difference is that Bakkt futures will notionaly equal 1 Bitcoin, while CME futures notionally equal 5 Bitcoin.
The margin requirements for a single Bakkt contract will be three thousand nine hunded dollars. This is around 40% of Bitcoins current price and equates to around two point five x leverage. In comparison to other futures, the margin requirements are pretty steep, but this is probably to be expected from a nascent
Many crypto traders believe that Bakkt will be the main driver of the nexxt bull market. It will allow proper price discovery and it should eventually take a large market share of trading. Bakkt will also expand to other cryptos once Bitcoin launches, providing better trading opportunities for Ethereum, RIpple and others. When the Bitcoin ETF launches, it will probably use Bakkt futures for operations and their custody service to hold assets.
If history is going to be anything of a guide, a new Bitcoin bull market might be a few years away. When the CME futures launched in January 2018, the price tumbled 80%. WIll history repeat itself? Only time will tell once Bakkt launches this Friday.