The Diverse Offerings for Access to Digital Assets
ErisX has launched its spot market for digital assets and is planning to launch a derivatives market later this year. We are proud to be the first venue that services individuals, institutional investors, commodity producers, and hedgers in helping with price discovery, hedging opportunities and risk management. There are a number of digital asset markets with a diversity of licenses and traded products, that have launched, or are launching, and we often get questions about how, or if, our chosen approach is different. Our aim here is to distinguish our offering — a CFTC regulated futures exchange and clearinghouse, and a spot exchange and clearinghouse, all on a single platform- from the various other alternative products and markets available to investors. While spot, futures, and swaps transactions may appear similar, there are important distinctions. Not all are accessible or optimal for all market segments or use cases. In this post, we will explain the difference between each of the contract types, the venues where they trade, as well as the benefits and trade-offs. We hope that after reading this you will have information that will assist you in determining which solution best fits your needs.
Swaps and Swap Execution Facilities
The first product we want to distinguish is a swap. A swap is a type of derivative contract where parties exchange value or cash flows of one asset for another. Originally, swap contracts were bespoke agreements made by farmers or commodity producers that were looking to manage the risk of holding that commodity, also known as hedging, and by merchants that have a future need for the commodity.
Swaps grew into privately designed, customizable agreements to exchange cash flows based on a variety of financial instruments including but not limited to interest rates, stock indices, commodity prices and digital assets, etc.
Following the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, swaps are generally traded either on a swap execution facility (SEF) or over the counter (OTC) between sophisticated parties, classified as Eligible Contract Participants (ECPs). ECPs, under the Commodity Exchange Act (CEA), includes entities or persons that have, among other requirements, more than $10 million in assets, or less, if the entity has a business purpose such as hedging, for trading swaps.
Due to these qualifications, products for ECP’s are not typically available to retail investors. As a result, SEFs and OTC swap markets tend not to have the diversity of participants found on other types of markets. As such, digital asset swaps traded at SEFs must cater to a very specific segment of the market and exclude many in the trading ecosystem.
Commodity-based swaps fall under the jurisdiction of the Commodity Futures Trading Commission (CFTC), pursuant to the Commodity Exchange Act (CEA).
While swaps are not typically accessible to retail traders, digital asset spot markets can provide retail as well as institutional investors access to digital assets. In the spot market, participants are buying and/or selling the digital asset itself (not a derivative) at the prevailing market price for immediate delivery.
Digital asset spot markets may be subject to some level of state banking or financial regulatory oversight, under money transmission or similar statutes, and are typically subject to Financial Crimes Enforcement Network (FinCEN) and Anti-Money Laundering (AML) and Bank Secrecy Act (BSA) requirements.
Digital asset futures markets may provide retail and institutional investors access to digital assets. The U.S. futures markets are also regulated by the CFTC under the CEA, which mandates that futures be executed on or pursuant to the rules of a designated contract market (DCM) and cleared by a derivatives clearing organization (DCO).
For further clarification, a DCM is a licensed exchange that operates in accordance with a rulebook that, among other things, sets out robust policies and procedures to ensure market integrity, fair access, and surveillance for fraud and manipulation. A DCO is a licensed clearing house that can custody assets and ensures that trades settle, removing counterparty risk.
Futures contracts are standardized agreements that create an obligation to make or take delivery by buying or selling the underlying commodity at a specified price and time in the future. Because futures contracts are standardized, they may be offset prior to the time of contract expiration by entering into an equivalent but opposite trade. This eliminates the obligation to deliver the underlying commodity.
As with futures contracts on other commodities, futures contracts on digital assets may be physically delivered or cash settled on the date of the contract’s expiration, according to the contract’s specifications. Cash-settled futures require the delivery of the value, at the agreed upon price, whereas physically delivered futures require the delivery of the underlying digital asset itself upon final settlement.
The classic use case for futures contracts is to manage risk in the agricultural commodity markets. Farmers use futures to manage the financial risk of having to produce goods for future use and/or carry inventory in an unpredictable macro environment by buying and selling futures to lock in prices to help manage that risk. Similarly, Bitcoin miners who mine and hold actual coins may choose to enter a futures contract to manage the risk that the coins they currently hold, or to be held in the future from their mining activities, will decrease in price before the miner is able or willing to sell the bitcoin, for example.
ErisX — A Unified Platform
ErisX currently offers a spot market and will add a physically settled futures market through our DCM and DCO. ErisX believes that offering trading on one unified exchange and clearinghouse platform will provide increased market transparency, price discovery and liquidity, as well as reduced volatility. Further, a single spot and futures platform will allow for efficient use of collateral enabling participants to settle both spot and futures positions at a single clearinghouse, rather than managing the risk and inventory costs associated with having positions at various exchanges to collateralize different products.
To meet state requirements for spot trading, ErisX has secured the required licenses in 39 states and is in the process of securing the remaining required licenses as well as a New York State Bitlicense. ErisX is registered with the CFTC as a DCM and on July 1, 2019, became registered as DCO to clear digital asset futures. We are currently preparing the platform to launch physically settled futures in 2019.
With futures contracts and spot trading on a unified platform both are subject to the same protections, controls, processes and surveillance programs for fraud, manipulation and participant protection. This is to ensure market integrity as well as build a familiar and trusted environment that institutional investors expect from regulated markets. While spot contracts on digital assets do not fall under the jurisdiction of the CFTC, spot market manipulation is within the Commission’s purview to the extent that spot prices impact futures prices.
ErisX has a robust offering for individuals and institutions that want to access the digital asset markets. We offer a spot market, and will in the coming months offer a futures market alongside it, for liquidity, price discovery, hedging opportunities and risk management. Our clearing house will act as the counterparty to every trade, eliminating counterparty risk and the need to know who is on the other side of a trade. ErisX is confident that a broadly accessible unified platform will enhance the digital asset trading and investing experience for retail and institutional participants, alike.