Traders wary of the nascent cryptocurrency market got some welcome news Tuesday: CME Group announced plans to launch bitcoin futures.
But longtime participants of derivatives markets say starting up a healthy, thriving market for cryptocurrency futures or options could be complicated. They point to issues like how to value bitcoin derivatives and whether there will be enough traders who can consistently post prices.
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Futures are derivatives contracts that investors and companies typically use to speculate on prices or hedge risk against turns in the market. Other major markets like stocks, bonds, commodities and currencies all have derivatives based on them.
For trading of virtual currency futures to be a robust market, several things have to happen first, said Julian Hammar, an attorney who focuses on derivatives at Morrison & Foerster.
Many futures contracts struggle to gain traction. "They get listed but they just don't kick off," Mr. Hammar said. "You have to hit a sweet spot in terms of having that commercial need and sufficient price volatility, as well as interest by speculators."
Bitcoins are attractive to traders because of their lack of correlation with other markets, as well as their wild swing, which have been absent from assets like stocks for years. But transferring this dynamic to a nascent market like cryptocurrencies could pose challenges.
Analysts and traders point to several hurdles. There needs to be plenty of market makers -- traders willing to post price quotes throughout the trading day -- to ensure liquidity, the crucial ability to do trades without significantly moving prices. A liquid market helps an investor buy or sell a future or option without prices for the contracts moving significantly.
Derivatives veterans also raise questions such as how to price futures or options of digital currencies. Bitcoin is also traded on multiple exchanges around the world. Prices for the cryptocurrency are often inconsistent across different venues, and pricing derivatives based on them could also be problematic, they say.
Cboe Global Markets Inc.,which announced plans in August to launch bitcoin futures, joined with Gemini Trust Company LLC to help solve the pricing issue. They will run a daily bitcoin auction, which will run a settlement process at the end of each trading day to determine a set price.
Cboe declined to comment on CME's announcement about bitcoin futures.
Over the last two decades, Cboe found success launching futures on its marquee volatility Index, or VIX, and now there is an ecosystem of contracts on it spanning VIX futures, options on VIX futures, a slew of exchange-traded products and then options on those as well.
Futures contracts could be used as the building blocks for exchange-traded funds, which would make it easier for both institutional and retail investors to buy and sell virtual currencies.
Cboe is "pursuing some of the same features that we learned were important for our derivatives product with the VIX," said John Deters, chief strategy officer at Cboe. Re-creating that for cryptocurrencies "depends on a lot of different bricks in the foundation," he said.
The exchange giant isn't the only one vying for a position in the cryptocurrency derivatives business. Bitcoin options exchange LedgerX launched in October after winning approval to clear bitcoin options from the Commodity Futures Trading Commission. The venue, backed by options exchange operator Miami International Holdings, Inc., is focusing on institutional investors for its digital currency swaps.
More than $2 million in notional value have changed hands since trading on LedgerX started, said a spokeswoman for the exchange.
That U.S. exchange giant CME is getting into bitcoins could draw traders, especially since equity markets have been so quiet this year. Derivatives traders and investors rely on big price fluctuations to capture profits.
"It's been a tough year," said Josh Fabian, an Illinois-based retail trader. "The lack of volatility has been really challenging."
On bitcoin derivatives, he said "I'm interested in trading them for sure."
Write to Gunjan Banerji at Gunjan.Banerji@wsj.com
(END) Dow Jones Newswires
October 31, 2017 14:49 ET (18:49 GMT)