COINFLEX RESEARCH – Physical delivery: a better approach for Bitcoin futures

On the 17th of May 2019, starting at 2.58am GMT, the price of Bitcoin on Bitstamp started falling rapidly. Over 11 minutes the price fell 11 percent, from above $7600 to $6178 (1). Prices on other exchanges lagged behind Bitstamp and fell less. The exchange tweeted that the crash was caused by a single large sell order.

Bitstamp 1 min chart showing price plunge on the 17th of May

Dovey Wan, co-founder of Primitive Ventures, tweeted that as no one would hold 5000 BTC — a sell order worth about $40 million — at an exchange, the order must be a “dump scheme” rather than an accident of some sort. The reason, according to Wan, was simply to profit from a large short position on Bitmex, another Bitcoin exchange (2). About $250 million in long positions on Bitmex were liquidated (3). Bitmex’s perpetual swap and its futures products are derivatives that reference the average spot price of Bitcoin on two unleveraged exchanges — Bitstamp and Coinbase Pro. By manipulating the spot price of Bitcoin on Bitstamp, the alleged attacker could force the price down on the highly leveraged Bitmex exchange relatively cheaply. 

Bitmex’s products “cash settle” against Bitstamp and Coinbase Pro. In cash settlement, derivatives products like futures are valued with reference to some underlying price. This underlying price is usually constructed by tracking an average or median from other typically much less liquid products. At settlement, buyers and sellers settle their positions relative to this underlying index price by paying or receiving cash from each other (4). 

Cash settlement in futures

Across the universe of derivatives exchanges, the usual method to settle derivatives products is by “physical delivery”. Here, a futures contract for example is settled by a short position holder at contract expiry by the delivery of the actual product. The long position holder has in turn to provide the counter asset, usually a fiat currency, with which to purchase that product. In their modern format, futures trading exchanges can be traced to the Dojima rice exchange in the early 18th century in Osaka (5). In terms of a direct lineage to currently existing futures exchanges,  the Chicago Board of Trade, recently made part of the Chicago Mercantile Exchange (CME), was founded in 1848.

Futures trading on derivatives exchanges hit new highs by volume in 2018 & 2019. They continue to trade orders of magnitude more by volume than their spot or cash equivalents. The liquidity they provide remains a core component of the global financial system. Some 30 billion contracts changed hands in 2018 with Asian exchanges doing most of that volume. It is the leader in futures trading by world region. The CME, however, remains the largest futures and options exchange in the world. It traded 4.84 billion contracts last year (6). Notably, the CME listed a cash-settled Bitcoin futures product in December 2017 that has seen some growth across 2018 and into 2019 (7). Bitcoin futures products are growing rapidly in importance as part of the price discovery process and, given the large amount of wash trading on some spot exchanges highlighted by the Bitwise Report, may have been leading price action for some time now (8).

As the largest and oldest futures and options exchange in the world, the CME is worth looking at in detail. It currently lists some 1977 futures products with settlement information: 880 products are physically delivered and 1097 are cash settled (9). However, the vast majority of the latter are products that would make no sense to physical deliver because they are derivatives on the difference between the prices of other products — swaps, spreads and basis futures.

Stripping those exceptions out we have 396 futures products that are cash settled, most of which are minor oil-related products, equity indices or local region electricity products. These are all products which are difficult to store and deliver physically. The cost of doing so outweighs the benefits of physical delivery.

What are the benefits of physical delivery?

CBOT corn futures pit, 1993

Major physical delivery futures tend to be the older contracts that remain important to the global economy and include currency futures, US Treasuries, major energy products including crude oil and natural gas, gold and silver, as well as a large variety of agricultural commodities like corn, wheat and cotton. Financial innovation in the 1970s led by the Chicago exchanges resulted in the creation of futures contracts on products that either could not be delivered physically or would be very expensive to do so. Probably the most liquid of these is the CME’s S&P 500 equity index futures. Physical delivery would mean having to purchase or short the entire basket of 500 stocks at contract expiry. As the futures contract is much more liquid than the underlying stocks, the primary concern here is price manipulation. 

The CME list their Bitcoin futures product in the “equity index” category. But there is no basket of things that make up one Bitcoin. On the contrary, an important feature of Bitcoin is precisely that although it is virtual in character it is very much a “thing” just like an agricultural commodity or a metal. The only difference is that its substance is made up of an abstract process called “proof of work”. So why then did the CME choose cash settlement and what counter measures do they take against price manipulation?

The most likely reason is simply that they were unable to find a clearinghouse they trusted who were willing or able to process Bitcoin transactions. Instead the CME adopted the index methodology of CryptoFacilities (now part of Kraken Exchange) to try to reduce price manipulation near contract expiries (10). They use a volume-weighted median set of prices from trades partitioned into 12 time periods of 5 minutes. Prices and trades come from Bitstamp, Coinbase, Itbit and Kraken across the one hour period from 3pm to 4pm GMT.

The weight of this machinery all designed to mitigate price manipulation itself suggests that a cash-index future for Bitcoin is simply the wrong approach. Given the ease with which a relatively small “Bitcoin whale” was able to shift not just Bitstamp’s prices over a significant period of time but also therefore prices on similar exchanges like Coinbase, Itbit and Kraken suggests strongly that no matter how well a design is used it cannot both accurately reflect real market prices and be resistant to manipulation.

A physically delivered futures market is not susceptible to the risk of price manipulation. A buyer who holds their position to futures expiry is required to produce payment for the physical goods. Likewise, a seller will have to supply those goods. It is of course up to the exchange and their clearing operation to make sure that buyers and sellers have the capital and resources to do that accurately. In the literature on physically delivered markets, some authors have argued that physical delivery is at risk to what is classically called “corners and squeezes” (11). Here the attack involves controlling the supply of the physical goods and the delivery method and profiting from that control by building up a large position in futures. For example, building a long position in a physically delivered future that is larger than the current supply of the actual good itself. In this case, sellers of the futures would be unable to deliver and therefore would have to bid up futures prices well in excess of “natural” demand/supply considerations. Similarly, developing control over the costs of delivery itself — owning the oil tankers that move crude oil from depot to depot, for example — would enable someone to manipulate physically delivered futures prices.

But how likely is this in the specific case of Bitcoin and other cryptocurrencies? Preventing an account or group of accounts from building up a position that is larger than the available supply in the underlying spot market is a matter for correct margining and collateral management. As an exchange employing physical delivery we monitor those risk levels accordingly. In particular, our  “ramp-up” or “deleveraging” method as futures expiry approaches ensures that longs have enough USDT to pay sellers and that sellers have enough BTC to deliver to the longs and receive USDT in return. In the last few days, over-collateralisation may be needed. With respect to control over the delivery method itself, cryptocurrencies are by design particularly well placed. They are designed from the ground up to be resistant to censorship and manipulation. The costs may increase from time to time as a function of network activity, but these changes are transparent and can be reflected in futures prices easily. For these reasons, it is clear that physical delivered futures offer many more advantages for Bitcoin and other cryptocurrencies than the prevailing method of cash-settlement.

1.“Bitcoin Price on Bitstamp Crashed by Nearly 20% in Minutes Causing a $250M Long Squeeze.”

2.Wan, “As NO ONE Will Simply Keep 5000 BTC on Exchange, This Is Deliberately Planned Dump Scheme, Aka Manipulation Imo   That Dumper Can on One Hand Dumping on Stamp with Poor Liquidity > Move the Bmx Contract > 100x Short on Bmx to Take Huge Advantage in Stacking Cheap BTC.”

3.Castor, “News.”

4.In the case of a “perpetual swap”, this settlement usually happens every 8 hours with a payment between buyers and sellers. The payment is capped and published in advance. The swap can therefore be modelled in part as an automatically rolling 8 hour futures position.

5.Schaede, “Forwards and Futures in Tokugawa-Period Japan.”

6.“A Record Year for Derivatives | MarketVoice.”

7.The Chicago Board of Options Exchange also launched a Bitcoin futures product in 2017. It does very little volume.

8.Bovaird, “95% Of Reported Bitcoin Trading Volume Is Fake, Says Bitwise.”

9.The CME list these as “financially settled” as the settlement method. Information accessed on 12th June, 2019.

10. “Analysis of CME CF Bitcoin Reference Rate – CME Group.”

11.Lien and Tse, “A Survey on Physical Delivery versus Cash Settlement in Futures Contracts.”


“A Record Year for Derivatives | MarketVoice.” Accessed June 10, 2019.

“Analysis of CME CF Bitcoin Reference Rate – CME Group.” Accessed June 10, 2019.

“Bitcoin Price on Bitstamp Crashed by Nearly 20% in Minutes Causing a $250M Long Squeeze.” The Block (blog). Accessed June 14, 2019.

Bovaird, Charles. “95% Of Reported Bitcoin Trading Volume Is Fake, Says Bitwise.” Forbes. Accessed June 20, 2019.

Castor, Amy. “News: $250 Million Longs Wiped out by Bitcoin Whale, Binance Reopens Withdrawals, Bitfinex Set to Trade LEO.” Amy Castor (blog), May 18, 2019.

Lien, Donald, and Yiu Kuen Tse. “A Survey on Physical Delivery versus Cash Settlement in Futures Contracts.” International Review of Economics & Finance 15, no. 1 (January 1, 2006): 15–29.

Schaede, Ulrike. “Forwards and Futures in Tokugawa-Period Japan:A New Perspective on the Dōjima Rice Market.” Journal of Banking & Finance 13, no. 4 (September 1, 1989): 487–513.

Wan, Dovey. “As NO ONE Will Simply Keep 5000 BTC on Exchange, This Is Deliberately Planned Dump Scheme, Aka Manipulation Imo   That Dumper Can on One Hand Dumping on Stamp with Poor Liquidity > Move the Bmx Contract > 100x Short on Bmx to Take Huge Advantage in Stacking Cheap BTC.” Tweet. @DoveyWan (blog), May 16, 2019.

CoinFLEX September Recap & Outlook

In the blink of an eye, August is now behind us. With it came novel activity in crypto markets the likes of which attract, confound and excite anyone who has given even the slightest glance at the state of crypto today.  A big story of the last month has been…

CoinFLEX Update: New Coins, New Markets, Our DeFi Vision

TLDR: Today we are launching several new markets, including markets for LINK and the first derivatives markets for YFI, CRV and BAND. Our first foray into listing DeFi-related markets, we aim to be a go-to exchange venue for trading, hedging, and accessing yield opportunities across DeFi assets, in the familiar…

CoinFLEX August Recap & Outlook

There’s a lot of projects in this industry that are all bark, but very little bite. And while we made a bit of a splash last month with the launch of CoinFLEX v2, a completely new exchange and product suite rebuilt from the ground up, we’ve been busy building. We’ve…