Physical Delivery

Most Things Are Cash Settled These Days

When you buy or sell stocks, everything gets settled. Sell, you get cash in your account. Buy, a custodian holds the stock for you until you sell. Your account balance changes based on the fluctuation of the stock.

In commodities, everything used to be settled with “physical delivery”. It meant if you bought a wheat contract and held it to expiration, you eventually got a warehouse receipt that told you where your wheat was and you started paying the storage costs for it.

Commodities were also traded on margin meaning that you didn’t put up the full price of the commodity to hold it. A centralized clearing house managed the daily fluctuation and your account value went up or down depending on the price of the underlying commodity. If it went down too much, you got a margin call and had to add money to your account to hold the position.

A hilarious story I heard regarding physical delivery was with a huge lumber trader named Stu Gimbel. Stu had taken delivery of a lot of lumber. He was up in the office talking to all kinds of brokers all over the country to unload it. It just happened that at that time, a barge loaded with stud lumber was coming down the Chicago River. Someone in the office shouted, “Hey Stu, look out the window. Here comes your fucking lumber now.”

One of the most revolutionary things that happened in commodities was in the 1960s at the Chicago Mercantile Exchange when they delivered live animals. Hogs and Cattle needed the price discovery of futures markets and CME came through for the industry.

In the 1970s financial futures were invented. Initially, they were all settled with physical delivery. You got the bonds or the currency you owned contracts on. In the early 1980s cash was finally used just like stock markets to settle contracts like Eurodollars and the S+P 500. It was just too hard to deliver those things, so delivering cash was easier.

That opened the way to lots of innovation in futures markets.

However, there are some industries that prefer physical delivery. For example, the energy industry wants physical delivery. People in that industry call for “wet barrels”. The aforementioned lumber market switched from physical to cash-settled and so did hogs. But, grains and cattle are still physically delivered. How a market is settled does affect the final price. One method is not better or worse than the other, but you have to understand how it’s settled because it affects trading strategy as you get closer to the first notice day.

The reason I bring this up is that Bitcoin’s price is down 38% since November 8th. A lot of Bitcoin advocates have said it’s a hedge against inflation. Well, we certainly have a lot of inflation but that hasn’t helped Bitcoin’s price. When something is that volatile, it’s not a “store of value” either.

Bitcoin never had a futures contract until CME finally listed one. I actually went to my friend Leo Melamed’s office in 2013 to talk about listing one. Leo invented financial futures and his first foray was foreign exchange. He grasped the concept immediately. But, he also asked me if his buddy Vito could launder money through Bitcoin futures. If you know Leo it was a joke, we laughed. I told him it would be cheaper to launder money through Bitcoin than it was the S+P 500 pit.

When CME listed the futures contract, Bitcoin’s price imploded. It went from something like $20k to $3k. That told me the speculative fever and the risk of owning a Bitcoin was built into the price. Since the futures contract offered a pressure relief valve, the price dropped. However, the contract was settled in cash. This is mildly ironic and humorous since most Bitcoin advocates don’t like the mechanisms associated with fiat currency.

But, it’s super hard to settle something like Bitcoin physically. You have to get the inventory, hold it, and then figure out a way to deliver it.

It’s ironic, but in November a company in my personal investment portfolio started trading Bitcoin futures with physical delivery. Bitnomial launched. I am not going to make the case that Bitnomial’s physically settled Bitcoin futures contract has had repercussions in the larger Bitcoin market. I think there are other factors afoot like the threat of three interest rate rises in 2022 by the US Federal Reserve along with other central banks following suit. But, it is interesting to note that the price of Bitcoin dropped when Bitnomal started trading.

When I first invested in Bitnomial back in 2014, it was just an idea with one employee, CEO Luke Hoersten. We met at the old Coop in Chicago. I introduced him to several investors and only two of them decided to invest. It took the company a long time to get off the ground because of the way they were approaching the business. I reinvested in 2018. They had to build a clearinghouse and jump through thousands of regulatory hoops before they could trade a contract. They did that. Now they are trading and if you are a Bitcoin trader, I highly recommend that you check them out.

Bitnomial is a true competitor to the way things have always been done as far as the futures industry goes. I know a lot of the team and they all came from very innovative backgrounds prior to joining Bitnomial. Instead of being people enamored with crypto and just building some flimsy system that matches trades, these people truly understand how markets and exchanges work.

In 2020, the CFTC approved Bitnomial Exchange, LLC as a contract market (DCM) to operate an exchange for margined and deliverable digital asset futures and options, a first for new exchanges. Getting a DCM is arduous, long, expensive, and hard.

They have best in class trading systems and best in class clearing.  Unlike other startup exchanges, Bitnomial does not trade on its own exchange to inflate early volumes. 

They have Prime Brokers and they have a lot of big institutional traders who are making markets daily on the platform. Liquidity isn’t an issue like it is on some exchanges. Notional volume and other indicators show they have a healthy contract and are all pointed in the right direction.

There is no doubt that they will add new crypto physically delivered futures contracts in the coming years. They proved that their platform works, and more importantly that there is a large amount of demand for what they are doing. One of the things we always wondered about was whether the path was cash-settled, or physical. The jury is still out but it certainly looks like there is strong demand for physically delivered cryptocurrency futures.