Rating agencies are considering downgrading banks that clear bitcoin futures – and potentially even those just exposed to the contracts through their central counterparties – should volumes continue to increase on the new, volatile contracts.
Since the launch of bitcoin futures contracts in December, the cryptocurrency has seen a significant downturn. The price of bitcoin on the spot market dropped by 66% over a four-month period after the derivatives went live on CME Group and rival CBOE, according to data from Coindesk. A partial recovery in April proved short-lived, and a subsequent slump has left the cryptocurrency at $6,836 today (June 12), significantly below its all-time high in December of $19,343.
That volatility coupled with a lack of historical data available – bitcoin was launched in 2010 – has prompted rating agencies to consider whether a bank’s decision to clear the contracts, or even its membership at a clearing house that offers it, should negatively affect its credit rating.
“[The impact on ratings] is something that we think is perhaps not fully appreciated by the market and something that warrants monitoring going forward,” says Nathan Flanders, global head of non-bank financial institutions at Fitch Ratings.
The three main rating agencies – Standard & Poor’s, Moody’s and Fitch – agree that the current size of the bitcoin futures market gives little cause for concern. Bitcoin futures open interest on the two exchanges totalled $144 million on June 8. However, a sharp increase in futures volumes could force the agencies to rethink their position.
Of the three agencies, Fitch’s stance on how bitcoin futures affect bank creditworthiness is the strongest. Flanders says any bank that is a member of a central counterparty (CCP) that clears bitcoin futures is vulnerable to credit rating downgrades – regardless of whether the firm itself clears the contract – due to the risk it is exposed to if a firm clearing the contracts defaults.
CBOE clears bitcoin futures via the Options Clearing Corp, while CME uses its in-house clearing service. Both OCC and CME Clearing channel bitcoin futures clearing through their main guarantee funds, as opposed to setting up a separate default fund just for the contracts.
“If the notional materiality increases, that is going to increase our dialogue with the banks,” Flanders says. “For banks, even though they are saying they are not directly engaging in the trading of cryptocurrencies as clearing members, they have some indirect exposure to it, whether they like it or not.”
Moody’s agrees that the volume of futures clearing is a critical factor in determining any increase in credit risk and, ultimately, the effect on bank ratings.
Ana Arsov, managing director at Moody’s, says: “If a bank were to establish a very large business clearing cryptocurrencies, that would be credit negative. As with any asset class, if there is a new concentration of risk that we think is inappropriate, that can create downward ratings pressure. However, we don’t see that risk as imminent.”
Fitch acknowledges that to downgrade a bank on the basis of its exposure to bitcoin futures would be an extreme measure. The credit strength of most clearing houses, and the limited impact of combined counterparty exposure on banks’ overall risk profiles, limits the likelihood of bank ratings being affected, it notes. “At present, this is not a primary driver of banks’ ratings,” Flanders says.
Futures commission merchants (FCMs), comprising large banks active in clearing, are dismissive of the prospect of ratings downgrades. A global head of over-the-counter clearing at one large US bank says an FCM that is a member of one of the two bitcoin futures clearers, but does not clear the product itself, has limited exposure to the new contracts and should not see a credit downgrade as a result.
“I don’t think members are going to stand for a ratings downgrade because they are a member of a CCP clearing bitcoin. We would work closely with the CCP to increase its collateral to a level where everyone agreed it made sense,” the head of clearing says. “I think it is an unlikely situation. And if we were to be subject to some kind of ratings action because of our membership at a CCP, we have a big problem because the regulators are encouraging central clearing as a means to mitigate risk.”
Others see the clearing houses’ risk management activities as more pertinent than increased contract volumes from individual clearing members.
Craig Pirrong, a professor at Bauer College of Business at the University of Houston, says: “Implicitly, the rating agencies seem to be assuming that the CCPs will not margin the risks adequately, and will not scale a member’s default fund contributions commensurately with the risk they bring to the CCP.”
CME and OCC’s decision not to create separate default funds for bitcoin futures was a widely debated topic in the lead-up to the contracts’ launch. The Futures Industry Association questioned why a public discussion had not taken place around whether a separate guarantee fund was appropriate prior to the self-certification of bitcoin futures by the two exchanges.
FCMs also voiced concerns that the volatile nature of bitcoin makes a default by trading participants more likely, jeopardising the clearing fund contributions of members that do not clear the contracts themselves.
Fitch suggested CCPs consider setting up separate default funds for cryptocurrency derivatives should the market “materially grow” in a release published in May. While decisions regarding guarantee funds are ultimately left to the CCPs, Flanders suggests clearing members do hold some influence.
“I don’t know if in an extreme case [clearing members] could take some of their business to competing clearing houses where there wasn’t as much equivalent risk,” he says.
OCC declined to comment. CME did not return requests for comment in time for publication.
Thierry Grunspan, director of global financial institutions ratings at Standard & Poor’s, agrees that a significant hike in the trading levels of bitcoin futures – a tenfold increase at a bare minimum – would make it advisable for OCC and CME to set up separate clearing funds for the cryptocurrency contracts. In its CCP ratings, S&P assigns a positive weighting to separate clearing funds, giving a “+1” to the clearing and settlement risk scores for CCPs with separate funds.
Grunspan also agrees that if bitcoin futures trading volumes were to increase, a bank that clears bitcoin futures could see its credit rating affected.
“For the clearing members that do trade cryptocurrencies, there is clearly a direct effect,” he says. “If volumes explode, it means some of their hedge fund clients are trading heavily, so it is putting some extra risk on their shoulders. The link is direct.”
I am not saying Fitch doesn’t have a point. I just think it is very, very remote for now
Thierry Grunspan, Standard & Poor’s
Thomas Peterffy, CEO of Interactive Brokers, an electronic brokerage, says the risk within bitcoin futures clearing is mainly concentrated in the positions of non-bank FCMs’ customers.
Interactive Brokers has roughly half the open interest in bitcoin futures, Peterffy says, but charges high margins on shorts – $40,000 on CBOE’s one-bitcoin contract and $200,000 on CME’s five-bitcoin contract – and therefore clears few short positions.
Not all FCMs are as conservative with their margin requirements, he adds, leaving other clearing members left to foot the bill in a default situation.
“These are usually small clearing members who allow shorting by their clients and take a calculated risk,” Peterffy says. “In the unlikely event there is a huge price rise, the small members keep only $10 million in the company, and they will lose that and the rest of the community will pay the remainder.”
S&P’s Grunspan says FCMs not directly clearing bitcoin futures ought to remain insulated from credit rating downgrades. Their exposure, he says, is too remote and indirect.
“They would only be impacted to the extent that the creditworthiness of the CCP is jeopardised, or to the extent that the probability of the CCP tapping into its clearing fund contributions is increased,” Grunspan says. “I am not saying Fitch doesn’t have a point. I just think it is very, very remote for now.”
Moody’s follows a similar line of thinking. Arsov says the relatively small size of the cryptocurrency derivatives market, the high margins imposed by the CCPs and the banks’ generally limited participation in the market make it “not a significant concern at this stage”.
Editing by Alex Krohn