Cash Versus Physical Settlement

What’s the difference between cash and physical settlement?  Why is it important and does it make a difference?

The Bitcoin exchanges are getting going.  As I have said in the past, the ones prior to Coinbase and Winklevoss are not “exchanges” in the classic sense because they have no back office and use accounting methods to value margin rather than statistical analysis.  I am not sure what all the exchanges have planned, but let’s hope a working on the run clearing operation is a part of it.

One choice these exchanges have to make is physical versus cash settlement.  There are arguments for both.  The settlement needs to be tailored to the market the contract is being created for.

Almost all new futures contracts that are created today are cash settled.  That means there is some index that is created.  A futures contract trades around that index.  On the last trading day, positions are marked to the index, and the difference is paid out, or collected in cash.  Cash settlement is very simple, and cheaper to do than physical settlement.

But, there is an argument for physical settlement.  Live Cattle ($LE_F) futures at CME are physically settled.  Lean Hogs ($HE_F) are not.  Crude oil ($CL_F) is physically settled.  A contract owner literally pulls a truck up to the spigot in Cushing, OK and takes delivery.  Most of the grain contracts are physically settled.  Lumber is not.

Traders feel the threat of actually getting product delivered helps to limit speculation.  When you get to first notice day, the true speculators jump ship.  They don’t want to deal with delivery.

We used to joke that if we wanted to host the world’s biggest barbeque, all we had to do was take delivery of one cattle contract.  One time,  $CME trader Stuart Gimbal wound up taking delivery of lumber contracts when they were physically delivered.  He was up in the office calling all over Canada and the Northwest to sell his lumber.  Someone looked out the window at the Chicago River and saw a barge tooling down it, laden with stud lumber.  They said, “Hey Stu, look out the window!  Here comes your fucking lumber now!”

Physical delivery is difficult because the exchange has to examine, and contract with the delivery points.  Delivery points can sometimes make or break a contract.  They get political.  In the 1990’s, there was a big controversy at the CBOT over using the Illinois River for grain delivery.  By adding in Nebraska delivery points in Live Cattle, it changed the quality of beef, and changed the contract.  The delivery point can cause a mismatch between the market and the underlying futures contract being used to manage risk.

I advocate for physical delivery of anyone doing Bitcoin futures for a variety of reasons.

1. The threat of physical delivery puts speculators on notice.  They better have the bank account to accept delivery, and the bank facility (wallet) to deposit into.
2. Physical delivery will cause more accounts to actually be set up and used denominated in Bitcoin
3. It’s good for market liquidity for more and more accounts to hold Bitcoin-not unlike bank accounts at banks.
4. Physical delivery will bring discipline to the exchange, and the back office.
5. Current FX contracts are physically delivered at regulated exchanges.  Making Bitcoin trade similarly jives with current FX market behavior.
6. Physical delivery is more of a match between the cash Bitcoin market and the Futures Bitcoin market.  An Index might not necessarily track the cash.
7. I think the Bitcoin market will be “winner take all”.  I don’t think more than one exchange will attract enough liquidity to have a meaningful price discovered market.

Physical delivery is more expensive.  But in the long run I think it tracks the market, would be better for the overall ecosystem, and will make the contract more successful over the long run than a cash settled index.