Bitcoin Derivatives, Liquidity and Counterparty Risk

With well over $1 billion in Bitcoins now in circulation, the highly volatile cryptocurrency would benefit greatly from a transparent derivatives market enabling investors and businesses to hedge the risks of dealing in it. Existing offerings in this space leave much to be desired.

The Need for a Bitcoin Derivatives Market

The headline-grabbing volatility of Bitcoins vs. the US dollar, with daily swings sometimes measured in double digit percentage terms, might provide super-sized opportunities for currency traders, but it also creates tremendous risk, both for investors and speculators and for organizations attempting to use it as an actual currency for conducting business. If a transparent market for Bitcoin derivatives were available, the value of current or future holdings in Bitcoins could be hedged, effective volatility in the market could be reduced, and the risks inherent in treating Bitcoins like a real currency rather than one big gamble could be mitigated significantly.

Although it might seem like Bitcoin currency exchanges would themselves be a natural first choice for creating a derivatives market, so far there are few public indications of any solid plans in this direction. To my knowledge, no existing Bitcoin currency exchange has even progressed to the point of providing market making services — despite the clear opportunity to enhance their own revenues by capturing the bid/ask spread for themselves, in return for providing liquidity to the market. And until exchanges are willing to become the direct counterparty to every transaction, as distinct from merely acting as a third party arranging sales between buyers and sellers, it seems unlikely that anything resembling a transparent and standardized derivatives market will emerge on their watch.

Bitcoin Futures

Case in point: the ICBIT exchange. ICBIT offers futures on BTC/USD, where for example the September 2013 contract is currently going for around $174.50. I’ll come back to the obscene steepness of the futures curve in a moment (BTC/USD is currently around $128, and the July contract at around $148.50), but the main point is that this derivatives market is neither as standardized nor as transparent as it might seem. While ICBIT provides clearing services, it is not acting as a clearing house per se. Despite the appearance of standardization, for investors trading futures on ICBIT, there is no clearing house guarantee, and counterparty risk remains largely unknown.

(Update, 14 September 2013: Previously, I had indicated that ICBIT does not act as counterparty to the futures trades it brokers. The exchange has pointed out to me that this is wrong: the exchange does act as the central counterparty for trades in futures contracts. Unfortunately, however, it does not act as a final guarantor for the clearing process itself, with the results of the clearing process still ultimately dependent upon the exchange’s ability to effect margin calls where necessary; should that process fail due to counterparty risk from individual traders, the exchange does not guarantee to make up the difference. Thus, the exchange acts as counterparty only until it decides it won’t because it is unable to extract funds from traders on the wrong side of contracts which it holds.)

This is of more than theoretical interest. The main ICBIT thread on bitcointalk.org is full of complaints from traders who argue they have lost money wrongly. Traders have objected to manipulation of the order book, lack of transparency in forced liquidations, irregularities in the twice-daily mark to market procedure, and more. From what I can tell, it appears that ICBIT is forever jumping through hoops attempting to manage the contracts fairly, when the primary underlying problem is wild variation in basic counterparty risk. Introduce a real clearing house, and many of those problems go away.

It’s not just the unknown counterparty risk and its side effects which compromise the effectiveness of ICBIT futures as a hedging mechanism, it’s also the distinct lack of liquidity — September currently shows minimal volume and open interest of around 10,000 contracts — and the steepness of the futures curve. The lack of liquidity and the correspondingly wide spread, together with the steep futures curve, make hedging an existing position in BTC relatively expensive. Buying or selling futures on ICBIT in order to hedge against changes in the value of BTC relative to the dollar means paying over the odds for the privilege of trading one uncertainty (currency risk) for another uncertainty (counterparty risk).

Other Types of Bitcoin Leverage: Margin Trading, CFDs and More

Direct margin trading in Bitcoins is also available, as are contracts for difference (CFDs), but currently both come with problems of their own.

Bitfinex offers margin trading, for example, but lending rates for both dollars and Bitcoins are extremely volatile. As with ICBIT, the exchange itself does not act as a counterparty, and margin lending comes out of a small pool of capital offered by its users. Bitfinex does offer optional ‘insurance’ to protect lenders from counterparty risk; infer what you will about risk from the fact that insurance costs a full two thousand basis points. Demand for dollars to buy Bitcoins appears to be significantly higher than demand for Bitcoins to short, with two-day dollar borrowing rates currently around 63% APR and corresponding Bitcoin borrowing rates now just over 5% APR.

US-based CampBX.com^(?) claims over 20 thousand members and margin trading/shorting once their total liquidity passes an as yet undisclosed threshold. While margin trading isn’t yet active, CampBX is at least functioning, whereas venture-backed Coinsetter appears still to be varporware. I’ve exchanged a few emails with Coinsetter CEO Jaron Lukasiewicz, and I can’t discern much yet one way or the other — except that filling in the form to request access to a private beta results in automatic subscription to a mailing list powered by AWeber, a mailing list platform famous for its integration with affiliate software and multi-level marketing schemes and its lack of requirement for any identity confirmation. (Dispensing with double-opt-in makes AWeber a favorite tool for spamming sending valuable and carefully targeted informational marketing material.) Coinsetter’s site — which, oddly, is built on HTML5 responsive bootstrap code yet doesn’t render properly on the leading mobile web browser Safari — bills it as a “professional, transparent and secure platform” providing a “levered forex trading platform for bitcoin”. There is no mention of plans to go beyond the hands-off approach of existing exchanges and act as counterparty, although the lengthy terms of use document seems to suggest it has no intention of doing so.

A new service (still in beta) at BTC.sx provides a facility which bears many similarities to CFDs, enabling investors or speculators to take highly leveraged long or short positions on the value of Bitcoin vs. the dollar. To use an example from the site’s FAQ, an initial collateral of 2 BTC in a long position can net a profit of 1.5 BTC on a price move of just $8 in BTC vs. USD. Each position comes with what amounts to a guaranteed stop loss order, preventing the customer from losing any more than their initial deposit, while enabling potentially unlimited gains. Unlike normal CFDs, the BTC.sx system is settled only in BTC: no fiat currency balances are involved. I’ve exchanged several emails with BTC.sx founder Joe Lee, and while I was originally skeptical that BTC.sx could really be offering what it seems to be offering, the underlying mathematics are now much clearer in my mind. What’s happening is that when a speculator opens a new position on BTC.sx, the system automatically calculates the corresponding position in actual Bitcoins that will ensure the worst case scenario for the position (hitting the stop loss) will be exactly covered by the speculator’s deposit. The system then opens that position in actual Bitcoins. In the background, BTC.sx is essentially providing a margin loan to cover the cost of that open market position — and charging interest on the loan. When the position is closed, the margin loan is repaid and the gains or losses are passed on to the speculator. From the standpoint of the investor or speculator, margin isn’t involved: all they see is a position worth a specified amount of Bitcoins per pip of movement in BTC vs. USD, and that position requires an initial deposit and an ongoing charge for keeping the position open.

Larger players in the traditional CFD space have also entered the BTC market, most notably Plus500^(?). The CFD provides leveraged exposure to BTC vs. USD — 1:5 leverage in the case of Plus500. Being a larger and more established operation, it’s not surprising that this traditional CFD house provides significantly lower daily maintenance costs and also lower spreads than BTC.sx, but they also provide much lower leverage. Finally, the other major player in CFDs, IG Markets, offers binary options on BTC vs. USD. However, in my view binary options are so primitive as a hedging mechanism that they are barely worth considering.

When Will We Have Real Options — Literally or Figuratively?

Futures have undeniable value for businesses trying to protect their cashflow from currency fluctuations, but for investors and speculators who view Bitcoins more as an asset than as a currency per se, there’s probably a strong interest in options rather than futures as the most attractive derivative for hedging risk. (And there’s a reason the forex options market is the largest and most liquid options market in the world: it’s serving a useful purpose.) Yet to my knowledge, not one of the existing exchanges and not one of the startups sniffing the fumes of early stage VC backing has yet committed to delivering anything like standardized options on Bitcoins. Words like “margin” and “shorting” seem relatively popular in the press releases and the forum discussions, but “put” and “call” are comparatively rare (and good luck finding “counterparty risk” more than once in a blue moon). I have to wonder: why would anyone want to take on unlimited risk to short such a volatile currency in preference to the limited risk (and typically lower margin requirement) of simply buying a put option on the same?

With well over $1 billion now in circulation, and with roughly $100 million worth of Bitcoins being exchanged per day, I am puzzled by the relative primitiveness of the finance side of the Bitcoin economy: where are the finance professionals who make it their business to nail counterparty risk, where are the standardized derivatives Bitcoin so badly needs, where are the liquidity providers who would ordinarily be eager to provide market making services in exchange for the spread? And while big venture capital firms have yet to touch the Bitcoin space in any meaningful way, smaller VCs and angel investors are dipping their toes and making a big splash about it in the press. If they are paying more attention to these kinds of basics, why don’t they make a bigger deal of it publicly?

Confidence in the future of Bitcoin and its viability for real business use could enjoy a significant boost if it were more clear that these kinds of considerations are being taken seriously.

(January 2014 Update: A handful of folks may have been confused by the fact that this article deliberately does not mention the quasi-options available on a site that likes to call itself “THE” exchange. That site does not appear in the article simply because I don’t have anything especially positive or constructive to say about it.)

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