Bitcoin Derivatives

This is exactly what you need with your plate of mystery… a side dish of confusion.

With Bitcoin still in its infancy and still as mysterious as it ever was, two companies are taking Bitcoin trading to the next level by offering leveraged trading and swaps.

Australian-based trading platform BTC.sx has been offering its clients a means of trading Bitcoin on 10-times leverage with the potential to multiply one’s profits – and losses – 10 times faster. BTC.sx is close to securing venture capital of an undisclosed amount from a U.S. hedge fund and Asian investors to expand its operations.

On the other side of the world, New Jersey based Tera Group has drafted its own Bitcoin swaps contracts which would allow two parties to bet against each other on the future direction of Bitcoin’s price. The firm is applying to the Commodity Futures Exchange Commission for approval to list its Bitcoin swaps for trading on U.S. exchanges.

With these new ways of trading Bitcoin – in addition to Bitcoin futures offered by the Russian-based exchange ICBIT – it is Cowboys and Aliens all over again, as the wild west of Bitcoin is swarmed by the mysterious creatures of derivatives.

The Swaps

For Bitcoin to become more widely accepted, merchants need protection against sudden drops in price which can exceed 10 percent in just minutes. During periods of high volatility, a merchant’s entire profit margin could be wiped out if he doesn’t convert his Bitcoins into cash quickly enough.

On the surface, Tera Group’s proposed 25-day Bitcoin swaps seem like a great idea to protect merchants from such volatility. Swaps allow two parties to enter into an agreement with each other, where one party takes the long position while the other party takes the short position.

Here’s how a simple swap works, as applied to Bitcoin:

• Parties A and B enter into a 25-day agreement with each other over the price of Bitcoin, where Party A (a speculator) believes the price will rise in 25 days while Party B (a merchant) seeks protection in case the price falls.

• Bitcoin’s price at the start of the contract is $600, which becomes the “fixed” price of the agreement. Bitcoin’s price at the end of the contract in 25 days is known as the “floating” price, or closing price.

• When the agreement expires in 25 days, the price of Bitcoin has fallen to $500. At that time, the two parties swap payments. Party A (speculator) will pay Party B (merchant) the fixed price of $600 locked by the agreement, while Party B pays Party A the floating or closing price of $500.

The net result is that the speculator loses $100, since he bet the price would go up when in fact it fell, while the merchant wins $100, compensating him for the drop in Bitcoin’s price. Simply put, the swap is a means for hedging against volatility.

There is only one problem: very low regulation.

Even in normal swaps transactions which trade in the poorly regulated OTC (over-the-counter) market, there is no guarantee either party will uphold their end of the bargain. In the example above, Party A could simply decide not to pay Party B anything. The merchant would then be stuck with a Bitcoin worth $500 when it was worth $600 at the start of the agreement, costing the merchant his entire profit margin on the merchandise he sold 25 days ago.

Yet even with stricter regulation, Bitcoin swaps are not efficient for your average retailer such as a coffee shop or shoe store, since swaps are designed for extremely large transactions worth hundreds of thousands or even millions of dollars. Making bite-sized swaps available for small amounts of just 1 BTC – or even fractions of BTC as in the price of a coffee – would be highly impractical and would require real-time bid-ask spreads much like on a futures exchange.

For small BTC amounts, if a merchant has the time to key in a mini-swap or futures transaction at the end of each and every sale, he may as well just convert his BTC into cash and not even bother with the derivatives. It’s hard to see the availability of swaps enticing merchants to climb aboard the Bitcoin train.

While swaps might be more useful to large institutions who hold Bitcoins in very large quantities, in the end swaps will not diminish the volatility of Bitcoin prices, since swaps will remain out of the reach of the majority of participants.

Leveraged Contracts – Bitcoin on Steroids

The other platform to be wary of is leveraged Bitcoin trading through the BTC.sx exchange. Is Bitcoin not fast enough for you? Do you really want the merry-go-round to go faster? If you do, you had better hold on tight, because BTC.sx speeds things up by a factor of ten – and most riders get thrown clear off.

Here’s how BTC.sx describes its service at bitcoin forum “bitcointalk.org”:

“Introducing an intuitive trading system designed simplify leveraged (geared) trading. Our platform is designed to allow the trading of bitcoin using bitcoin without the involvement of fiat. Yes that is correct, for both long and short positions to be opened, no USD or Fiat is required.”

“When a position is opened, a deposit is taken [in Bitcoins]. Our trading engine will then place a leveraged open market order. Upon liquidation, PnL [profit/loss] will be calculated on the (closed) market order automatically. The deposit will be returned on close and profits paid out (or losses deducted).”

This is how its done with any leveraged instrument from futures to stocks. You open a position at the current price, putting up a small deposit. When you close the position, the opening price is subtracted from the closing price, and you are either credited the profit or debited the loss.

Yet on 10-times leverage, the deposit you put down is only 10 percent of the amount you buy. Thus, with just 1 bitcoin in your account you can buy 10 bitcoins on margin, rewarding you with 10 times the profit if the price goes up, or punishing you with 10 times the loss if the price falls.

If that weren’t wild enough, there is no way to protect your losing position. In normal leveraged trading, if your position is losing money to the point where your entire deposit is used up, you can still save your position by depositing more money. It’s called “answering a margin call”, where your broker gives you a small period of time in which to deposit additional funds, allowing to keep your position open if you believe the price will climb back up again.

Not so with BTC.sx. There are, as they put it, no margin calls. But not having margin calls is not a relief – it’s a concern, since the absence of margin calls gives the exchange the right to automatically close your position on a drop of just 10 percent, even if you have additional BTC available to shore up your position.

“BTC.sx reserves the right to force liquidate any position that hits its stop price,” the company explains. “Fills at that exact stop price are not guaranteed as this is dependent on market liquidity at the moment the position hits the stop. This is done to limit losses in volatile market conditions.”

During fast moving periods, you can end up losing a lot more than you bargained for, since no one can guarantee at what price your exit order will be filled at. Bitcoin has been known to drop like a stone in water within seconds, triggering forced sells at levels far below what you might be prepared for.

Further increasing the risk is that “the ticket price displayed may differ from actual execution price,” BTC.sx warns.

“In a liquid market, execution prices will beat offer prices. However at times of rapid movement and low liquidity, they may also be worse.”

This is normal in any illiquid or fast-moving market including stocks, where the fill price you get can be quite different from the price first quoted. But users of BTC.sx’s system believe there is more to it than that. They accuse the platform of deception and outright theft.

Note these complaints from Reddit and Bitcointalk:

“I’ve had trades open up and disappear when they become positive to reappear magically once I’m in loss. Funny, isn’t it? I’ve even had trades OPEN randomly when I asked to close on profit older trades, causing more than 1.5 BTC of loss of funds/profit.”

“The buy/sell spread is huge… and will never get your order filled at the price shown… They force a ridiculously low stop-loss on you which makes it almost impossible to win… The stop loss is so low that in period of volatility, the spread is so horrible that opening an order will automatically get it closed in loss.”

The list of complaints includes support tickets and help requests that go unanswered for weeks if ever at all.

Not Stable Enough

Introducing yet another floor to the Bitcoin house while its foundation is still wet and soggy is perilous.

Bitcoin derivatives such as swaps, futures and other leveraged trading vehicles simply add risk on top of risk. It’s like picking up a bar-bell while standing on a ball.

The future may hold good things for Bitcoin and its many trading vehicles. But until adequately regulated, investors will continue to be exposed to greater risks than are found at your mainstream stock market.

Investors beware.

Joseph Cafariello