Bitcoin Derivatives

Topics Covered

• What is a derivatives contract?• Bitcoin derivatives use cases• Trading considerations and risks• Simple arbitrage strategies• Present and future of Bitcoin derivatives market• BitMEX – Bitcoin Mercantile Exchange

What Is A Derivative?

• A contract between two parties based on the outcome of an event

• The underlying can be any asset or outcome• Can be either exchange traded or OTC• We will talk about CFDs, Binary Options,

Futures, Forwards, and Options

Exchange Traded vs. OTC

Exchange Traded Derivatives• Standardized contract terms• Centralized clearing and margin• Fungible

OTC (Over The Counter)• Bespoke contract terms• Margin determined counterparty by counterparty• Not fungible

Types Of Bitcoin Derivatives

Futures & Forwards Contracts• Contract to buy or sell an asset at a specified price on a

future date

CFDs (Contract For Difference)• A cash settled futures or forward contract

Options Contract• Right but not the obligation to buy or sell an asset at a

specified price on a future date.

Bitcoin Derivatives Use Cases

• Shorting Bitcoin• Reducing volatility• Allow traders to hedge future cash flows• Create more advanced Bitcoin financial products

Shorting Bitcoin

• Derivatives allow traders to synthetically sell Bitcoin they don’t own

• Alternative is to borrow Bitcoin, then sell on spot market

• Bitcoin borrow market under developed• Shorting promotes a healthy market structure

Bitcoin Volatility

Bitcoin Volatility

1 19 37 55 73 91 1091271451631811992172352532712893073250%

50%

100%

150%

200%

250%

300%

30D Realized Volatility Jul ‘13 – Jun ‘14

Bitcoin Volatility

• Derivatives allow traders to avoid the spot market

• Quicker execution allows traders to dampen price swings

• Ability to short easily dampens upward volatility• Options market allows the trading of volatility as

an asset

Hedging

Payment Processors and Merchants

Hedging Future Cash Flows

Merchant signs order to deliver shoes for fixed payment of Bitcoin in one month• Has fixed costs in USD• Will receive payment in BTC in one month• Exposed to currency risk for one month• Cannot sell BTC spot as they have not received payment• Can sell BTC, buy USD forward via a derivative

Hedging

Fund Managers

Hedging ETF Inflows

ETF listed in USD that gives exposure to Bitcoin• Investors pay USD for the ETF• Fund manager must gain long exposure to BTC• Fund manager can either buy spot or derivatives• Buying spot uses 100% cash• Buying derivatives uses < 100% cash• Excess cash can be deposited in money market funds• ETF performance is enhanced

Bitcoin Financial Products

• Principle Protected Notes• Volatility Indices and Swaps• Single Stock Bitcoin Futures Contracts

Trading Bitcoin Derivatives

Margin Calls

Margin Calls

Initial Margin• Equity required to open a position

Maintenance Margin• Minimum equity require to hold a position• If your equity falls below this level a margin call is issued

Leverage• E.g. If maintenance margin is 20%, leverage equals 5x

Counterparty Risk

Counterparty Risk

OTC Traded Derivatives• Risk that counterparty cannot pay up• Risk that counterparty loses or steals margin funds

Exchange Traded Derivatives• Risk that exchange has faulty margin policy• Risk that exchange cannot cover bankrupt traders• Risk that exchange loses or steals margin funds

Pricing Bitcoin Derivatives

CFDs, Futures, and Forwards• Covered interest rate parity• Where can you borrow and lend BTC vs. fiat• Contango vs. backwardation

Binary and Vanilla Options• Black Scholes model• Implied vs. realized volatility

Simple Arbitrage Strategies

Spot Exchange Arbitrage

Exchange A $500, Exchange B $5501. Construct a portfolio of half fiat, half BTC2. Sell BTC futures to hedge3. Deposit fiat on A, BTC on B4. Buy BTC on A, sell BTC on B5. Withdraw fiat from B and transfer BTC from A to B, and

repeat

Spot vs. Forward Arbitrage

1m BTC forward = $1,000, BTC spot = $8001. Borrow USD2. Sell USD, buy BTC on spot market @ $8003. Buy USD, sell BTC forward @ $1,0004. After one month the forward expires at the spot price5. Buy USD, sell BTC on the spot market6. Pay back your USD loan, the residual is profit7. If you borrow USD < 25%, then put on the trade

Current Derivatives Landscape

• Very few exchanges• Thinly traded• Limited number of tradable products• Expensive funding charges

Future Growth

Fiat Currency Market• Forwards and options ADV of $1.017tn (BIS)• Heavy presence of corporates and banks

Bitcoin market• Forwards and options est. ADV $0.5 – $1MM• Dominated by individual retail traders

BitMEX – Bitcoin Mercantile Exchange

• Centrally cleared exchange• Offering futures and options on BTC vs. fiat

currency pairs• Margin, profit, and loss all in Bitcoin• July 1 paper trading game with 10 BTC prize• Sign up at BitMEX.com