Say what you will about Bitcoin’s ebbs and flows, the cryptocurrency’s profile just keeps rising. As it has been in the past with Bitcoin, each new player seems to increase the odds that more will join the wave.
Yet so far, Bitcoin trading volumes in U.S. dollars — done mostly on overseas exchanges in places like Slovenia and Hong Kong — have been low. Bitcoin trading hit a seven-day average of $39.5 million in December 2013. A year later, the seven-day average was about $2.6 million. A handful of U.S.-based Bitcoin-derivatives-trading companies launched during the past two years is on a mission to pour some liquidity into the Bitcoin economy. Some of these platforms are not yet in full operation, whereas others already offer traders a variety of derivative instruments, including forwards to total return swaps. But whatever the timeline for rollout, the need is there.
“The underlying commercial story line needs institutional capital markets for it to really thrive,” says Christian Martin, co-founder and CEO of TeraExchange, a derivatives exchange based in Summit, New Jersey.
The derivatives exchanges may face a bumpy road on the way to assuming the major role they expect to play, however. For one thing, bringing together the disparate world of regulated financial markets with the Bitcoin and blockchain-related businesses is fundamentally challenging because they represent two incompatible systems, according to Daniel Gallancy, co-founder and CEO of SolidX Partners, a New York–based firm that offers institutional investors total return swaps on Bitcoin. Both markets are functional markets, although the Bitcoin market is comparatively immature, he claims. “Market A doesn’t really connect to Market B, both related to logistics and information,” he explains. “We need to fix that.” One way to create those interconnections, Gallancy adds, is through derivatives that bring the liquidity of regulated financial markets to Bitcoin and “help mature the Bitcoin market” in the process.
For their part, U.S. exchange entrepreneurs see their ventures as potential powerhouses that could boost Bitcoin’s network effect — the increase in value that comes as more people join into the cryptocurrency’s trading system — by providing ways for merchants and payment processors to hedge Bitcoin inventories while also providing a pathway for new capital into the Bitcoin market.
This effect has perhaps been best described by Marc Andreessen, co-founder of Andreessen Horowitz, the venture capital firm that has invested just under $50 million in Bitcoin start-ups. “The more people who use Bitcoin, the more valuable Bitcoin is for everyone who uses it, and the higher the incentive for the next user to start using the technology,” he wrote in a New York Times op-ed a year ago. Last July Andreessen Horowitz was the lead venture capital investor in a $2.8 million round of funding for TradeBlock, a New York–based digital currency data firm that provides a Bitcoin price index used by some derivatives traders.
At the moment, TeraExchange is the only Bitcoin derivatives exchange licensed by the U.S. Commodities Futures Trading Commission. The CFTC approved the design of the company’s exchange in September 2013 and approved certification for TeraExchange to list Bitcoin forwards for execution and trading in November 2014. So far, trading in forwards is “de minimis — but that’s okay,” says Martin, “because the market is just open for business.”
Besides TeraExchange and SolidX, other fledgling Bitcoin exchanges include LedgerX, a New York company that has applied for licensing from the CFTC as both a derivatives exchange and a clearinghouse, and San Francisco–based Hedgy, a start-up that offers over-the-counter forwards through programmed smart contracts, which are computer programs that execute a deal’s terms. Hedgy contracts are based on the price index developed by TradeBlock.
Exchange entrepreneurs report that they have found commercial Bitcoin companies quite receptive to using derivatives. LedgerX co-founder and CEO Paul Chou says that in his conversations with potential customers and participants, miners and payment processors tell him they are ready to embrace derivatives to mitigate the risks they face in holding an inventory of Bitcoin. For derivatives trading truly to flourish, it needs to be based in the U.S. and with federal oversight, according to Gil Luria, chief analyst for financial technology at Wedbush Securities in Los Angeles. He says, “Bitcoin trading developed outside the U.S. first so it could develop outside U.S. regulation.” And, according to Luria, when it comes to exchanges, regulation is a good thing.
Some observers believe that the rush to build a Bitcoin derivatives market may be getting the cart before the horse, however. After all, a number of U.S.-based Bitcoin trading platforms, such as Buttercoin, Coinsetter, Kraken and SecondMarket, are engaging in either over-the-counter or cross-digital trading or both but have yet to play a prominent role in exchange-based Bitcoin-to-dollar trading, largely because of regulatory hurdles.
Nonetheless, the rise of Bitcoin mining on an institutional level has furthered the call for these derivatives, according to Arthur Hayes, co-founder and CEO of BitMEX, a start-up in Hong Kong that since last September has offered futures contracts on the price of Bitcoin in U.S. dollars. “You have more people actually mining Bitcoin, and maybe before [now] miners were happy to hold on to their Bitcoin because they were hobbyists,” he says. “But now that mining is at an industrial level, they need to sell Bitcoin to pay bills.”
Miners who earn Bitcoin from processing transactions face operating costs almost entirely in fiat currency. Recently, some miners have shut down operations temporarily because the cost of operations was higher than the value of the Bitcoin they were earning. Pending a green light from the CFTC, miners could do “call overrides,” in which they sell call options for potential upside appreciation of Bitcoin they hold, LedgerX’s Chou suggests. This would prevent miners from having to sell their Bitcoin to raise capital. Chou also expects that merchant payments processors can benefit from derivatives, removing some of the underlying selling pressure that occurs when payments processors quickly dispose of their Bitcoin inventory for fiat currency to avoid the risk that the price of Bitcoin might decline. Chou suggests payment processors might want to limit their exposure with so-called costless collars, in which they sell an upside call and buy a downside put.
The advent of several start-up exchanges has raised expectations that the tiny derivatives market can soon play a bigger role. “I think this is going to be the year that people really start focusing on derivative products, and the volume in derivatives is going to grow exponentially compared to that of the spot market,” says Hayes. There’s a precedent in the fact that derivatives trading is greater than spot trading in foreign currency markets. According to a Bank for International Settlements survey published in September 2013, foreign exchange markets averaged $5.3 trillion in trading a day in April 2013. Of that, about $2 trillion was daily trading in the spot market, and roughly $3.3 trillion was in derivatives. Hayes expects that, just as various types of financial products use forex derivatives, Bitcoin derivatives can lead to the creation of financial products such as saving products, insurance and peer-to-peer lending.
Asks an over-the-counter Bitcoin trader who works with institutional investors, At the end of the day, what’s more important: creating a vibrant trading volume in Bitcoin and U.S. dollars in the physical market in the U.S. or achieving big U.S. trading volumes in Bitcoin and U.S. dollar derivatives? “There’s always the-chicken-and-the-egg thing regarding the physical market and derivatives,” the trader says. “You need to have both for things to be successful.”
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