Thursday, May 9, 2013

Futures & Options on Bitcoin: Why It Won't Work...

Just to clarify: it won't work now without significant attention from the right people.

Bitcoin would stand to benefit from some type of options or futures market, as these instruments help people mitigate their risk in other assets when used properly (yes, I'm looking at you, Dick Fuld).  Currently the only way you can protect yourself from losses in BTC is to sell at the right time, and everyone knows timing any market is very hard to do.  (Well, not so hard---just sell next time someone hacks the system, as it starts falling, then buy again in about 24 hours.  It's tricky to actually pull off, though, when currently one exchange handles most of the transactions and basically falls apart during high volume.)

Apparently, due to the denial of service attacks on Mt. Gox, the most popular Bitcoin exchange, within the past few weeks, folks have been looking to create an open-source trading platform that will allow anyone to make their own BTC exchange with all the bells & whistles they care to provide.  This not only gives users choices for where to keep and/or how to store BTCs, but also makes it more difficult for hackers to propagate an effective DoS attack because they'll have to pour more resources into bringing down more sites.  The open-source platform is called Buttercoin, and I'm sure someone could adapt it to do all sorts of futures & derivatives, at least in the software.  Several people have asked me about what it would take to do this, given some of my past exploits, but I've advised them to just stick with a straight-up bitcoin exchange with no such frills.

I'm sure the capability to trade futures and even options on BTC will exist eventually.  To do it right will require people with much deeper pockets and many more connections than your average college student or DIY enthusiast so the exchange can be properly bankrolled and publicized.  Time to market is everything; the first player to offer these kinds of products will probably gain a lot of notoriety among active Bitcoin fanatics and market watchers alike, and perhaps even the SEC if they try to set up an exchange without following their rules, obtaining licenses, collecting user info to comply with the USA PATRIOT Act, and all sorts of other things.  Existing Bitcoin exchanges have to follow the same rules, much less anyone trading options and/or futures.  However, besides making a futures exchange itself, it might be smarter to start up the harder part that most folks will probably forget about, yet will be very important to their success -- the clearing house.

One big reason deep pockets are required is the need for any BTC exchange dealing with contracts to manage exposure to risk, such as market risk or counterparty risk, brought on by the wild fluctuations of BTC itself or simply the avarice of any nefarious traders.  A good exchange will mitigate risk for itself and its participants; a sketchy exchange will leave every man to himself.  Commodity exchanges manage risks by balancing the buying power of people's accounts based on movements in their holdings on a daily basis.  Margin calls can be imposed on accounts that fall short of minimum requirements, forcing the deposit of more funds or liquidation.  Exchanges also use clearing houses to manage risks.  Most clearing houses employ sophisticated mathematical models such as Monte Carlo simulations to help figure out various things such as the right level of funding in trading accounts.  In most American markets, the Options Clearing Corporation, backed by the SEC & CFTC, is employed as a clearing house, or some exchanges use their own.  Since there are no clearing houses on BTC transactions that I know of, an exchange founder would have to start one themselves to enforce good behavior and proper account maintenance.  The exchange's compliance department would have to be powerful enough to enforce actions on users whose positions completely backfire, and be able to unwind the positions of people who can't satisfy their margin calls by liquidating part or all of the existing positions and just eating the rest of the losses.  There are still a lot of shady people using Bitcoin for illegitimate purposes, too.  Trying to get them to play by legitimate rules before they deceive exchanges and honest traders, while leaving the rest of us holding the bag for their bad bets, could be near impossible.

Margin accounts require a lot of maintenance, and a careful eye on exactly how much leverage all trading accounts are using.

For a futures exchange to guarantee maximum security for all its participants:
  • Anyone looking to buy BTC futures must have sufficient funds in their account, held in "escrow" until time of delivery or the futures position is removed.
  • Anyone selling  BTC futures must have that number of BTCs held in "escrow" until delivery time occurs or until they remove their futures position.
  • Never allow any kind of naked shorting due to the insane volatility of BTCs.
However, traders would have little reason to trust that exchanges or "bitcoin banks/brokerages" would truly hold their valuables in escrow and not just steal them outright.  There's an untrusting mentality with many of the folks who seriously back BTCs.  Plus, having to hold property in escrow isn't the way a margin account usually works; most times, the account's buying power is reduced by the maximum amount the positions would possibly cost to cover if they end up going bad.  The problem lies in that Bitcoin is so volatile, plus some of Bitcoin's biggest proponents are, say, just a little too good with computers.

One final thing: to do options on BTC, which would be the ultimate way to hedge against downside risk, whoever starts the market would need substantially deep pockets to create enough liquidity for them to really work.  Unfortunately, it would be enormously expensive to try and hedge against all that risk because there are just no other assets like BTC at all.  You can't just buy some other options contracts whose deltas add up to the opposite of the position you just took on, since all the deltas of BTC options will be correlated with each other.  And if the market becomes extremely lopsided and everyone wants to buy or sell at once, there's no way anyone looking to simply inject liquidity could ever manage to stay alive.  The options contracts would need to be treated like futures, i.e. not there until someone really wants them.  There may have to be non-standard arrangements made "over-the-counter" instead of in an organized fashion with set strikes, expiration dates, etc.  But even if you left the control in the hands of individuals, you'd still need a clearinghouse and an observant margin-watching department with some sharp teeth to make sure people behave out there, make honest deals, and don't just run away leaving someone holding the bag.

There are too many things that could go wrong if a bunch of small-time, inexperienced people try to go on building exchanges to trade Bitcoin futures and derivatives.  Unfortunately, this pretty much leaves the creation of such exchanges to those who rigged certain "casinos" in New York City and elsewhere in the first place.  It would be interesting, though, to try and build a futures & derivatives trading platform based on Buttercoin that could be used on actual licensed products.  This could promote even more transparency in markets and nurture a DIY culture among trading enthusiasts.

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