The bitcoin derivatives market is slowly developing. Lynn Strongin Dodds explores the challenges and opportunities institutional investors may encounter as this space evolves
Bitcoin may have generated a great deal of buzz recently but the bubble has been pricked with prices sliding 44% over September and October to around $300 from last year’s $1,150 high, according to digital wallet provider coinbase.com. Threats of regulation among other reasons are spooking retail investors but ironically a tighter grip may entice the much sought after institutional crowd.
The digital currency made its debut in 2008 in the wake of the financial crisis as a new form of payment processing. It also gave rise to a plethora of stock exchanges although many are little more than a website and software programme registered in offshore tax havens such as the British Virgin Islands. However, there are also larger more established venues such as US-based firms coinbase and Kraken which combines forex trading and Bitcoin exchanges under one umbrella, Slovenian Bitstamp and its Bulgarian rival BTC-E as well as BTCChina, which is the country’s leading player.
There is also TeraExchange, a regulated swap execution facility (SEF) which made the news in October with the first USD/Bitcoin swap between digitalBTC, a publicly listed company on the Australian Stock Exchange and a hedging counterparty. Leonard Nuara, president and co-founder of the US based group, expects this to be only the tip of the crypto based derivative iceberg. “Bitcoin exchanges are volatile and it is difficult to manage risk when trading in such a volatile market. Thus, as bitcoin usage grows we see an increasing demand for a bitcoin derivative to manage that volatility. However, it will take time to determine the exact demand and how many transactions there will be in the near future.”
Overall volumes are thin on the exchanges. Industry figures put the combined average daily turnover on the biggest bitcoin exchanges at around $60m at current prices. This is a proverbial drop in the bucket compared to the over $5 trn that changes hands daily in the world’s traditional established currency markets. The lack of liquidity is not only contributing to the instability on the markets but also dampening its appeal as a payments vehicle even though retailers are increasingly making it available as an option.
“I do not think regulation will stifle innovation but offer the protection and clarity that investors want. Once the safeguards and reporting are in place which I think it could be in New York by the end of the year, investors will become more comfortable and liquidity will build over time.” – Ron Quaranta, CEO of Digital Currency Labs.
Although a hotly debated and controversial subject, regulation may help bitcoin’s cause. Virtual currencies had escaped the policymakers’ scrutiny until earlier this year after Mt. Gox, once the world’s largest bitcoin exchange, filed for bankruptcy in Japan after losing an estimated $480m. The incident, not surprisingly, pushed the subject higher on the legislative agenda with the New York’s Department of Financial Services proposing legislation that would require firms dealing in virtual currencies to hold certain levels of capital, hire compliance officers and obtain special licenses.
The US-based Consumer Financial Protection Bureau (CFPB) also weighed in issuing a warning to consumers about the danger of digital currencies. It said currencies like Bitcoin and Dogecoin can have volatile exchange rates, unclear costs, and are vulnerable to hacking and scams. These statements made some participants question whether the agency was ready to ink new rules. Across the pond, the UK has launched a review as to whether regulation of the sector is required while the European Banking Authority (EBA) has published a study advising banks to steer clear of virtual currencies until rules are in place.
Market participants are divided on the benefits of a more stringent environment. For example, some attendees at a recent International Monetary Fund (IMF) conference claimed it could choke off innovation while others believed it would make larger institutional investors less nervous about taking the plunge. “I do not think regulation is that necessary for bitcoin as a currency used by a large proportion of consumers,” says Pete Harris, industry expert and founder of US-based Crypto Markets & Technology. “Many of these people do not have bank accounts and do not care as much about regulation as institutions and Wall Street firms. There are a lot of exchanges out there who will not pass muster and attract institutional trading without regulation.”
Ron Quaranta, CEO of Digital Currency Labs, a financial technology and strategic advisory firm, adds, “I do not think regulation will stifle innovation but offer the protection and clarity that investors want. Once the safeguards and reporting are in place which I think it could be in New York by the end of the year, investors will become more comfortable and liquidity will build over time.”
Nuara adds, “Bitcoin swaps are not your traditional institutional instrument but we see the desire for a regulated exchange for them. We worked closely with the Commodity Futures Trading Commission (CFTC) for over six months to ensure that the swap and the Tera Bitcoin Price Index satisfied the CFTC’s rules and regulations. The index was an important tool for us to develop because it takes into account global data points as well as underlying exchange input and is not susceptible to manipulations which is what the market needs. The other difference with our exchange is that we are geared towards institutional clients whereas most of the others target retail.”
Simon Hamblin, CEO of Netagio, the first British bitcoin, gold and sterling exchange also believes regulation as well as internationally recognised standards will bolster the industry’s standing in the financial and retail communities. However, he is not sure that a completely new set of rules need to be written. “We work closely with the Isle of Man and Jersey regulators and their approach is to look at the existing structures and see what works and what doesn’t. Netagio is not regulated but we meet the European Payment Services Directive, with stringent anti-money laundering (AML) rules, ‘know your customer’ (KYC) checks and regular exchange and trade monitoring surveillance.”
It also became the first UK bitcoin company to comply with ISAE 3000, an. internationally recognised standard by the International Auditing and Assurance Standard Board (IAASB), which assesses quality of assurance work, report verification, internal compliance, corporate governance and other areas of corporate responsibility. The company also recently launched its Application Programming Interface (API) which enables institutional investors to plug in their execution management systems (EMS) and order management systems (OMS) and fully automate their trading on the exchange.
“We have had very active discussions with many institutional and professional investors since we launched in July this year,” says Hamblin. ”We wanted to offer this group of investors ease of integration via an API, which means they will be able to create their own trading strategies, using standards they recognise and that are compatible with their front end systems.”
Looking ahead, Daniel Masters, co-founder of Global Advisors Jersey Ltd which recently launched the first regulated bitcoin hedge fund – Global Advisors Bitcoin Investment Fund (GABI), says, “I see the green shoots of a full blown financial marketplace. It reminds me of the oil industry in 1985 when I started as a trader where there was only one cargo of Brent crude oil and prices were very volatile. However, over the last 15 years oil prices rallied and the market has developed significantly. I believe the same will happen with bitcoin in that prices will stabilise as the currency and technology mature.”
Want more information? DerivSource has a free Bitcoin Derivatives Special Report
This free special report includes in-depth analysis of how the world of bitcoin is coming to the derivatives market with independent coverage from DerivSource and analysis from leading Bitcoin experts.Download our free report to learn more how regulation and recent market activities may be paving the way for more institutional involvement as this new frontier emerges.
http://development.derivsource.com/content/virtual-frontier-bitcoin-derivatives-are-coming
