(1) Not compliant. No SIPC coverage for customer funds and no SEC registration. This is a bigger problem for Derivabit than Mt Gox. First, it appears they are U.S.-based. Second, derivatives are closer to the U.S. definition of securities than crypto-currencies.
(2) Underlying price determination. I see the current spot price as $587. Where is this coming from? American options are continuous-time derivatives. These are sensitive to price information disruptions. Perhaps consider European or binary options?
(3) No rates or collateral markets. Options market makers need rates and collateral markets to provide liquidity and correct market aberrations through arbitrage. Rates markets are venues where one can borrow and lend capital, in BTC or U.S. dollars, to conduct Bitcoin market activity. Collateral markets are venues where one can borrow and lend Bitcoins. Non-linear derivatives market participates need collateral markets to manage their risks. Without collateral markets, volatilises for puts and calls will diverge and the market's robustness will suffer. The lack of rates and collateral markets also makes this market vulnerable to some well-known predatory trading tactics.
(4) Counterparty risk. U.S. exchange-traded equity options are centrally cleared through the Options Clearing Corporation (the "OCC"). Whether the writer of a contact pays up is irrelevant to the buyer - the OCC always pays everyone. Several layers of reserves and guarantees enhance the creditworthiness of the OCC. Counterparty credit is likely a greater risk than volatility for a Derivabit contract.
So suppose, I'm WantToBeBTCBillionaire.com broker and want to offer my customers outlets to trade, I have to pay for a seat to Internet Board of Bitcoin Exchange (IBBE), a non-profit which funds their compliance staff which will audit my finances to make sure that I'm sufficiently capitalized to take on the risks on my and my clients' option books. Also each trade I execute on behalf of my client will deducted a fee to ensure the operation of BBE.
In addition, I have to have a clearing broker, BitApex Clearing or Bitman Bachs Executions LLC whose sole role is to provide capital reserve necessary in case I default on my contracts. They'll also take a fee to ensure for each trade. And all trades that take place during the day, will be transmitted electronically to their virtual clearing house and settled T+3 days.
In addition, I as a broker will enforce strict margin calculations on all of my clients, e.g., (https://www.interactivebrokers.com/en/index.php?f=margin&p=o...) and enforce margin calls/liquidation and force my clients to wire money overnight in case they exceed their margins.
Isn't BTC suppose to be without fees though? What a scam!
For 2), I will use the MtGox mid between bid/ask as the settlement price as a few months ago, all of bitcoin exchange display this as the most authoritative. To avoid underlying price manipulation, I'll make an esoteric settlement price that is the volume weighted average of all BTC traded prices across major exchanges at a special random time on settlement day.
For 3), I will also open WantToBTCBillionaire.com as a bank where all of my depositors have to sign an electronic signature allowing me to lend their BTC out temporarily to BTC punters for short selling purpose/lending facility. The daily bank interest will be determined at the market price at which the BTC punters are willing to bid for, with me as the broker skimming a few pips to make money as well.
You are referring to mutualisation, and I agree it is a good idea. In a de-mutualised system, like Derivabit, if my counterpart farts then I alone get stuck with the downside. In a mutualised system, like the NYSE, when one counterparts fails the losses are distributed.
Mutualised systems are stronger than de-mutualised ones. Liability sharing incentivises members to watch and regulate the financial condition of their peers. And for the same reasons a diversified portfolio is safer than a concentrated one, they are more robust. Yet they also restrict who can and cannot trade (e.g. only NYSE members can trade on the NYSE).
Strong members build the foundation of a mutualised system. Having a party of Mt Goxes does nothing for market stability. Mutualising losses across the holders of an expiry seems like a reasonable middle ground. For example, if 10% of writers of options expiring on 25 March 2014 defaulted, Derivabit would not stick it to a random 10% of holders. Instead, all holders would receive a 10% "haircut" on the amount they are credited. Selling insurance on this haircut could be a future business.
> Isn't BTC suppose to be without fees though? What a scam!
There is no such thing as a free lunch.
I've always thought this is a pretty clever way of structuring a market.
You have some entity at the top, who's responsible for making good on a certain type of contract. Since it has this responsibility, it will want to make sure that the companies that mediate the selling and buying of these contracts (brokers) are able to pay them, so they put whichever requirements in place needed to make sure that they are able to pay.
Now these companies allow their customers to trade these contracts, and you can be sure that these companies will make sure that their customers can cover their obligations, cause if not, the company is forced to pay for the customer. This incentivizes the companies to make sure that their customers can pay.
We could even imagine a fourth level, where customers sell contracts onto other people, and the customers would want to make sure that these other people are able to pay, or else it's the customers that risk losing money (not whoever buys the contract in the end).
It just seems to me to be a nice way to build a well-functioning market: the incentives are in place for each participant to make sure they aren't exposed to excessive risk, or else their investors will lose their money and their employees their jobs.
EDIT: That goes for everyone else reading this too, of course. If you have any experience or thoughts in this area, please chime in.
When you talk about options trading, you need market makers. A key attribute of a market maker is that they have the ability to absorb huge losses through other investments by creating synthetic counterparts to their options to hedge risk through their HFT platforms. Without that, you're a sitting duck.
This is what Goldman or other large investment firms provide. Derivabit might work as an OTC options exchange, but the minute a large market maker arrives and provides liquidity, the OTC market will move to them.
Basically, it's really hard to displace traditional market makers because you need a bigger pile of money than them. You can't do that as a startup. You basically have to be a bank to start an options trading desk because otherwise they can (legally) run you out of the market.
(2) They're apparently using the Coinbase price (which appears to be based on the Bitstamp price). It's not clear how they're settling the options so I can't determine whether it actually matters whether there's an uninterrupted price feed or not.
(3) This is an inherent "feature" of an immature market such as this. Bitcoin seems to have skipped a step (futures). Besides, there's nothing to stop me from borrowing USD and converting it to Bitcoin in order to play around in the Bitcoin options market.
(4) Oh yes.
From a US district court judge's opinion dated 7 August 2013: "Bitcoin is a currency"
> . . . one could argue that derivatives based on the price of a Bitcoin are more akin to bets than financial derivatives
No, one couldn't. Pork bellies are definitely not a currency, but they're something of the prototypical subject of financial derivatives.
Yeah, because that carries a lot of weight...
> Pork bellies are definitely not a currency, but they're something of the prototypical subject of financial derivatives.
Pork bellies are a commodity and, as such, are regulated by the CFTC.
Intrade sold binary options depending on, among other things, the outcome of political elections. They were most definitely a bet, but they were still a security according to the CFTC.
“It is against the law to solicit U.S. persons to buy and sell commodity options, even if they are called ‘prediction’ contracts, unless they are listed for trading and traded on a CFTC-registered exchange or unless legally exempt,” http://www.outsidethebeltway.com/americans-shut-out-of-intra...
The CFTC sued Intrade in 2012, and Intrade closed its doors to US customers.
As for the price of Bitcoin? Like I said, it'll be interesting to see what the CFTC say.
Collateral markets would let one borrow and sell the underlying, in this case Bitcoins. The deepest and most reliable collateral market is the U.S. Treasury repo market. U.S. equities stock borrow markets, which enable short selling, are another example.
Collateral markets are critical to a functioning options market. Not being able to borrow Bitcoins means not being able to short. Not being able to short means not being able to convert calls into puts. It may be possible to account for this bias by dynamically adjusting the call and put margin requirements. Done improperly that risks mutating a structural risk into a counterpart one.
None of these problems are insurmountable. There are clever ways of accommodating, both in how the contracts are structured and how the market is built. This takes time and every market is different. Derivabits is, for now, in the "play and speculation" versus "serious risk management instrument" bucket.
Does that clarify my thoughts?
The fact that they require 100% margin on call options isn't as much of a concern (for simple risk management applications), because you still gain the exposure to the underlying bitcoins. It would be like if the exchange required you to submit 100 shares of MSFT to them to open the call contract, rather than using cash settlement. It's not good for liquidity because it makes it hard to be an options trader, but there will be very little liquidity anyway the way it's set up currently.
Another concern is that the guide doesn't disclose what they use as the underlying price for the contract, what exchange they use as the benchmark.
It should also be noted that they appear to require photo id in order to withdraw any funds from your wallet, which is likewise not disclosed in their guide.
In my opinion this is extremely misleading and to call such a contract a "put" and hide the real definition in a FAQ is straightforwardly wrong.
There is also a summarized version built into the trade form.
Regarding your other concerns, we'll address those with more complicated margin requirements for new contracts and multi-sig Bitcoin transactions. For now, you can just set an extremely high price limit for buying puts in exchange for the tail risk you're taking on.
Edit: buying, not selling
Wouldn't the first priority be to establish escrow with a trusted third party, or use m-of-n transactions?
At the very least, build the site with full transparency so you can prove publicly, every 24 hours, that you control the private keys to all Bitcoins entrusted to you.
For an options market to work you need both buyers and sellers of volatility. Is anyone really going to show up to sell vol here? At what kind of price?
Even if we assume that BTC is infinitely liquid and sellers of options could do theoretically perfect dynamic hedging, my guess is that implied vol is so extremely high that prices will look crazy and expensive to potential options buyers.
Edit: I also wanted to add, are you serving as counterparty to any customer transactions (for providing liquidity) or are you working with any sort of market makers?
That was the first thing I was looking for.
Actually while I have never seen a legitimate use for binary options elsewhere, they are more attractive in the bitcoin domain, where you really really want to limit downside risk. even at the expense of all other aspects of risk management...
How do the site's creators think market participants will handle these conditions?
In a way portfolio management through risk diversification isn't free lunch. For example if an investor has $1000 he can't realize a portfolio weight of 10% in a stock that is worth more than $100 per share.
Also, if there is demand for different margin requirements we'll add contracts with those requirements.
Care to speculate? ;-)
How often is margin calculation done? And what is the time period allowed for option sellers to cover their margin?
Also, what happens if my counterparty can't pay? Is the exchange going to step in and guarantee the trade?
If your counterparty can't pay, then you get the full value of their margin account for that trade (plus the premium payment, which you already received) and no more.
Suppose BTC drops 40% in value or $60 in one month, now the notional value of my BTC contract should be $40/BTC or $4,000/contract. Not only does 20 BTC valued at the original value of $2,000 no longer cover the mark-to-market value of my put contract, its market value at $1,200 covers even less that requirement.
Now suppose I'm nervous because I'm sitting on a contract that should be worth 4K when the collateral of my counterparty is only worth 1.2K. Also since I bought a put which means that I'm betting against BTC, that would only make me more nervous about counter-party risk; and I'd demand my counter-party to put up more collateral.
However, if the exchange isn't willing to extract from my counter-party and isn't willing to step in. Then, I have no confidence in such a market.
This also greatly reduces the service's usefulness as you are unable to implement many standard option strategies.
I agree with you on the other issue (though you borrow money elsewhere to simulate a lower margin).