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Show HN: Bitcoin derivatives – call and put options (derivabit.com)
95 points by ciscoriordan on March 24, 2014 | hide | past | favorite | 55 comments



Former volatility market maker here. Interesting concept, one I have considered playing with myself. Issues I see so far:

(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.


A simple way to mitigate this is to set up the BTC exchange like CBOE like NYSE, where all of the members are broker/dealers and have clearing brokers and real-time margin requirements.

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!

EDIT: 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.


> A simple way to mitigate this is to set up the BTC exchange like CBOE like NYSE

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.


> (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.

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.


I'd like to pick your brain some more, but I don't have any specific questions at this point. Would you mind continuing to talk more about this space? It's something I'm very interested in, so if you can think of more than those 4 (excellent) points then that would be very helpful. Thank you!

EDIT: That goes for everyone else reading this too, of course. If you have any experience or thoughts in this area, please chime in.


Great review of the issues here.

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.


(1) As Bitcoin has yet to be recognised/classified as a currency or security, one could argue that derivatives based on the price of a Bitcoin are more akin to bets than financial derivatives. It'll be interesting to see if the CFTC will object.

(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.


> As Bitcoin has yet to be recognised/classified as a currency or security. . .

From a US district court judge's opinion dated 7 August 2013[1]: "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.

[1]: http://ia800904.us.archive.org/35/items/gov.uscourts.txed.14...


> From a US district court judge's opinion...

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.


> (1) As Bitcoin has yet to be recognised/classified as a currency or security, one could argue that derivatives based on the price of a Bitcoin are more akin to bets than financial derivatives. It'll be interesting to see if the CFTC will object.

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.


I seem to recall that the CFTC were primarily concerned with the fact that Intrade offered options based on the price of currencies and gold. Nadex were also smacked down when they tried to offer derivatives based on US elections, so those are clearly regulated too.

As for the price of Bitcoin? Like I said, it'll be interesting to see what the CFTC say.


"one could argue" isn't worth a damn when the SEC or some other federal law enforcement agency comes knocking.


What exactly is a "rates market"? Can you provide an example of a market that fulfills this function?


Rates markets let one borrow and lend capital. Whether that capital is in U.S. dollars or Bitcoin is irrelevant so long as one can freely convert between the two. The deepest and most reliable rates market is the U.S. Treasury market. This can act as a proxy for Bitcoin - I can borrow U.S. dollars and convert them to Bitcoin. The risk of the BTC/USD slipping while I convert my dollars to Bitcoins would comprise the extra risk to Bitcoin borrowing.

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?


So is Bitfinex' "liquidity swap market" [1][2] a rates market? It's basically just people with either USD, BTC or LTC deposited with the exchange, offering to lend it out at a certain rate, and borrowers bidding to borrow it.

[1] https://www.bitfinex.com/pages/features#swap [2] http://charts-bfxdata.rhcloud.com/bitfinexLiquidityBTC.php


I would be very careful with using this for risk management. It has very different characteristics from exchange-traded options contracts that you may be familiar with in the US. Purchasing call options is pretty safe (excluding security risks, of course), but purchasing put options is quite dangerous. They have a margin requirement of 20% on put options that are written by users, but critically, this is the maximum amount of liability the put writer is taking on. So it's actually not a put you are buying, but a "bear put spread" with a lower leg 20% below the upper leg. This makes it unsuitable for managing tail risk, which, for bitcoins, is significant. For example, if you had bought a contract at $1100 which is roughly the top of the bitcoin market in December, and it fell to $600, you would only be covered for $220, and would be out $280 plus the cost of the contract (Edit: apparently this isn't correct, in another comment they say that you get the cost of the contract back).

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.


I was going to write a response disagreeing based on the assumption that, like any normal exchange, Derivabit would fully intermediate the trade. But after reading the guide, I realize you are correct! They explicitly say the maximum you could ever recover on your put option is the 20% margin.

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.


Another cause for concern is that this is a company whose only staff seem to be two engineers and a designer.[1] Do any of these guys have any experience in running a financial services business? Do they know how to comply with legal and regulatory requirements? Do they have enough capital in reserve to satisfy their financial obligations under a worst-case scenario, or will their customers be left holding the bag? The web site doesn't even state in which country this business is located.

[1] https://derivabit.com/about


I just noticed that they don't actually provide an order book or any sort of bid-ask spread information. That makes price discovery extremely challenging, and makes this even more difficult for providers of liquidity (traders, dealers, etc.). Charitably, I assume this is coming and they haven't had time to implement it yet.


The order book is at https://derivabit.com/order_book. You can drill down into specific contracts for more details.

There is also a summarized version built into the trade form.


Oh, I see. I didn't realize those line-items were clickable. For the interface of the order book you should really check out how it's displayed on a trading system or something (with bids and asks in separate columns), although it's impossible for me to know how your system would look with more orders attached.


Thanks for the suggestions, the guide has been updated.

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


According to my understanding of your materials, one isn't taking on tail-risk if one is writing puts on your site. In actuality, the price you require to write puts should be lower than if you were writing real puts, not higher.


History says if you send any bitcoins to derivabit you will duly be relieved of them by some hacker.


Seriously, the last two years are littered with the corpses of Bitcoin exchanges, wallets and trading platforms. Why would anyone send Bitcoin to a new site at this point?

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.


We use m of n locked contracts on our site, so you dont need to trust the exchange with bitcoin https://www.cointures.com


I will be interested to see if this works. Best of luck to you, but I am skeptical.

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.


What's the legality of this operation in terms of your base of operation and location of customers you are serving? Did you guys have to get a MSB license or similar oversight? Or do you think this falls into an unregulated area?

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?


We only support Bitcoin derivative instruments, which we believe to be under the CFTC's jurisdiction (http://www.law.cornell.edu/uscode/text/7/2).


Did you guys already get registered as a designated contract market?


Looks cool (like the Authy integration), but you might want to make the Guide a little more visible (https://derivabit.com/guide).

That was the first thing I was looking for.


There are reasons why this kind of thing is usually regulated. For excellent historical and introductory material, look at the coursera course "Financial Markets" from Yale (also on Youtube).

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...


Quick question about MtGox data, since the relevant crowd may be here. Do the activities of User 15 in these charts appear to have anything to do with options trading?

http://bitcoin.stamen.com/


To me that looks like attempted manipulation of the spot rate.


It's not obvious that you need to verify your identity to withdraw. It would be very easy for someone to see a deposit address and assume withdrawals would be just as friction-less.


I've added copy to the guide and the deposit modal making that more clear.


So... counterparty risk?


A couple of projects have looked at solving the trust issue by implementing a distributed exchange without counterparty risk on top of the bitcoin blockchain: https://www.counterparty.co/ http://www.mastercoin.org/. The idea is that the protocol itself handles escrow and matching orders instead of going through a centralized exchange.


This might be workable with an exchange (there still needs to be trust in the guy holding the USD). However, options markets require margin accounts. It is pretty hard to offer anyone credit without a lot of trust.


For now, steep option seller margin requirements. 100% of the underlying Bitcoin for calls, 20% for puts.


It seems conceptually crazy to me to buy a put option in such a system where I would be exposed to USD/BTC as well as having no recourse against an anonymous issuer (for 80% of the underlying price).

How do the site's creators think market participants will handle these conditions?


That's the problem with learning all about options before actually caring for the reason they exist: risk management. Options can be replicated with a portfolio, which usually requires a certain minimum size. Investors with a lesser budget would then buy the smaller units of "risk management".

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.


Right now the market can bake those risks into the option prices.

Also, if there is demand for different margin requirements we'll add contracts with those requirements.


It will be pretty interesting to see what spread emerges between calls and puts in these circumstances.

Care to speculate? ;-)


Why 20% for puts? Although loss for puts is capped at 100% of margin value, BTC is as much liable to go up 20% or 20% in a short period of time.

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?


The margin is a percentage of the underlying Bitcoin. So no margin calls.

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.


I see. Let's suppose I own a 1 contract (x100 BTC multiplier) of BTC/USD put contract at strike price $100 BTC/USD when BTC is trading at $100 USD with expiration two months from today (an at the money put). As part of initial margin requirement to enter the trade, the seller has to put down 20 BTC or cash equivalent of $2,000.

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.


So only selling covered calls are allowed, in other words?


"Covered calls" are covered by the underlying asset. That's not the same as a 100% margin requirement.


From the call writer's perspective it's indistinguishable from a covered call transaction.

This also greatly reduces the service's usefulness as you are unable to implement many standard option strategies.


The initial transaction, yes, but not the final payoffs.

I agree with you on the other issue (though you borrow money elsewhere to simulate a lower margin).


Are you Scott Hansen? Or just a fan of the musician? Just curious.


Neither. Name is from an AI character in a game called Marathon. Which was in turn named for the historical scientist/astronomer.


Is there any API to speak of?


Not yet, it's on the roadmap. Contact info in my profile.




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