Cryptocurrency investors turn to derivatives to survive the crash
By Bloomberg | 13 Feb 2019 at 09:39hrs
Desperate to survive the collapse of their market, cryptocurrency diehards are reaching into the financial tool kit to raise some old-fashioned cash.
They've begun selling derivatives linked to digital tokens to squeeze something out of their depreciating assets. Their need is so acute that ventures run mainly by software developers and tech experts are negotiating the terms with financial pros who earned their chops on Wall Street.
It's the cost of surviving what's come to be known as the crypto winter—and a stunning turnaround from the mania that drove Bitcoin up by 1,400 percent in 2017. The most valuable token is down about 80 percent from its peak. For the other side of the trade, it's an inexpensive way to bet on a rebound.
"Anyone sitting on a stockpile of tokens saw in the bear market of 2018 that their business is at the mercy of crypto prices," said Sam Bankman-Fried, chief executive officer of Alameda Research, a quantitative trading firm for digital assets in San Francisco. "It can be crucial for those players' survival to have some cash if digital asset prices go down."
Miners, who produce new coins and verify transactions, as well as companies that raised money in the initial coin offering boom of 2017, are having to get creative to keep the lights on. They are among the main sellers of derivatives similar to covered call options, a trade popular among stock investors.
Options trading has also been propelled by a growing crowd of ex-Wall Street professionals who have quit traditional assets for crypto. Key players include QCP Capital and Akuna Capital, firms staffed by former employees of hedge funds and high frequency trading shops.
While Bitcoin futures, which were introduced in late 2017, trade on public markets managed by regulated companies such as CME Group Inc., most options trades, which began appearing about six months ago, are private bilateral contracts. That means official statistics are hard to come by.
Interviews with a dozen crypto traders and investors from New York to Sydney yielded a variety of estimates on sales volumes, from $125 million per month to $500 million, and differing views on whether the main users are professional counterparties trading between themselves, or the miners who create the digital assets and other large token holders.
For long-term holders who are stuck after the cryptocurrency collapse, the trade is a no-brainer.
Covered calls suit those who want to generate some income from assets they're holding. They limit the seller's ability to benefit from price increases past a certain point, with most of the upside of any substantial gain going to the buyer.
For example, QCP last month bought a three-month call option for a notional amount equivalent to 250 Bitcoins—or about $900,000—according to Darius Sit, a managing partner at the crypto trading firm in Singapore. The contract has a so-called strike price of $4,200, which compares with a market price at that time of $3,625.
If at expiry the market price for Bitcoin is below the $4,200 level, QCP's counterparty—in this case an ICO project—would collect a premium of $66,250 and keep its Bitcoins. If, in April, Bitcoin exceeds $4,200, the counterparty will be required to sell its 250 Bitcoins at that price, with QCP getting the rest of any gain, according to Sit.
While the market has grown rapidly, some traders point to burdensome constraints. Since there are no market standards, counterparties typically demand significantly more collateral than would be required for options on more widely accepted traditional currencies, according to Rich Rosenblum, co-founder of GSR, a Hong Kong-based algorithmic trading firm focused on digital assets.
To make matters worse, volatility, the lifeblood of options contracts, has declined in recent months, making the trades less attractive, said Cedric Jeanson, CEO of BitSpread Ltd., a blockchain asset management and advisory firm.
Still for long-term holders who are stuck after the cryptocurrency collapse, the trade is a no-brainer. Take the miners. For some of these lynchpins of the crypto ecosystem, the cost of making digital tokens now exceeds their selling price, forcing many to shut down.
Miners expected a one-way street in the heyday, overinvesting in machines and infrastructure, and made themselves vulnerable, said Dovey Wan, founding partner of crypto-asset investment fund Primitive Ventures, who splits her time between Singapore and San Francisco. The average production-weighted cash cost to create one Bitcoin was $4,060 in the fourth quarter, compared to the current market price of about $3,600, according to JPMorgan Chase & Co., making miners increasingly open to swimming with sharks.
"But they'd better be on their guard against being duped by the clued-in derivatives houses," said Sath Ganesarajah, a former Citigroup Inc. credit derivatives trader who now oversees a crypto mining operation in Vancouver. "The trading professionals will try to take the miners for a ride by getting them to sell options too cheaply."