Wednesday, November 29, 2017

"Five Ways To Short Bitcoin" (and a backgrounder from Alphaville's Izabella Kaminska)

We'll get to the shorts in a second but first FT Alphaville:

Why Bitcoin futures and a shoddy market structure pose problems
There’s a popular opinion in cryptoland that the launch of bitcoin futures by the CME in December will trigger an investing rush as institutional investors and hedge funds wade into the market in size. This in turn, the theory goes, will see the price zoom even higher.

But here’s the thing. Smart money almost never takes unhedged directional bets.
To the contrary, it seeks out risk-free arbitrage opportunities that usually involve spread or basis-based trades that take advantage of market pricing anomalies.

Back in 2008, one of the biggest arbitrage opportunities of this sort came in the shape of the disconnect between US TIPs securities and conventional Treasuries, which emerged due to Lehman’s preference for using TIPs as collateral in repo trades. As the investment bank’s liquidity troubles escalated, the distressed selling of TIPs securities by the bank fueled a sharp rise in yields.

Due to the related financial panic, however, almost nobody (bar a few plucky hedge funds) was able to take advantage of the arbitrage on the table. This is because the cost of funding the trade far exceeded the potential windfalls most players could realise from it in the long run.

In the end, it was only when the Fed undertook its asset purchase programme, which included TIP securities on the shopping list, that a no-arbitrage condition was able to be reinstated. Interestingly, it didn’t even take all that much TIPs buying to do the trick.

So what’s the opportunity once the CME launches a reliable futures contract that’s both properly risk-managed and in full view of regulatory supervisors?

To understand this it’s worth taking a closer look at the details of the contract at hand. But also at why it’s been so incredibly hard to short bitcoin efficiently to date.

A few points become immediately obvious.

First, the CME contract as currently devised is set to be cash rather than physically settled. This is understandable to some degree. Imagine the security and monitoring burden for the CME of having to oversee delivery of actual (KYC/AML compliant) bitcoin into an inventory system and/or over to counterparties directly?

Cash settlement is much less of a potential liability in comparison.

And yet, it’s not without issue. Cash-settled derivatives depend on some sort of index to settle against, exposing it to Libor-style risks....

Two quick points. My first thought when the futures were announced was "How will self-styled market makers lay off their risk when they take one side or the other?" (self styled because there are no formal market makers)
Secondly, arbitrage is pure alpha and the total amount of alpha (of which arb is a subset) is very, very small.
To get self-referential, from a 2013 post:
The entire amount of alpha available to the entire hedge fund industry is only $30 billion per year.
As reported by a hedge fund maven via Investment News back in 2006: [David A. Hsieh, Duke University]....

... Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06.
This is probably just a definitional problem so let's say it plainly:

In so called risk (merger) arbitrage the emphasis is on the first word.
Cash-and-carry, buying physical and shorting a derivative is not arbitrage.
When people use the term "arbed away" when talking about market anomalies the are not talking about an arbitrage.
Shorting an ETF and buying the component equities is not an arb, it's just a hedged trade.
Same for Index Arbitrage.
The total pool of arb opportunities may be as small as $1 billion.
Even the old Royal Dutch and Shell Transport trade was not an arb, just a fairly good pair trade....
So, words matter, something to keep in mind when reading the following. These are not shorts, by definition.
And from ZeroHedge:

Five Ways To Short Bitcoin
Looking to put bitcoin’s rise in context? How about this: Over the last five years, the world’s most valuable digital currency has risen an astonishing 11,000,000%. Furthermore, since Jan. 1, it has climbed 950%, compared with a total return of 18% for the S&P 500.

Given the torrid pace of bitcoin’s climb, one would imagine that there are few traders left who possess the wherewithal to short the digital currency. And until recently, the options to short bitcoin were mostly offered through unregulated exchanges, and very risky given bitcoin’s volatility.

But increasingly, mainstream exchanges have begun offering bitcoin-based derivatives that could make it easier for retail traders to short the digital currency. CME Group has said it will introduce a suite of bitcoin-linked products by the end of the year, and LedgerX, the first CFTC-approved Swap Execution Facility (or SEF), traded more than $1 million in bitcoin swaps and options during its first week.

In Switzerland, one exchange has introduced options that make it easier for investors to profit if the bitcoin price drops. But other more creative ways to short the digital currency have existed for a while now – in some cases, for years.

“All the options to short in common markets are becoming available in the bitcoin market,” said Charles Hayter, co-founder of market tracker CryptoCompare. “There’s pretty good liquidity for shorting bitcoin. The main difference with shorting the Nasdaq for example, is it will be a lot more volatile, so there’s a lot more risk. The rate to borrow will also be a bit higher."
With bitcoin on the cusp of breaking above $10,000 for the first time, here’s a list of popular options for shorting bitcoin, per Bloomberg.

Contracts for Difference
"One of the most popular ways to short bitcoin is through CFDs, a derivative that mirrors the movements of the asset. It’s a contract between the client and the broker, where the buyer and seller of the CFD agree to settle any rise or drop in prices in cash on the contract date.

'CFD is currently a great market if you want to short bitcoin, especially ahead of that milestone 10K mark, which we think will bring some retracement,' said Naeem Aslam, a chief market analyst at TF Global Markets in London, which offers the contracts. 'The break could push the price well above $10,100 and it would be in that area when we could see some retracement.'"
Margin Trading
"Another common way to short bitcoin is through margin trading, which allows investors to borrow the cryptocurrency from a broker to make the trade. The trade goes both ways; a trader can also increase their long or short position through leverage. Depending on the funds kept as collateral to pay back the debt, this option increases the already risky bitcoin trade. Bitfinex, one of the biggest cryptocurrency exchanges, requires initial equity of 30 percent of the position.

Short-margin trading positions on Bitfinex were at around 19,188 bitcoins on Monday, versus 23,931 long positions, according to, which tracks data on the bourse."
Borrow to Short Bitcoin
"Most of the brokerages that allow margin trading will also let clients borrow bitcoin to short with no leverage. This will be a less risky way to bet bitcoin price will fall."
Futures Contracts
"The futures market isn’t as widely developed as CFDs and margin trading, but it’s still possible to make bearish bets on bitcoin with options. For now, LedgerX is the only regulated exchange and clearing agent for cryptocurrency options in the U.S. The CME Group Inc. and the Chicago Board Options Exchange have both asked for approval to list bitcoin futures, so that may open up the market to more investors."....MORE