This is a repost from Risk.net
Asia-based bitcoin derivatives exchange sees increasing hedging demand especially from China
Arthur Hayes, chief executive of Bitcoin Mercantile Exchange (BitMex) doesn’t have an office, in fact his company doesn’t even have a bank account, yet BitMex is one of a handful of bitcoin derivatives exchanges globally and the first major one in Asia outside of China that are betting on the future of the cryptocurrency.
BitMex started live trading in November 2014 and in a short space of time has launched bitcoin futures, leveraged futures and, more recently, what Hayes says is the world’s first bitcoin volatility futures contract.
“We offer financial products that allow businesses and individuals to accept, hold and transfer bitcoin without being exposed to the price volatility. We do this using futures contracts that lock in the future dollar value of bitcoin,” says Hayes who started his career as an equity derivatives trader at Deutsche and then Citi.
To date trade volume at BitMex has exceeded $5 million from a registered user base of 600 customers mainly from the US and Europe with the company adding six new customers per day. Hayes plans to launch a Chinese language version of BitMex later this year to attract customers from China, the biggest trading market for bitcoin with between 50–80% of global volumes.
BitMex’s base in Hong Kong is advantageous from a proximity perspective to China as well as from a regulatory standpoint. Regulators globally take disparate views on whether and how to regulate this new sphere of finance. In the US, bitcoin is classified as property while other regulators view it as a currency. Hong Kong takes a lighter touch classifying it as a virtual commodity, which Hayes says is like buying “World of Warcraft swords” or any other virtual product.
It also means it sits outside of the scope of regulations governing the markets for fiat currency – paper currency which isn’t backed by gold reserves.
“We are not regulated as we only use bitcoin. We have done that to be outside of traditional fiat derivatives regulation as we don’t think the new economy needs to be restrictive to do business. When we want to offer fiat derivatives versus bitcoin we will see how regulators want to regulate these products; it’s still unclear what they will do. We could be based anywhere but Hong Kong is good as it is close to China which is the largest trading market and the regulatory regime doesn’t cover bitcoin.”
Hayes says he wants to attract more bitcoin start-ups that are exposed to price volatility by accepting and holding a stock of the digital currency.
“Hedgers are people doing remittance. Some companies are disrupting the money transfer market and use bitcoin to send value between Hong Kong and the Philippines for example, and use derivatives to hedge the price risk. Payment processors like Bitpay also need to hedge as they hold an inventory of bitcoin,” says Hayes.
In the last 18 months bitcoin has experienced significant price turbulence, decreasing 90% in value from $1200 to $230. Much of the depreciation took place during a period when Mt. Gox, a Tokyo-based spot exchange for bitcoin, went bankrupt in February 2014 after a combination of fraud, theft and mismanagement led to more than 500,000 bitcoins being unaccounted for.
Hayes says that BitMex has appropriate risk controls in place to prevent such an incident. “The Mt. Gox episode was bad accounting as they didn’t know what they had versus what was on the blockchain of addresses. We have internal records of customer funds and can send tickets to check that versus the blockchain ledger,” he says. “BitMex also uses a multi-signature bitcoin wallet for all customer funds so if we are hacked there is no way that a hacker can spend any customer funds. It’s slower but safer than other wallets.”
In common with most bitcoin exchanges, Mt. Gox used a hot/cold wallet operating procedure for withdrawing funds. A hot wallet has private keys on an internet-exposed server making it vulnerable to hackers as it allows instantaneous withdrawals by customers. When the hot wallet runs out, the operators must refill it from a cold wallet where the private keys are stored offline. BitMex’s multi-signature wallet requires Hayes and his two co-founders to approve customer withdrawals.
BitMex also has strict margining procedures on its products as a risk management safeguard. Initial margin on a futures contract is 30% and maintenance margin (MM) is an additional 20%.
“We reached that figure after examining five-year historical data to find a safe level for us looking at how much the price moves in a 24-hour period,” says Hayes who also adds that margining is instantaneous in contrast to a regular exchange.
“As it’s a 24/7 market we do continuous margining. When customers get to the MM level we begin forced liquidation of positions. Using an algorithm, we liquidate the smallest amount possible of customers’ positions to get them back above the minimum threshold. It’s safer as it’s continuous pricing so you don’t get gaps like when an exchange opens the next day.”
For BitMex’s volatility futures product it takes a price snap every five minutes from the spot price and then takes a standard deviation of the price to create a daily number for customers who want to bet on the historical volatility number at the end of each day.
Digital currencies are also gaining favour for their ability to cut down settlement times for a variety of securities. Risk.net reported that Blythe Masters, the former JP Morgan executive, is involved in a start-up that uses the blockchain technology of bitcoin to reduce settlement risk and Hayes also sees this as a big advantage for the cryptocurrency.
“In the near future I don’t see why equities can’t be denominated in bitcoin. Why do we have to have five days a week trading at certain times in a certain jurisdiction? If a company wants its shares accessed globally why not have them denominated in bitcoin?” says Hayes.