BitMEX is committed to serving the needs of commercial hedgers. Commercial hedgers are merchants or payment processors who accept Bitcoin as payment and need to manage their Bitcoin vs. fiat currency risk. This manual is meant to instruct commercial hedgers on how to use BitMEX derivative products to reduce the currency risk their business faces when they choose to accept Bitcoin as a form of payment.
In this lesson, Bitcoin will be referred to with the three-letter currency code XBT. The Bitcoin / USD exchange rate is XBTUSD. The lesson will explain hedging strategies using three different types of futures contracts: XBT, XBU, and XU futures chains.
The XBT futures chain’s underlying is XBTUSD, the contract has a multiplier of 0.0001 XBT, and is quoted in USD. The value of each contract in XBT and USD depends on the XBTUSD exchange rate. Margin, profit, and loss are all denominated in XBT. This lesson will use the XBTUSD December 26, 2014 futures contract and will be referred to using the symbol XBTZ14. The below functions describe the value of a XBTZ14 contract in XBT and USD:
XBTZ14 Value in USD = 0.00001 XBT * XBTZ14 Price * Contracts * XBTUSD
XBTZ14 Value in XBT = 0.00001 XBT * XBTZ14 Price * Contracts
The XBU futures chain’s underlying is XBTUSD, each contract is worth $100 of Bitcoin and quoted in USD. Margin, profit, and loss are all denominated in XBT. This lesson will use the XBT/USD December 26, 2014 futures contract and will be referred to using the symbol XBUZ14. The below functions describe the value of a XBUZ14 contract in XBT and USD:
XBUZ14 Value in USD = $100 * Contracts
XBUZ14 Value in XBT = $100 * 1/XBUZ14 Price * Contracts
The XU futures chain’s underlying is XBTUSD, each contract is worth 0.01 XBT, and is quoted in USD. Margin, profit, and loss are all denominated in USD. This lesson will use the XBT/USD December 26, 2014 futures contract and will be referred to using the symbol XUZ14. The below functions describe the value of a XUZ14 contract in XBT and USD:
XUZ14 Value in USD = 0.01 XBT * XUZ14 Price * Contracts
XUZ14 Value in XBT = 0.01 XBT * Contracts
For the examples presented below assume the current date is Oct 1, 2014, the XBTUSD exchange rate is $800, and the USDXBT exchange rate is 0.002 XBT.
Merchant Accepts Bitcoin as Payment
The merchant is a shoe wholesaler. Normally the merchant accepts only USD as payment for their goods. Their clients order large quantities of shoes today, but will pay at the end of December. All the merchants costs are denominated in USD, i.e. salaries, rent, supplies etc. For cost savings, the merchant has decided to accept Bitcoin as a form of payment.
By taking Bitcoin for future payment, the merchant must cover their costs today in USD, but receive payment in the future in Bitcoin. The merchant cannot simply sell Bitcoin and buy USD on the spot market because the merchant has not been paid their Bitcoin yet. The merchant needs a derivative solution to forward sell Bitcoin and buy USD to hedge the currency risk until their client pays.
Merchant Hedges Using the XBTZ14 Contract
A client would like to buy $100,000 worth of shoes. Instead of paying in USD, the client would like to pay the merchant in Bitcoin when he receives the shoes on December 26, 2014. The XBTZ14 contract is currently trading $1,000, and spot XBTUSD is $800. The merchant and client must decide on an exchange rate to use for their deal. The merchant decides that because the client will pay for the goods in Bitcoin in the future, the XBTZ14 price should be used as the exchange rate. The below table summarises the merchant’s cash flows:
| Today | 12/26/2014 | |
| USD Costs | -$100,000 | |
| XBT Receipts | 100 XBT |
If the XBTUSD exchange rate rises, the merchant will make an additional profit as the XBT they receive in December will be worth more in USD. If the XBTUSD exchange rate falls, the merchant will make a loss as the XBT they receive in December will be worth less in USD. The merchant is short USD vs. long XBT or long the XBTUSD exchange rate.
The merchant uses their account at BitMEX to trade XBTZ14 contracts. The XBTZ14 contract has an underlying of XBTUSD, to correctly hedge their risk the merchant needs to sell XBTZ14 contracts. If one sells the XBTZ14 contract, one is short XBT vs. long USD or short the XBTUSD exchange rate. The following function describes how to calculate the correct number of XBTZ14 contracts to sell:
Contracts = XBT Value to Hedge / (XBTZ14 Price * 0.00001 XBT)
The merchant needs to hedge the 100 XBT they are receiving. The merchant needs to sell 10,000 contracts [10,000 = 100 XBT / ($1,000 * 0.00001 XBT)]. On December 26, 2014, the client pays the merchant 100 XBT and the XBTZ14 futures contracts expire. The below table shows the merchant’s cash flow using different XBTUSD exchange rates observed on December 26, 2014:
| XBTUSD | XBT Received | XBTZ14 PNL XBT | Total XBT | Total Value USD |
| $800 | 1,000 XBT | 20 XBT | 120 XBT | $96,000 |
| $900 | 1,000 XBT | 10 XBT | 110 XBT | $99,000 |
| $1,000 | 1,000 XBT | 0 XBT | 100 XBT | $100,000 |
| $1,100 | 1,000 XBT | -10 XBT | 90 XBT | $99,000 |
| $1,200 | 1,000 XBT | -20 XBT | 80 XBT | $96,000 |
As described above, the XBTZ14 contracts pay out in XBT. The merchant must now decide whether they will keep the XBT or convert into USD. The table above shows that the USD value of the merchant’s XBT is not fully hedged. Any deviation from a XBTUSD price of $1,000, negatively impacts the total value of the merchant’s XBT. The XBT futures chain is a quanto derivative. It is linear in XBT terms, but non-linear in USD terms. For more information about quanto derivatives, please read the BitMEX blog post XBUU14 vs. XBTU14.
The Merchant Uses the XBUZ14 Contract
A client would like to buy $100,000 worth of shoes. Instead of paying in USD, the client would like to pay the merchant in Bitcoin when he receives the shoes on December 26, 2014. The XBUZ14 contract is currently trading at $1,000, and spot XBTUSD is $800. The merchant and client must decide on an exchange rate to use for their deal. The merchant decides that because the client will pay for the goods in Bitcoin in the future, the XBUZ14 price should be used as the exchange rate. The below table summarises the merchant’s cash flows:
| Today | 12/26/2014 | |
| USD Costs | -$100,000 | |
| XBT Receipts | 100 XBT |
If the XBTUSD exchange rate rises, the merchant will make an additional profit as the XBT they receive in December will be worth more in USD. If the XBTUSD exchange rate falls, the merchant will make a loss as the XBT they receive in December will be worth less in USD. The merchant is short USD vs. long XBT or long the XBTUSD exchange rate.
The merchant uses their account at BitMEX to trade XBUZ14 contracts. The XBUZ14 contract has an underlying of XBTUSD, to correctly hedge their risk the merchant needs to sell XBUZ14 contracts. The XBUZ14 is an inverse contract meaning when one goes short one is actually going long USDXBT (the inverse of XBTUSD). Therefore, if one sells the XBUZ14 contract, one is long USD vs. short XBT or long the USDXBT exchange rate. The following function describes how to calculate the correct number of XBUZ14 contracts to sell:
Contracts = USD Value to Hedge / $100
Each XBUZ14 contract is worth $100; therefore to hedge a USD exposure of $100,000, the merchant needs to buy 1,000 contracts [1,000 = $100,000 / $100]. The below table shows the merchant’s cash flow using different XBTUSD exchange rates on December 26, 2014:
| XBTUSD | XBT Received | XBUZ14 PNL XBT | Total XBT | Total Value USD |
| $800 | 100 XBT | 25 XBT | 125 XBT | $100,000 |
| $900 | 100 XBT | 11 XBT | 111 XBT | $100,000 |
| $1,000 | 100 XBT | 0 XBT | 100 XBT | $100,000 |
| $1,100 | 100 XBT | -9 XBT | 91 XBT | $100,000 |
| $1,200 | 100 XBT | -17 XBT | 83 XBT | $100,000 |
As described above, the XBUZ14 contracts pay out in XBT. The merchant must now decide whether they will keep the XBT or convert into USD. At each given XBTUSD rate on December 26, 2014, the value of the merchant’s XBT holdings is $100,000. By hedging with the XBUZ14 contract, the merchant has eliminated their USD / Bitcoin currency risk.
The Merchant Uses the XUZ14 Contract
A client would like to buy $100,000 worth of shoes. Instead of paying in USD, the client would like to pay the merchant in Bitcoin when he receives the shoes on December 26, 2014. The XUZ14 contract is currently trading $1,000, and spot XBTUSD is $800. The merchant and client must decide on an exchange rate to use for their deal. The merchant decides that because the client will pay for the goods in Bitcoin in the future, the XUZ14 price should be used as the exchange rate. The below table summarises the merchant’s cash flows:
| Today | 12/26/2014 | |
| USD Costs | -$100,000 | |
| XBT Receipts | 100 XBT |
If the XBTUSD exchange rate rises, the merchant will make an additional profit as the XBT they receive in December will be worth more in USD. If the XBTUSD exchange rate falls, the merchant will make a loss as the XBT they receive in December will be worth less in USD. The merchant is effectively long XBT vs. short USD, or long the XBTUSD exchange rate.
The merchant uses their account at BitMEX to trade XUZ14 contracts. The XUZ14 contract has an underlying of XBTUSD, to correctly hedge their risk the merchant needs to sell XUZ14 contracts. If one sells the XUZ14 contract, one is short XBT vs. long USD or short the XBTUSD exchange rate. The following function describes how to calculate the correct number of XBTZ14 contracts to sell:
Contracts = XBT Value to Hedge / 0.01 XBT
Each XUZ14 contract is worth 0.01 XBT; therefore to hedge a XBT exposure of 100 XBT, the merchant needs to sell 10,000 contracts [10,000 = 100 XBT / 0.01 XBT]. The below table shows the merchant’s cash flow using different XBTUSD exchange rates on December 26, 2014:
| XBTUSD | XBT Received | XUZ14 PNL USD | Total Value USD |
| $800 | 100 XBT | $20,000 | $100,000 |
| $900 | 100 XBT | $10,000 | $100,000 |
| $1,000 | 100 XBT | $0 | $100,000 |
| $1,100 | 100 XBT | -$10,000 | $100,000 |
| $1,200 | 100 XBT | -$20,000 | $100,000 |
As described above, the XUZ14 contracts pay out in USD. The merchant must now decide whether they will keep the XBT received from the client, or convert into USD. At each given XBTUSD rate on December 26, 2014, the value of the merchant’s currency holdings is $100,000. Buy hedging with the XUZ14 contract, the merchant has eliminated their Bitcoin / USD currency risk.
Contango and Backwardation
The future value of any currency pair is determined by the interest rate differential between the two currencies. This means that a Bitcoin futures contract can and does trade at a premium or discount to the spot exchange rate. When a futures contract trades at a premium to spot, the futures contract is said to be in contango. When a futures contract trades at a discount to spot, the futures contract is said to be in backwardation. To understand more about these concepts, please read the BitMEX blog post Bitcoin and Interest Rates.
In all three examples above, the futures price was different from the spot price. A savvy merchant can take advantage of contango and backwardation in the futures contract to earn extra income. Instead of the merchant using the futures price to determine the amount the client pays, the merchant will use the prevailing spot price at the time of the transaction. The client will pay the merchant 125 XBT [125 XBT = $100,000 / $800] instead of 100 XBT. The below tables illustrate for each hedging option, the monetary outcome for the merchant:
Hedging using the XBTZ14 contract, the merchant will sell 15,625 contracts [15,625 = 125 XBT / (0.00001 XBT * $800)].
| XBTUSD | XBT Received | XBTZ14 PNL XBT | Total XBT | Total Value USD |
| $800 | 125 XBT | 31 XBT | 156 XBT | $125,000 |
| $900 | 125 XBT | 16 XBT | 141 XBT | $126,563 |
| $1,000 | 125 XBT | 0 XBT | 125 XBT | $125,000 |
| $1,100 | 125 XBT | -16 XBT | 109 XBT | $120,313 |
| $1,200 | 125 XBT | -31 XBT | 94 XBT | $112,500 |
Hedging using the XBUZ14 contract, the merchant will still sell 1,000 contracts as the USD value of the goods has not changed.
| XBTUSD | XBT Received | XBUZ14 PNL XBT | Total XBT | Total Value USD |
| $800 | 125 XBT | 25 XBT | 150 XBT | $120,000 |
| $900 | 125 XBT | 11 XBT | 136 XBT | $122,500 |
| $1,000 | 125 XBT | 0 XBT | 125 XBT | $125,000 |
| $1,100 | 125 XBT | -9 XBT | 116 XBT | $127,500 |
| $1,200 | 125 XBT | -17 XBT | 108 XBT | $130,000 |
Hedging using the XUZ14 contract, the merchant will sell 12,500 contracts [12,500 = 125 XBT / 0.01 XBT].
| XBTUSD | XBT Received | XUZ14 PNL USD | Total Value USD |
| $800 | 125 XBT | $25,000 | $125,000 |
| $900 | 125 XBT | $12,500 | $125,000 |
| $1,000 | 125 XBT | $0 | $125,000 |
| $1,100 | 125 XBT | -$12,500 | $125,000 |
| $1,200 | 125 XBT | -$25,000 | $125,000 |
In each example, the merchant is earning more money than before. The XBTZ14, XBUZ14, and XUZ14 are all trading at $1,000, while XBTUSD is at $800. Because the merchant is selling these contracts, they are earning an extra $200.
Merchants should always analyze whether the futures contract they use to hedge is in contango or backwardation and price their goods accordingly. An intelligent hedging strategy can allow a merchant to earn additional income.
Margin Considerations
Merchants are only allowed to trade on BitMEX once they have deposited the appropriate margin. Depending on the futures contract, the merchant will either need to post Bitcoin or USD. For XBTZ14 and XBUZ14, the merchant must post Bitcoin as margin. For XUZ14, the merchant must post USD as margin. Depending on the currency composition of the merchant’s working capital, one contract might be more attractive than another from the currency in which margin is posted.