BitMEX Bitcoin Hedging Futures Reborn

hedge

In the past few months, BitMEX has shifted focus towards speculative Bitcoin trading products. Our most successful product, is the 100x leveraged Bitcoin / USD daily futures contract, XBT24H. We have not forgotten about the hedging needs of the community. In order to increase liquidity in our Bitcoin Hedging XBU chain of futures contracts, we have reduced the maturity and restructured the fee schedule.

The BitMEX Bitcoin / USD Hedging Weekly Futures Contract, XBU7D, will expire every Friday at 12:00 GMT. The settlement price will be based on the two hour Time Weighted Average Price (TWAP) from 10:00 GMT to 12:00 GMT on the TradeBlock XBX Index. XBU7D goes live Friday December 25 12:00 GMT.

XBU7D is called a hedging futures contract because BitMEX guarantees settlement. Unlike the highly leveraged Bitcoin Speculation futures contracts, there are no profit adjustments. BitMEX is able to guarantee settlement because of a conservative margin policy. When placing an order, traders are granted 3.33x leverage (an initial margin of 30%). Traders are margin called once the leverage rises above 5x (a maintenance margin of 20%). BitMEX will use the 20% equity remaining to close out the position at prevailing market prices. BitMEX will close positions until a trader’s effective leverage has fallen below 5x. For more details about the margin policy for the hedging contracts, please read Margin Call and Liquidation.

In order to attract more liquidity, the fee schedule has been restructured. Makers who provide liquidity will be paid 0.10%. Takers will pay 0.30%.

BitMEX for Commercial Hedgers

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.