The USD is the biggest shitcoin out there. However, all assets are priced against it. Crypto is not immune. The Bitcoin / USD price is the most important cross in the crypto asset universe.
Moving into the altcoin space, the most active crosses are against the USD as well. To replicate our inverse style derivatives on an altcoin / USD cross requires us to accept the altcoin in question as collateral. The next natural altcoin BitMEX could accept is Ether. However, to fit into our multi-sig security process, it requires us to use/code an Ethereum multi-sig smart contract.
Unfortunately, due to various exploits of popular Ethereum multi-sig smart contracts, we never felt comfortable custodying Ether. Rule 1, to infinity minus 1, of operating a crypto trading platform, is don’t lose the crypto. Anything we can do to limit our risk surface area we must do. Therefore, taking Ether as collateral given the current state of the protocol is a non-starter.
Given these constraints, we cannot launch an Ether margined inverse ETHUSD contract. An inverse style contract is one where the margin and PNL currency is denominated in the home currency (ETH), the quote currency is denominated in the foreign currency (USD), and the contract value is a nominal amount of the foreign currency (USD).
Inverse Contract Example: XBTUSD Swap
Margin Currency: XBT (Bitcoin)
Quote Currency: USD
Contract Value: $1
In order to offer risk on ETH/USD where Bitcoin is used as the margin and PNL currency, the quanto derivative type is necessary.
A quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate risk.
Quantos are exotic derivatives that can move non-linearly with respect to the underlying. However, they are very beneficial for speculators and hedgers in search of liquidity, where they can post margin in a currency in which they feel comfortable. In my time as a delta one trader, we routinely traded USD quanto derivatives to get exposure to local currency futures contracts in countries that restricted the trading ability of foreigners (e.g. India and Taiwan).
The recently launched BitMEX ETHUSD Perpetual Swap is a quanto derivative. The contract pays out 0.000001 XBT per 1 USD. This means that the Bitcoin multiplier is constant regardless of the nominal USD price of ETH. This is great for speculators, the Bitcoin return varies linearly with respect to the ETHUSD price. For those using this contract to hedge the ETH/USD cross or market makers, it gets a bit trickier. I will get into the mechanics of hedging and market-making later in this newsletter.
Quanto Worked Example Spreadsheet
We have created a spreadsheet for users to download and work through some of the below use cases that can be accessed here.