XBTUSD: The Philosopher’s Stone

Over the past 5 years, the USD has strengthened aggressively. This poses problems for many emerging markets (EM).

Most global commodities are priced in USD. As the USD strengthens, prices usually fall. In addition, most EM governments borrow USD denominated debt. The strong dollar decreases their commodity earnings, and makes it more expensive to roll over expiring sovereign debt. The result is a depreciating local currency.

Michael Pettis wrote an excellent book, “The Volatility Machine”, on why country balance sheet funding mismatches are the cause of most EM financial crises.

Below is a list of selected EMs whose currencies have experienced severe weakness over the past 5 years. The percentage listed is the amount the currency has depreciated vs. the USD.

  • Turkish Lira: 53.91%
  • Russian Ruble: 46.68%
  • Brazilian Real: 42.19%
  • South African Rand: 37.68%
  • Indian Rupee: 21.83%

Unfortunately, these countries import many foreign goods from developed markets. Food, clothing, and other essentials that are priced in USD or EUR must be paid for with a dwindling stock of foreign currency. As a result, consumer price inflation is high.

For local savers, the challenge is to obtain assets denominated in hard currencies. Ideally they want to own USD denominated assets. Due to immature banking systems and or capital controls, ordinary citizens find it difficult to save in USD terms.

A friend of mine in Kenya uses Bitcoin for payment. He emailed me asking if there was a way to use BitMEX to help people hedge against currency devaluation. I previously wrote about this same person in a blog post titled, “Case Study: Using Bitcoin Derivatives in Global Trade”.

BitMEX doesn’t offer a product on Bitcoin trading pairs aside from USD, CNY, and JPY. However, assuming you can obtain Bitcoin, using the BitMEX Bitcoin / USD Swap, XBTUSD, one can turn toilet paper local currency into synthetic USD held digitally. This same friend then asked if I would write a post explaining how to create synthetic USD.


Hedging Local Currency at BitMEX

Assume you have 100 units of local currency (LOC) and wish to turn this LOC into synthetic USD. The first step is to acquire Bitcoin. This may be easy or hard depending on your country. The LOC/XBT exchange rate is 100; therefore, you purchase 1 Bitcoin.

In many cases, the LOC price of Bitcoin will be more expensive than the equivalent USD price of Bitcoin. The magnitude of this premium is a representation of how difficult it is for traders to obtain USD. I will come back to this premium later.

Currently you are long 1 Bitcoin and short 100 LOC. You are exposed to Bitcoin price volatility, which is not the end goal. Now you must convert your Bitcoin into a USD asset. After that conversion, your risk becomes short LOC vs. long USD.

The BitMEX Bitcoin / USD Swap, XBTUSD, is worth $1 of Bitcoin at any price. If you are long Bitcoin, and sell XBTUSD, you lock in the USD price of Bitcoin. Since each XBTUSD contract is worth $1, you must sell 1,000 contracts to hedge your $1,000 worth of Bitcoin.

You now own 1 Bitcoin and are short 1,000 contracts of XBTUSD. BitMEX requires margin to place an order. At the minimum you must post 0.01 XBT as margin to open the short 1,000 position (100x leverage). This trade is not speculative so it is advisable to post the full 1 XBT as margin with BitMEX. By using no leverage, if the price rises your position cannot be liquidated. This may seem unintuitive, but because XBTUSD is an inverse contract, there is not unbounded potential loss for shorters.

Regardless of where the price of Bitcoin is, you will always have $1,000 worth of Bitcoin. If the price declines, the reduced USD value of your purchased Bitcoin will be offset with Bitcoin profit on the short XBTUSD position. If the price of Bitcoin rises, the increased USD value of your purchased Bitcoin will be offset with Bitcoin losses on the short XBTUSD position.

Therefore, gaining USD exposure is as simple as:

Long Synthetic USD = Long Physical Bitcoin + Short XBTUSD Swap


Earning Interest on Synthetic USD

Your synthetic USD also earns or pays interest. The XBTUSD product is a leveraged total return swap. Longs and shorts exchange interest payments every 8 hours. We call this funding, and it is used to anchor the XBTUSD price to the underlying spot price of Bitcoin.

As many like to say, Bitcoin will either be worth a lot or very little. If you short Bitcoin, the maximum unlevered return is 100%. If you go long Bitcoin, the maximum unlevered return is infinity. As a result, speculators are willing to pay high interest rates to go long Bitcoin using leverage. The funding rate swings both ways, but since May 2016, XBTUSD longs have paid shorts a total of 34.75%.

Your long synthetic USD position will most likely earn Bitcoin interest income. It is also a BitMEX liability, meaning you have BitMEX counterparty risk. Any investor must consider that the Bitcoin we custody may not be there in the future. Once created, your synthetic USD position cannot be moved off BitMEX. The possible interest income must be weighed against BitMEX counterparty risk.

In the future, you may wish to sell your synthetic USD and hold LOC again. To unwind the trade, you must first buy back your 1,000 XBTUSD contracts. The net Bitcoin amount you can withdraw from BitMEX is the sum of:

Net Profit + Net Interest Income + Initial Bitcoin Deposit

You next then convert your Bitcoin back into LOC. You initially purchased Bitcoin at a premium (P_Initial) vs. USD. At the end of the trade, you sold Bitcoin at a premium (P_Final) vs. USD. If P_Initial = P_Final then the premium did not impact your return. The degree to which P_Initial is greater or less than P_Final when you unwind the position decreases or increases your LOC return respectively.

At no time does BitMEX touch or hold physical USD on your behalf. Using derivatives and financial engineering, BitMEX can create synthetic USD exposure.