Bitcoin Derivatives

Inching Towards Bitcoin Derivatives

Bitcoin derivatives are more in demand than ever, as bitcoin company executives seek to hedge balance sheet risk. A liquid futures and options exchange for bitcoin will provide commercial hedging opportunities as well as increase overall price stability. Yet the necessary methods to achieve this are contentious. Here we look at the exchange structure and exchange jurisdiction.

What are derivatives?

Derivatives are instruments derived from an underlying commodity or index. In theory, the price of the physical commodity underlies and provides the basis for pricing in the futures market due to the explicit option for physical delivery. In the case of an index, cash settlements are the norm.

Exchange structure

The emergence of derivatives in the context of bitcoin would require a bitcoin derivatives exchange to be electronic with 24/7 availability to mirror the existing markets for bitcoin trading. Warehousing partners will need to be established to accommodate the safe storage of bitcoin necessary for exchange integrity.

Ideally, the broker-dealer community will go through one of several wholesale clearing members to access the exchange for their clients, and these clearing members will underwrite the performance risk of their clients.

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Posted collateral from the clearing members can take the form of cash, bonds or other liquid instruments determined by the exchange.

Reasonable margin rules and position limits will have to be enforced to insulate the exchange and its clearing members during periods of extreme volatility.

Exchange jurisdiction

Jurisdiction is important for the enforcement of contract performance, but exchanges would not require direct regulation for legitimacy.

Properly structured exchanges could easily facilitate and apply best practices for price discovery, trade clearing and trade settlement.

Multiple jurisdictions would be preferred for bitcoin derivatives exchanges in order to prevent a single jurisdiction from exerting too much influence on an exchange.

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