Coinarch, an online trading platform based in Singapore, has become the latest in a handful of companies offering derivatives based on bitcoin’s value – including what the firm says is the bitcoin world's first 'reverse convertible' investment product.
The appearance of such investment products is potentially a sign that bitcoin is maturing as a financial market, making activities like hedging easier.
The first product in the firm’s arsenal is the Booster. Designed for people wanting to bet on the rise or fall of bitcoin prices (going ‘long’, or ‘short’), it offers investors leverage to increase their potential gains.
If one person wants to bet on bitcoin prices rising, they buy the coins, with a view to selling them later at a profit. A person going short will borrow the coins, hoping for the price to fall so that they can then buy them at a reduced price later.
Coinarch manages long and short orders itself by buying and selling bitcoins. The company provides up to eight times leverage, meaning that it will boost an investor’s $1,000 position to $8,000 for example, to maximise their profit potential.
“To manage the risk on your position we need to buy eight bitcoins. So we have this line of finance,” says Coinarch co-founder and CEO Jeremy Glaros, who says that the company has raised $250,000 in capital so far. “We also have lines of credit with shareholders.”
Customer accounts are protected using a stop-loss system, which closes out the customer’s position to stop them losing more than their initial investment, Glaros says. The company also charges interest and a gap protection fee to customers.
Earning interest on bitcoins
The more complex product is the Maximiser. This investment vehicle is designed for customers who don’t expect bitcoin prices to rise in the short term, but still want to earn interest on the bitcoins that they hold.
Maximiser offers them the chance to earn up to 50% interest, while also buying bitcoins along the way if the price drops.
Customers investing in the Maximiser set an maturity date for their investment. They also agree to purchase bitcoins at a discount to the market price, known as the ‘strike’, when the investment matures.
The Maximiser then calculates a cash settlement price, which is the original amount invested plus a predetermined interest rate based on the maturity date and the strike.
If the bitcoin price is below the strike when the Maximiser matures, the customer must buy the bitcoins at the strike price. If it finishes higher, they receive the cash settlement.
The Maximiser arrangement exposes the customer to losses should the bitcoin price drop substantially by the Maximiser’s maturity date, but it also gives them a healthy return on their investment should the market stay relatively static.
Profiting from volatility
Glaros explains that Coinarch makes its money on volatility with the Maximiser, using a probability model to determine how many bitcoins it should buy at the market price at set intervals.
The firm’s internal modelling will offer a probability of bitcoin finishing below the strike price, based on the current market price.
For example, when a customer invests in bitcoin at $400 with a strike of 95%, the strike price is $380. At a current market price of $400, there might be a 25% probability that the Maximiser matures below the strike price (although the model is complex and the real probability may be different).
To hedge its risk, at this point the firm buys 25% of a bitcoin (0.25 bitcoins) at that current market price.
If the bitcoin subsequently moves from $400 to $500, then the probability of the price finishing below $380 drops (it might drop to 5% for the sake of example). So the firm only needs 5% of a bitcoin.
To balance things, the firm sells the 20% of a bitcoin that it doesn’t need, but this time at price per BTC of $500, profiting 20% of the $100 price movement.
A bitcoin first
Coinarch makes money on the downside too, Glaros says, because the customer has agreed to buy bitcoins from it at the key price, effectively protecting it.
If the price drops to $200 from $400, the probability of the Maximiser finishing below the $380 strike price is higher (say, for example, 75%). So the firm buys 0.75 bitcoins at the lower price. If the Maximiser does indeed mature below the strike, then the customer must buy those bitcoins from Coinarch for the $380 strike price.
In investment banking circles, the Maximiser is what’s known as a reverse convertible, exposing customers to downside risk in return for potential interest.
Glaros claims it’s the first such security to make its way from the investment banking community into the bitcoin world:
The Maximiser relies heavily on volatility to make money for the provider. Bitcoin’s volatility has shrunk during 2014, perhaps due to greater liquidity. Below is a chart from btcvol.info, which takes its data from CoinDesks’s Bitcoin Price Index:Glaros conceded that Coinarch’s profit potential on convertible notes shrinks as volatility flattens out, explaining:
You can go long or short on bitcoin with Coinarch, or you can sit back and collect the interest in a stable market. But with bitcoin having been in an apparent free-fall recently, it’ll be a brave investor who’d expect the cryptocurrency’s fortunes to stay stable at the time of writing.
Disclaimer: This article should not be viewed as an endorsement of any of the companies mentioned. Please do your own extensive research before considering investing any funds in these products.
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