Bitcoin's Parimutuel Problem (Or Why Shorting Doesn't Pay Today)

When the price of bitcoin plunges — as it did last week — seasoned investors are caught in a market that doesn't exactly have the mechanisms they're used to.

Case in point, hedging long positions, is today a difficult prospect. Unlike most traditional stocks, where investors can open a margin account with their broker that allows them to short most shares, the tools in bitcoin are few and far between.

Yet, while some see betting big on bitcoin as a gamble in and of itself, a new casino-like exchange type is filling the gap for those seeking to bet – or otherwise prepare for – the cryptocurrency's drops.

Enter parimutuel betting pools.

Far from a familiar term, it's nonetheless an important one should traders want to know what they're buying into. In simple terms, parimutuel pools are a way of speculating on the future price of cryptocurrencies without actually owning the coins themselves.

Or as Lanre Sarumi, CEO of Level Trading Field, which last month launched parimutuel pool Bitcoin Market Predictor, told CoinDesk:

Yet, their structures can differ dramatically. One might look more like a cryptocurrency Powerball, while the other is an intense derivatives exchange touting triple-digit leverage.

While their use for short exposure is a bit underdeveloped, more investors are participating in these pools – knowingly or not – to fill the gap.

And if they're not aware of the limitations and risks involved, they could end up surprised – after all, parimutuel betting isn't the most sophisticated structure for providing short exposure.

Lanre's Bitcoin Market Predictor, what he calls a "game of skill," is the latest evidence that parimutuel pools could add some cushion to the cryptocurrency market's lack of shorting options.

But while theoretically it gives users the ability to bet on bitcoin's price dipping, the rules of the game are strict, allowing only groups of 10 to bet on the price of bitcoin only 60 minutes in the future. The three players with the most accurate predictions, whether the price is up or down, split the money from the group's betting pool, so at $50 per player per round, the most an investor can make off their prediction is $225.

Obviously, this presents problems for serious retail investors, since the price of bitcoin (which they might hold) could drop substantially, and all they've done is make $225 at most betting that it would.

And if three other players predict closer to the actual price, an investor loses even the money they put in the pot.

In this way, Level Trading Field's parimutuel pool is less a sophisticated way to short bitcoin, and more an enticing platform for those interested in gambling, and only gambling on bitcoin.

Still, the latter limitation could be especially important in today's cryptocurrency market, since in early August all bitcoin investors got equal parts of another cryptocurrency, when a group of enthusiasts split from bitcoin's blockchain creating bitcoin cash.

After all, if free money is being given out to bitcoin holders, it isn't exactly to the investors benefit to be caught in a limited short position.

The bitcoin-only limitation carries over to the other end of the parimutuel betting pool spectrum with BitMEX's full-blown derivatives exchange.

The high-octane exchange is run by former Citigroup trader and ferocious bitcoin bull Arthur Hayes, who told CoinDesk its 100 times leverage was not only its differentiator, but its sex appeal. Traders come to BitMEX wanting to place high-powered bets with very little money down. But, clear that kind of colossal leverage isn't without risk.

Parimutuel betting means that one trader's gains are offset by another trader's losses — so every dollar you win is offset by a dollar someone else in the parimutuel pool has lost – which creates what Hayes calls "moral hazard."

And that hazard means if your trades are crushing it on BitMEX, there might not be enough equity in the system to pay out your winning bets.

In a way, it's like breaking the bank at a casino. If the market makes huge moves too fast, traders with losing positions have those bets closed and sold. And without enough equity in the system to payout on the other side, traders with winning positions will also be closed out early, in essence capping the returns they can get.

To Hayes's credit, he's incredibly upfront and transparent about it:

Yet, still, candid or not, this risk doesn't allow traders to get a foolproof short opportunity.

In this way, the market – however mature it's becoming – is still struggling to offer investors refined mechanisms as they prepare for another possible plunge.

Deck of cards image via Shutterstock