Bitcoin’s bear market fuels allure of derivatives exchanges in Hong Kong for traders to hedge bets
Once an asset class coveted for its volatility, the slump in the value of bitcoin – which has hovered below US$9,000 since May 11 this year – has cast a shadow over the entire cryptocurrency market which is not only proving hard to shift, but is getting bigger.
However, its rangebound movement is also increasingly fuelling the appeal of crypto-futures and -derivative trading platforms, as traders look for ways to leverage up their position to multiply returns.
In Hong Kong, the increasing number of crypto-futures exchanges operating in a city which is yet to set specific regulations governing their trading and buying, highlights the challenges these operators face in maintaining market order, and spells considerable risk for investors.
One such crypto-derivative exchange that has gained strong traction since its launch in 2014 is BitMEX, which claimed on July 26 it had traded a record 1 million bitcoin in 24 hours.
Another milestone that has also attested to the business’ success is its taking of an entire floor of Cheung Kong Center, one of the city’s flagship office buildings, making it the most expensive workspace in Hong Kong.
While its headquarters are in Hong Kong, the crypto-coin trading platform is registered in the Seychelles.
One of its key attractions to many investors is the up to 100-times leverage which is offered in both its daily bitcoin/yen futures contract, and its perpetual bitcoin/US dollar contract.
Arthur Hayes, BitMEX’s co-founder and chief executive, says compared with the futures contracts offered by the US derivative exchanges, CME and CBOE, BitMEX’s perpetual contracts use bitcoin as collateral (in the form of initial and maintenance margins), rather than US dollars. The high leverage, and its smaller contract notional also appeal to retail traders, he adds.
“Because cryptocurrency markets are driven by retail flow, BitMEX products have better liquidity than the CME and CBOE bitcoin products, which feature lower leverage and have a higher per contract notional,” says Hayes.
“These contracts [from CME and CBOE] appeal to the institutional traders.”
Its perpetual contract, which is similar to a futures contract but with no expiry date, can be used by traders who prefer to hold positions for the long term.
At a US$1 contract notional value, for bitcoin the initial margin is at 0.01 per cent of the prevailing bitcoin US dollar value. BitMEX claims on its website that it performs 100 audits per second.
“Due to the high leverage we offer, the numbers always have to add up, or the exchange could lose money. Therefore some of the real-time audits we perform are pre- and post-trade to ensure all profit and loss sums are zero, as are the number of long- and short contracts are summing to zero,” said Hayes.
Like many exchanges, BitMEX operates a “maker-taker” fee model, rebating traders who provide orders that do not need to be filled immediately and charges those that accept bids or take offers on their venues.
The exchange’s revenue comes from the spread between the rebate and fees.
Another exchange, Bitfinex, allows traders to use up to 3.3 times leverage through its peer-to-peer margin trading services.
The financing for such spot trading of cryptocurrencies is agreed upon and completed between two traders, and Bitfinex, which enforces the trades, is not a party to these financing contracts. Bitfinex operates in Hong Kong but is currently incorporated in the British Virgin Islands.
Meanwhile, Jim Bai, chief executive of hybrid exchange EMX, is targeting a kick-off in Hong Kong by the end of this year, and is now in the process of registering his business in Bermuda.
Currently based in Silicon Valley, California, EMX is building a derivative trading platform that offers futures contracts not only on bitcoin and ethereum, but also traditional assets including equities, commodities and fiat currencies. But traders will be paying their collateral and transaction fees with the EMX token, which is based on ethereum.
“We are working through the process of getting fully licensed by the US Commodity Futures Trading Commission but will launch in non-US jurisdictions ahead of any regulatory approval there,” said Bai.
Amid increasing popularity of cryptocurrency futures contracts, Hong Kong’s Securities and Futures Commission (SFC) issued a circular in December 2017 warning investors to be aware of such futures contracts, as it may be illegal for exchanges to offer these services without an appropriate SFC licence or its authorisation.
“Parties carrying on dealing in bitcoin futures, including those who relay or route bitcoin futures orders, are required to be licensed for Type 2 regulated activity [that is dealing in futures contracts] under the Securities and Futures Ordinance (SFO),” it said, adding “this is irrespective of whether the party is located in Hong Kong, so long as its business activities target the Hong Kong public”.
Gaven Cheong, a partner at law firm Simmons & Simmons, said although there are extraterritorial limitations to the reach of the SFO, as any entity incorporated offshore that receives trade from the Hong Kong public and executes them still needs to get itself licensed by the SFC.
“Under section 115 of the SFO – if you are ‘actively marketing’ your provision of a service from outside Hong Kong into Hong Kong, the service will also be deemed to have been carrying on a business that is a regulated activity in Hong Kong,” he says.