Tag Archives: Bitcoin

Hedging Cryptocurrency

Hedging Cryptocurrency

In search of cryptocurrency hedging solutions

Bitcoin cryptocurrencySomeone stopped by my Fiverr hedging gig the other day shopping for a Bitcoin hedging solution. He described himself as a digital currency dealer. After I explained that my exposure to digital currency (or so-called cryptocurrency) was slim to none, I agreed to investigate further to see if I could help him. After all, traditional hedging concepts should apply regardless the currency.

I embarked on a crash course on crtypocurrency. Bitcoin and its cousin rivals such as Ethereum and Litecoin represent a growing trend to implement currencies that work well with today’s digital commerce. These digital currencies seek to avoid government interference, precious metal backing, and other traditional currency entanglements. After my jet-ski tour of the subject, I traded thoughts with my potential client. We concluded that the markets and the currencies were not mature enough to allow for a hopeful hedge.

Our “cryptocurrency waltz” was a reminder of some significant considerations when hedging any type of commodity price risk. While bitcoin may have received some bad press due to Internet banditry, trading exchanges gone belly up, and the new currency’s “Wild West” feel, that doesn’t mean that it is going away anytime soon. To the contrary, CME Group began tracking it in November 2016, a telltale sign that the currency is gaining legitimacy. If it continues to catch on, then an adequate hedging tool for it is as important as having one for the US Dollar, coffee, corn, or gasoline.

To understand why we concluded it was not yet time to hedge Bitcoin price risk, see this separate blog post that explains five hedging issues for thinly traded commodities.

Future considerations for hedging cryptocurrency

If you own some currency price risk pertaining to a digital currency like Bitcoin and you aren’t speculating on favorable price changes, then I suspect you’ll conclude, like we did, that it’s still early in the game to find an adequate hedging solution. However, one may be coming down the road at the same speed as the growth of these digital currencies. Hang in there. Your patience will be rewarded.

CME Group’s tracking of an index for Bitcoin bodes well for the prospect of a futures contract at a later date. US-based CME Group is the largest exchange for hedging instruments in the world, offering contracts in most commodities. It has time-tested measures in place to protect market participants and may provide more comfort than today’s Bitcoin hedging alternatives. Regardless, always do your homework on possible trading partners before trading with them.

Chart USD Hedging Issues

5 Hedging Issues for a Thin Commodity

Chart USD Hedging IssuesHedging can be difficult enough for mature products. However, with some commodities, hedging issues may prevent you from even attempting to protect against price changes. Sometimes, you can add more risk to what you’re already trying to manage. For lack of a better term, I’ll refer to these hard-to-hedge products as “thin commodities.”

Recently, I tried to help an individual find a hedging solution for Bitcoin. That exercise proved fruitless for the same reasons that any new or otherwise thinly traded commodity may prove difficult to hedge. Here are five hedging issues for anyone who is seeking to protect thin commodities:

Issue #1: Counterparty credit risk

When hedging instruments increase in value, you must be able to collect the proceeds in a timely fashion. What is the financial wherewithal behind the counterparty to your trade, whether it be an exchange or a one-off trading partner? Up-front due diligence can help establish that the entity on the other side of your hedging position has the capacity to honor its commitment.

If you are dealing with an exchange, what procedures and safeguards does the exchange have making it likely that you can receive timely and full payment? If you have a dispute, how will you settle it, especially in an international setting? Note that some Bitcoin trading exchanges have already left investors holding an empty bag.

Issue #2: Insufficient liquidity

Futures markets need enough trade liquidity to allow for fair pricing and the ability to trade on short notice. Trade timing must be flexible enough to allow the hedger to trade his hedge positions simultaneous with “physical” deals on the index at risk.

When the hedger takes on risk with Bitcoin, for example, she must simultaneously enter a hedging position to oppose and thus offset the risk. The same holds true when the Bitcoin risk changes or goes away. In the cryptocurrency markets, this trade liquidity appears suspect at present.

Issue #3: Inadequate price correlation

Price correlation is a critical aspect of an effective hedge. Sometimes, however, a hedging instrument is a poor proxy for the price of the commodity or index it is designed to protect.

For example, the price of a futures contract factors in both current and anticipated supply and demand imbalances as seen by market participants. A future price of a commodity or index may differ substantially from current pricing for a variety of unpredictable and uncontrollable reasons.

In the case of Bitcoin, the market may still lack sufficient participation to provide pricing that truly reflects the marketplace and is devoid of significant manipulation by deep-pocketed speculators.

As an example, last week I looked at the price of Bitcoin futures on one futures exchange, Deribit. The Bitcoin contracts are quarterly (and three months may be too much time for a reliable price proxy on a hedged index). The price between the June and September contracts differed substantially. Today, when I compared those same contracts, they were close in value. So in the past week, those two contracts had poor price correlation. One of them changed much more than the other. And at least one of them would have been a poor price proxy for spot market Bitcoin.

Issue #4: Cash requirements

Many counterparties to hedging transactions will require margin (collateral) to protect their price exposure if their positions go against them. Often, however, they will not afford their trading partner the same treatment.

Understand and negotiate, if possible, the cash flow that may be required to hold your positions if the price of the hedging instruments goes against you. Presumably, that price movement will result in gains in the spot market. When you add this gain to your hedging loss, you are made whole. However, you may be unable to convert the gain to cash fast enough to pay for the loss on your hedging position.

Issue #5: Execution costs

Factor the cost of any trading, exchange, or margining fees into your hedging analysis. Make sure these fees are reasonable and do not leave you wishing that you had self-insured the risk.

Help is on the way

For additional explanation of related hedging issues, including the risks associated with hedging, the role of futures exchanges, and how hedge instruments work, check out my e-book on Amazon entitled Hedging Commodity Price Risk. It will help you understand hedging better and guide you through some relevant issues on your hedging program, no matter the commodity.

If I can be of service for any of your hedging needs or questions, please don’t hesitate to contact me via the contact form on this website or, if you prefer, through my hedging gig on Fiverr.