A group of students from Boston University has set out to build a commodity derivative exchange for digital currencies, allowing those who hold large amounts of bitcoin to hedge against market volatility.
Alt-Options, co-founded in June 2014 by Joe Zhou, Kevin Foo and Marco Cuesta, aims to act as the Chicago Mercantile Exchange for bitcoin, allowing digital currency derivatives to be publicly bought and sold instantly on its platform. The new platform launches in this month with a competition in collaboration with the College Cryptocurrency Network.
For the uninitiated, financial derivatives are simply contracts agreed upon between two parties: whoever holds the asset, in this case, bitcoin, and whoever wants to speculate on the future price of the asset. One of the most popular types of derivatives, a call, is defined as the right to purchase an asset at a preset price, called a strike price, before some date in the future. Should the market price increase above the strike price, the option owner purchases and immediately sells the asset, pocketing the difference.
In exchange for signing the contract, the option purchaser pays whoever owns the asset a small fee. Asset owners enter into these types of contracts for the guaranteed income, and the option purchasers are incentivized with the large upsides associated with this type of trading. Other popular financial derivatives include puts, where the option owner reserves the right to purchase an asset at a specific price up until a period of time, and futures, where the owner must purchase the asset at a specific price on a specific day in the future.
Users can purchase financial derivatives offered by Alt-Options in order to both speculate on large bitcoin price movements and decrease volatility. For instance, if a user believed the price of bitcoin was going to increase above $300 sometime in the next six months, he or she could purchase a call at $300 for a small fee. If the price were to reach $350 before six months passed, the user would exercise his option, the bitcoin would be sold on the open market, and the user would pocket $50. If the user’s prediction proved incorrect, the asset owner who sold him the option would simply keep the small fee.
However, if a user wanted to protect herself from a price drop below $250 in the next six months, she would purchase a put at $250 on her personal balance of bitcoin on the Alt-Options platform, again paying a small fee. Should the price fall below $250, she would exercise her right to sell her bitcoin for the strike price of $250, protecting her from volatility in the bitcoin market. And while this arrangement may not seem revolutionary, calls and puts play an important role in the world market today by allowing large players to hedge against large swings in the market.
Financial derivative exchanges have been lucrative for years. Founded in 1898, the Chicago Mercantile Exchange took in $3 billion in 2010. At the end of March 2008, the notional amount of all outstanding positions stood at $81 trillion, according to the Bank for International Settlements.
While Alt-Options is currently regulated by Financial Crimes Enforcement Network (FinCEN) regulations, it has been able to bypass stricter guidelines by using “strong partnerships with regulated (bitcoin) exchanges,” said Alt-Options co-founder Joe Zhou in a recent interview. “There are no specific guidelines regarding digital assets, but we foresee some sort of regulation or set of guidelines from the U.S. Commodity Futures Trading Commission in the future.”
Alt-Options aims to find the same volume that allowed Chicago Mercantile Exchange to prosper with bitcoin trading. With tools typically found on pro-trading platforms and American-style options for retail clients, a team of students is hoping to revolutionize the way mining firms liquidate assets, hedge risk and manage the incredible amounts of bitcoin they generate every day while allowing casual and professional traders to experiment with bitcoin.
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