The Risk of Using Bitcoin CFD Brokers - the Infamous Black Swan

This guest article was written by Marcie Terman, Communications Director, First Global Credit and XBT Corp Geneva.

Meet the Infamous Black Swan

No, not the character in that painful ballet movie played by Natalie Portman, but the meme that drifts by just beyond our next trade. Everyone is convinced they can see her coming. But in actual fact, no one can.

Notice that almost all of the brokers offering mainstream stock trading into the bitcoin market support only a dozen or so markets. The reason for this is that they do not place trades into the market on behalf of their customers and charge a commission. Instead, to make a profit they make a bid / offer spread on the market being traded that is roughly around the live price in the market at that point in time. And that spread is much wider than the actual market.

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For instance, I’m looking at the live S&P futures market. Right now it has a bid / offer spread of 25 ticks. Having a peek at one of the bitcoin CFD brokers at the same time I can see a bid / offer spread of 80 ticks. Instead of charging a fixed commission as First Global Credit does, with fills returned to the customers from trades we place on their behalf onto the stock exchange, the CFD broker charges their fluctuating spreads based on market Volatility .

But if you bear with me for a moment I will point out something even more sordid at play.

Let’s say their trading customers have 5,000 shares of the S&P that are long and 10,000 shares of the S&P that are short. The 5,000 longs and 5,000 of the shorts cancel each other out. If the market goes up, the longs make the money the shorts lose. Well, what happens to the extra 5,000 shorts? They’re losing money right? But there is no actual trade in the live market, so when the shorts close their positions at a loss, the broker pockets that money. Making a profit off the loss of their customer.

What happens in the same situation if the market goes the other way? There are 5,000 extra longs making money. Where does that money come from? It comes from the broker’s proprietary account. And that’s OK. It mostly works out because the cryptocurrency CFD brokers work on the premise that most traders lose money. (Sucks doesn’t it?) They only hedge in the market when they perceive that volatility is rising and therefore there is something to worry about.

This makes their business very cost efficient because they have practically no cost of service delivery... because there are no real trades out there. And that’s why they can only offer a few contracts. They need to aggregate trading around a limited number of markets, so their customers are trading against one another and losses are perceived as manageable. And that works most of the time, but…

This is what happens when THE BLACK SWAN swims by…

(And just to be clear I will provide a hypothetical scenario that might help make my point about market prediction.)

Let’s say everyone is bearish of Tesla and Elon Musk secretly plans a trip to the moon and tragically dies during the launch of his personal mooncraft. (If not Tesla, substitute any company where an unexpected event pushes the market beyond what people expect.) But in this case let’s say there are 10,000 Tesla shorts and everyone buys back their shares at once to cash in on the big win post Mr. Musk’s untimely demise. And each one makes 10,000 USD on their trade. That’s a loss of 100,000,000 dollars or 172,413 bitcoins (at Friday’s prices). Do you think the bitcoin CFD broker is sitting on that kind of war chest? Even at 500 times leverage, that represents a loss of 200,000, Would they be able to cough that sum up and continue to meet their other market obligations? Who knows?

Over time they have put some protections in around this issue. But there is a reason mainstream brokerages do NOT do this and this practice is illegal in many jurisdictions. Ultimately I believe this is the real reason that most brokers in the bitcoin space do not say who they are. If something goes terribly wrong, they will slip away and their customers will pay for it.