Earlier in the month we wrote that using CFDs provided a possible solution to arbitrage price differences among different bitcoin exchanges. Unlike taking possession of the actual digital currency, CFDs are a synthetic product that tracks the prices of bitcoins (more on the them in How to Arbitrage Bitcoins?). Offering bitcoin CFDs which can be both traded long and short have been a handful of forex and CFD brokers such as Plus500 and AvaTrade. Technically, creating CFDs for the product is rather easy, as it involves to integration of any major bitcoin exchange’s open API into a broker’s trading platform. Also, at least three technology providers, Gold-I, TLTL, and most recently Leverate, have begun to offer customized bitcoin feeds for brokers that use the MetaTrader 4 platform.
Although easy to launch, among broker sources discussing the product with Digital Currency Magnates, the two biggest hindrances of CFDs mentioned are risks associated with hedging and headline risk. In terms of headline risk, this ultimately led the decision by IG Group to cease offering binary options in bitcoins.
While headline risk appears to be subsiding somewhat, with global acceptance of the concept of digital currencies rising, hedging positions remains an issue. Trading CFDs entails brokers taking the other side of any trade with their clients. As such, when a trader buys, the broker is short bitcoins. Therefore, were clients to be net long 100 bitcoins and prices to have risen $500, the broker would be in the minus $50,000 to its traders. To mitigate this risk, brokers can hedge their positions by buying/selling bitcoins themselves. However, the downside of this method is that it limits the potential upside of trade. As a result, brokers that are acting as counterparties to their clients (referred to as market makers) aim to hedge as little as possible. In an ideal world for market makers, prices stay stable and they profit from the spread of the value between the buy and sell price.
In the forex market, market making benefits from the fact that traders often use excessive leverage; thereby becoming vulnerable to losses quickly, as well as volatility that is typically below that of other asset classes. Similarly, when bitcoins were trading around the $100 to $130 level during the summer, bitcoin CFDs were conducive to brokers.
However, after rallying to all-time highs above $1200, any broker whose clients were taking long term buy positions was vulnerable to large losses if they weren’t properly hedged. In addition, just because brokers can hedge their client’s CFD exposure by buying bitcoins on exchanges, it isn’t as easy. First of all, due to the spike in interest in bitcoins as prices rallied, deposits at many exchanges were hampered by delays. Secondly, with CFDs being offered to clients with leverage, such as 10:1 from AvaTrade, brokers would need to put up more capital to buy actual bitcoins than the money needed by their customers to purchase similar holding. With the exception of a few exchanges that provide leveraged bitcoin trading like Bitfinex, hedging creates a significant opportunity cost for brokers.
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As a result of the hedging difficulties, it appears that both Plus500 and AvaTrade may have been ‘caught with their pants down’ when bitcoin prices rallied. This was seen as both firms have enacted new trading conditions for their CFD products. At Plus500, the firm has discontinued offering 4:1 leverage to clients, and its currently only offering 1:1 trading. In addition they have effectively knocked out the availability of traders to take long term positions in bitcoin by enacting a daily contract expiration, with CFDs being closed at market prices at the end of each day. Trader desiring to take a long term position would need to buy a new CFD moments after the previous one closes.
At AvaTrade, the broker launched with a single CFD that offered 10:1 leverage. They have also gone ahead and removed leverage. However, they didn’t remove margin trading altogether, as in addition to the standard CFD, they launched a new CFD called ‘Bitcoin Weekly’. The product offers 10:1 leverage, but utilizes a weekly expiration to mitigate the broker’s risk.
More than the leverage restrictions, a greater concern that has come to the scene is whether brokers are cancelling trades of successful traders. Recently, on the Forex Peace Army website, there have been profitable Plus500 customers complaining of trades being cancelled due to ‘breach of contract’ of trading rules. While not 100% authoritative, as broker review sites can become breeding grounds for disgruntled clients who lost money legitimately, it highlight the conflict of interest that exists with CFDs. As the broker is a counterparty to trades, clients need to trust that profits will be honored.
In this regard, several technology firms have mentioned to DC Magnates that the future of bitcoins at brokers shouldn’t be focused on unhedged CFDs, but in the creation of trading products that link directly to major trading exchanges. On this front, BTC-e is reportedly involved with the forex industry as it partnered to use infrastructure from FXOpen when it launched trading on the MetaTrader 4 platform earlier this year. Overall, as bitcoin trading, and interest for digital currencies becomes mainstream, it will inevitably lead to a cross between old and innovative products merging together and the establishment of trading instruments to meet the needs of both established and new traders and brokers.