With the derivatives market making its way to Bitcoin, investors should be aware of the workings of new financial products that will start appearing on the Bitcoin market. The Bitcoin ETFs that the Winklevoss brothers are hoping to introduce are just one example, and these are actually among the less complex financial derivatives. A more complex financial derivative was announced by Tera Exchange in March 2014, when it finalized a swap contract created on behalf of two clients.
But what is a swap contract? And more importantly, what can be done with it? Since Bitcoin is classified as a commodity by the Internal Revenue Service in the United States, the following will explain the basics of commodity swaps and how this translates to Bitcoin.
To begin with, there are two types of commodity swaps. Fixed-floating commodity swaps and commodity-for-interest swaps. The former type can be compared to interest rate swaps, while the latter is similar to equity swaps or total return swaps. As fixed-floating swaps are also an alternative to futures contracts, these will be covered together at a later moment in time. The remainder of the article will therefore focus on the commodity-for-interest swaps.
In a commodity-for-interest swap contract involving Bitcoins, parties would agree to exchanging variable performance for a certain money market rate (plus or minus a spread). Assume a single Bitcoin is worth $600 when such a contract is agreed for a period of 30 days. If party A is the fixed-rate payer, then party A would be entitled to receive the return on a Bitcoin after 30 days (with a minimum of zero). If Bitcoin’s value rises to $700, A would receive $100 from party B, the fixed-rate receiver. If the value were to rise to $1,000 in 30 days, A would be entitled to receive $400. Should the value drop to any point below $600, then A will not receive (or pay) any amount as a consequence.
As mentioned, the other side of the deal would be A paying a certain money market rate to B. By entering into a swap deal, party A transfers the market risk (Bitcoin price fluctuations) to party B. Party B will receive compensation for this in the form of a money market rate (including a spread). For example, assume a spread of 5 percent on top of LIBOR rates (currently 0.16 percent for 1 month) over 30 days is agreed. After 30 days, at maturity of the swap, A will then have to pay $30.96 to B regardless of what happens. Because payments (may) have to made in both ways, amounts are netted in the final settlement.
To break even on this deal, party A will hope that Bitcoin’s price will rise to at least $630.96. At this point, A would receive $30.96 back from B. A, being the fixed-rate payer, effectively has a long position in Bitcoin without actually owning the digital currency.
For B, the best possible outcome would be a Bitcoin price of $600 or less. In this scenario, B would receive the agreed amount of $30.96 and have to pay nothing to A. By using entering into this swap contract, B can speculate on flat or declining Bitcoin prices.