How Does Bitfinex Funding Work?

If you have spare bitcoins kicking around, one way to use them is by lending them out to margin traders on an exchange such as Bitfinex. This post will explain how the Bitfinex funding market works, and how you can use it to earn more bitcoins (and even US dollar tether).

Bitfinex is a cryptocurrency exchange. Users can signup to Bitfinex to trade cryptocurrencies such as bitcoins, ethereum, bitcoin cash, and many others. One of the unique features of Bitfinex is their margin funding markets. For users who want to add leverage to their positions and users who want to earn interest on their bitcoins, Bitfinex offers a margin funding order book where those users can exchange margin funding with each other. So if you’re a trader with a bullish view on ETH over BTC, you can actually borrow BTC on Bitfinex and use those borrowed funds to jack up your ETHBTC position. This funding isn’t free, so users can also choose to lend those BTC and earn a daily interest rate.  The user funding market is an ingenious feature offered by Bitfinex which is one of the main reasons the exchange has attracted so much volume. Whereas a typical margin loan is made by a broker or dealer, as the exchange Bitfinex cuts out these middleman (as they remain as the middleman themselves).

What kinds of rates can lenders expect to receive? Since Bitfinex runs an open order book for funding, the rate you will receive is simply result of of supply and demand, and so the rate you will receive will fluctuate as the market dictates. Rates are quoted as percent per day. To find the simply daily annualized rate, multiply by 365 or use your own formula to find an APR. Follow this link to BFXdata where you can view historical Bitfinex funding rates. You will see that bitcoin funding mostly range from 0.01% per day and sometimes spike up to 0.60% per day.

What are the risks? Other than interest rate risk, and the risk that their bitcoins fall against your own unit of account (your home fiat currency?), the main risks that Bitfinex lenders face is the default risk of borrowers and the credit risk of Bitfinex itself. The risk that borrowers default is actually very low, in fact its so low that you will probably never have a borrow default on a loan. Why?  Because of the Bitfinex margin limits. Follow this link for a description of the margin rules. Bitfinex borrowers receive a margin call when the net value of their account equity reaches 22.5%. When the net value of their account falls below 15% of your borrowed funding value, the position will be force-liquidated.  Since Bitfinex is a very liquid exchange, and since there are so many ways to arbitrage the bitcoin price, the exchange can virtually always liquidate positions to make the lender whole.

The credit risk of Bitfinex is the main risk for lenders. Even though the risk of any individual defaulting is very low (virtually non-existent), the main risk is Bitfinex itself goes bust or gets hacked, and this is not pie in the sky, its happened before and it could happen again. I personally think the risk of Bitfinex being hacked again in a major way is low, the rate of return users can earn by funding margin loans reflects this risk.  Bitfinex funding does not earn you free money. I hope eventually clearing houses (maybe blockchain based clearinghouses?) will emerge to reduce the exchange default risk.

So, you want to earn some bitcoin interest by lending your funds out on Bitfinex? After you open an account, you deposit your bitcoins, and move them to your funding wallet. Now you can place an order to lend out your coins using similar mechanics to trading stocks and cryptos. There is an order book with bids and offers, choose your strategy and work your lending book. You can use the Bitfinex Flash Return Rate (FRR) which is kinda like the average daily rate on funding to automatically renew your loans, or you can auto renew at a fixed price, or you can manually update your loans using your fingers or the Bitfinex API.

Bitfinex also charges fees on margin funding. At the time of writing fees are 15% of the interest you earn.

If you have questions about Bitfinex lending, please post your comments below and I’ll do my best to answer specific questions.

Trade Bitcoins, Ethereum, Litecoin Online

I frequently get asked about how to trade crypto currencies. Aspiring traders see the daily swings in the bitcoin price and wonder whether they should take up trying to pick the highs and lows by trading. This post will describe some trading methods and provide you with a list of venues where you can trade.

The first thing to understand about crypto currencies such at bitcoin, ether, and litecoins, is their value is represented by their market price which is simply set by the powers of supply and demand. There is no central authority that determines their market price, so if you want to profit from the daily price swings, you’ll need to have a trading strategy that takes advantage of this volatility.

You’ll also need to choose your trading venue(s). Where you trade will be based on your trading strategy, but also on your legal/tax jurisdiction. Since you’ll need to comply with the laws of your local government, you should choose exchanges that are compliant for you. The place where you trade will be different if you’re American, Canadian, European, Japanese, etc. And sub-state governments such as provinces and states will also have their own laws. It’s common today for each US and European state to regulate bitcoin differently so do careful research to ensure you are trading in a tax compliant way.

The place(s) where you trade will also depend on your strategy. If you are arbitraging the bitcoin price between different exchanges you’ll need to hold accounts at more than one place, and also have wallets that serve as conduits/transfer nodes for cash, if you’re making your trades manually you’ll be more concerned about the trading dashboard and other human readable analytics, but if you’re using a bot to conduct your trades you’ll need the best API access with easy to use functionality.

Here is a step-by-step tutorial of how to trade on QuadrigaCX, a Canadian based bitcoin exchange. Once you open your account, you can fund it with Canadian dollars using Interac if you verify your account. You can also fund your QuadrigaCX account with bitcoin, ethereum, and litecoin without verification.

Once logged into QuadrigaCX, choose the “trade” tab from the header menu near the top of the page. As the image below shows, you’ll arrive at a page that shows the current market for CAD/BTC with a simple interface you can use to buy and sell. You’ll notice the best bids are listed on the left side in green, and the best offers are listed on the right side in red. These prices are bids and offers from other users on QuadrigaCX just like yourself who are buying and selling. You might be familiar with a market like this since it operates just like a stock market such as the TSX and NASDAQ.

 

 

You’ll notice on the image above, the current market has a best bid of $9,995.01 and a best offer of $10,000.06. This means another user is willing to buy at $9,995.01 and another user is willing to sell at $10,000.06. If you’d like to make a trade right away (a market order) you can sell to the user bidding $9,995.01 and buy from the user offering $10,000.06.  Depending on your trading strategy, you might only be willing to buy at $9,500, so in this case, you can place a order at that price and join the other bids in the order book. Your order will be placed with the quantity you determine at $9,500 until the market drifts down to that level and another user chooses to sell you their bitcoins at that price. Conversely, if you’d like to sell your bitcoins, but only at $10,500, you can place this order as well.

On QuadrigaCX, limit orders placed manually on the dashboard do not have expiration dates, so all orders are essentially good till cancelled (GTC).

As you review the order book from the image above, you will also notice an “amount” beside each price listed in the order book. This is the quantity being bid or offered by all users at that price. This quantity will help you determine whether your order can be filled entirely at the posted price or whether you should choose to pay up or offer down from the best posted price.

 

 

When trading, always keep the fees in mind QuadrigaCX charges an explicit fee of 0.50% per transaction. So if you buy 1 bitcoin at $10,000 CAD, your actual cost will be $10,050. You should also pay attention to the “spread”, which is the difference between the best bids and offers. Using the example above, with a current bid of $9,995.01 and an offer of $10,000.06 the spread is $5.05 or 0.06%. The spread represents an implicit cost of trading too.

Here’s an example of an easy to implement manual trading strategy with a bullish bias. Say you have $1,000 CAD to trade with, you’ve noticed the price of bitcoin is quite volatile, so you plan to make a market on QuadrigaCX to take advantage of this volatility. You will risk 10% of your account with each trade so your unit size will be 0.01 bitcoins since the current price is $10,000.

You place an order to buy 0.01 btc @ $9,993, which is slightly below the current market price using the example image above. You place the order and wait for the market to come to you, when your order is filled, place an order that is 3% above your purchase price (9993 * 1.03 = $10,292), enter your order to sell 0.01 btc @ 10,292 and leave the order in the market.

In the meantime, if you’re still feeling bullish, place another order below the current market, and if this order is also filled, place an order 3% above your fill price. Keep doing this until you reach the maximum value of your account. As you do this, the price of bitcoin will bounce around going up and down, and your orders will fill at prices where you make a spread between your buys and sells. You profit when the price of bitcoin trades within the range of volatility your limit orders imply, and you lose when the price of bitcoins drops straight down.

This is a simple market making strategy with a bullish bias that takes advantage of the volatile price of bitcoin. You can obviously tweak your own strategy to suit your own goals. You could use technical analysis to choose your entry and exit points, etc. Its completely up to you!

Follow this link for a long list of exchanges from around the world.

Crypto Credit Events

Crypto currencies, such as bitcoin and ethereum, are growing rapidly and the opportunities for profit are enormous. But these markets are also highly risky and investors using crypto currencies shoulder this risk. The situation should make risk management a main area of focus for crypto investors.

Risk in the crypto currency markets shows up in a variety of ways including many different forms of financial, tax and other operational risks. Much of the counterparty credit risk found in crypto currency markets comes from undeveloped crypto market infrastructure. We just don’t have the same plumbing in crypto currency financial markets as we do in fiat based financial markets. Fiat economies have developed the rule of law, deposit insurance, and credit ratings, but none of these these exist in crypto currency markets. Crypto currencies also don’t rely on any central authority, so dispute resolution is much more problematic, if not impossible. If your crypto currency wallet gets hacked, for example, you have little (or no) recourse to recover your loss.

Interestingly, the lack of financial market infrastructure also presents profit opportunities. Many financial services businesses operating in developed fiat economies could be replicated by clever entrepreneurs to crypto economies. The opportunities are huge.

Consider the cryptocurrency investor who makes a deposit on Bitfinex or Poloniex, and then lends their crypto currency to traders on the exchange in return for interest. How can this investor estimate the chances the exchange will remain solvent, and how can the investor estimate the chances of their account suffering a loss in the event the exchange gets hacked?  At present, there are very few ways to quantify the risks of such events. The crypto currency investor is left to rely on message boards, online posts, and a poll of their friend’s opinions. These methods are unscientific, and won’t give the investor reliable metrics they can use to make investment decisions. The average crypto currency exchange depositor simply relies on their own “gut feeling” along with some basic rules of thumb about portfolio management to make risk management decisions (don’t put all your eggs in one basket).

As far as I know, there doesn’t currently exist any method of obtaining deposit insurance for a crypto exchange or hosted wallet balance. In developed fiat economies, deposit insurance makes it cheap for consumers to assess the credit risk of counterparties, but the cryptocurrency world doesn’t currently have this same infrastructure. I believe that creating a rating agency for crypto currency credits is required for crypto currency finance to reach a more sustainable path.

One of my main goals as an investor is to better assess the creditworthiness of my cryptocurrency counterparties, and then use this information to make better investment decisions. As an investor, the degree of credit risk matters to me. Mostly all crypto currency investments have counterparty risk, but few ways exist to assess this risk. In fiat currency economies, we can rely on rating agencies, deposit insurance, and many different forms of information to make credit decisions. But this this same market infrastructure does not currently exist for most crypto currency finance.

To enlighten the market, the first step should be to define a credit event. When is a counterparty in default?  Below, I outline five categories of credit events: Bankruptcy, Acceleration, Default, Failure to Pay, and Restructuring.

Bankruptcy

Bankruptcy occurs when a relevant regulator declares the organization to be bankrupt.

Acceleration

Acceleration covers the situation, other than a Failure to Pay, where the relevant obligation becomes due and payable as a result of a default by a reference entity before the time when such obligation would otherwise have been due and payable.

Default

Default covers the situation, other than a Failure to Pay, where the relevant obligation becomes capable of being declared due and payable as a result of a default by the reference entity before the time when such obligation would otherwise have been capable of being so declared.

Failure to Pay

Failure to Pay is defined to be a failure of the reference entity to make, when and where due, any payments under one or more obligations. Grace periods for payment are taken into account.

Restructuring

Restructuring covers events as a result of which the terms, as agreed to by the reference entity and the holders of the relevant obligation, have become less favourable to the holders than they would otherwise have been.

By the above definitions, I believe it would be possible to achieve consensus on whether a credit event has occurred. The process of determining consensus could be done by a system of member voting and/or a pari-mutuel pool. The result of the credit event determination process could be used to settle derivative markets such as default insurance pools. These default insurance pools could in turn be used by market participants and credit rating agencies to help determine the creditworthiness of underlying entities. The pools themselves could also be used by both speculators and hedgers to manage their investment risk.

Price of a Binary Option

Consider an underlying price of 918. You are presented with the choice of buying or selling a European binary call option with 1 day till expiration and a strike price of 918 (i.e. at the money). The 30 day historical volatility of the underlying, as measured by standard deviation, is 5%, and the risk free rate is 1.50%.

Since this is a binary option, the bet is about whether the underlying price is going up or down tomorrow. So how should this option be priced?  If the price of the underlying is more than 918 in a day, the binary pays off 1, if the price is lower than 918 in a day, the binary pays off 0. Is this a 50/50 bet?  An amateur would say the option should be worth 0.50 since there is an equal chance of each event happening. But the price of this binary call is actually worth slightly more than 0.50. How so?

To value the option scenario described above, we need to consider the (1) time value of money and (2) the volatility of the underlying. If we use a black-scholes model, with the variables listed above, we come up with a call price of 0.506.

Try out various calculations on this example, check out the CME binary calculator link, here.

Using the same variables, but changing the time to expiration, comes up with the following values.

Days till Expiration Binary Call Price
1 0.506
30 0.531
90 0.552
180 0.572
365 0.599

Thoughts on the Basic Income Guarantee

Although I’m morally opposed to a basic income guarantee because it provides a negative incentive for citizens to live an economically productive life, I do think a basic income guarantee will become politically palatable in many jurisdictions as unskilled labour becomes less valuable. I believe the economic gap between the most skilled and motivated people and the rest will become wider with the further development of technology. At least in the most developed economies, we are getting closer to a time when its politically cheaper for society to tax the most economically productive and wealthy, and redistribute the tax to the rest, in the form of a straight payment. A society where anyone can simply choose to be a full time consumer can exist because we are creating the necessities of life in an increasingly productive way. Many of the extra fun things in life such as art, media, sports, are nearly free. Unskilled labour is becoming more of a political liability than a productive asset. Although the moral implications of the basic income guarantee are ruinous, it looks more likely to become reality.

EconTalk has a good discussion of some of the main issues.

What is Provably Fair Gaming?

In the “olden days” before the internet, casinos had to demonstrate their trustworthiness to players in order for players to have confidence they were being dealt a fair game. In places such as Nevada, the state also took on this responsibility by providing a regulatory system that ensured casino games are being dealt fairly, and extended the system to various electronic games and slot machines. Bucket shops online and in back rooms still pray on the uninformed and careless, but with greater access to online information, it has become easier for gamblers to find fair games by using an innovative cryptological process called Provably Fair.

What is Provably Fair and how can it be used to prove a game is fair? Provably Fair is a cryptological process that allows players to verify the randomness out an outcome. This is done by using an open source algorithm for random seed generation, hashing, and for the random number generator. Players can use such algorithms to test a game’s response to in-game decisions and evaluate the outcome by only using the published algorithms, seeds, hashes, and the events which transpired during the game. A provably fair game provides players with the tools to have confidence that a game is fair without requiring third-party verification.

The concept of Provably Fair was first implemented by BitZino back in 2012. Bitzino is a bitcoin casino that wanted to prove that its games were fair without having to register with a state based authority. Provably Fair methods do not require bitcoins or other digital currency, but the concept of provably fair matched well with a bitcoin based casino since the digital currency is extra-territorial.

Basically, bitZino deployed a cryptographic hash function (SHA256 algorithm) to create a digital fingerprint of an already shuffled deck. Since the SHA256 hashing algorithm is one-way and there’s no way a player can use that hash to figure out what the shuffle of the deck actually is, the casino can let players look at the hash before the game starts. Two “seeds” of data are needed, one provided by the casino called the server seed and another provided by the player called the client seed. The client seed is typically provided by the player’s browser.

Then, the vitural deck is reshuffled using the Fisher-Yates shuffle algorithm with the random numbers generated from the Mersenne twister algorithm that was seeded with a hash of the combined server seed and client seed. According to bitZino, “The second round of shuffling only serves to ensure that neither the server nor client could possibly know the final deck before the game starts.” Finally, the initial shuffle and the server seed are provided to the player for verification.

The provably fair method used by Bitzino set off a flurry of developments within the bitcoin gambling community. With provably fair technology, it is now a lot cheaper for online casinos to operate fair games since 3rd party verification of game fairness is not required and provably fair gaming also makes it safer for players since we now have the tools to test whether a casino is provably fair, thereby reducing the risk of being cheated. In the wake of provably fair, a group of “provably fair verification” services emerged to make it easier for players with less technical knowledge to test provably fair games.