Bitcoin's volatility is one of the obstacles to become mainstream as a currency. Above all the fear from crashes is hindering adoption by merchants and consumers. Here I'll describe an idea I got to be able to
hedge against crashes using Atomic Swaps. This may look strange, but it could make sense if we consider that atomic swaps are, in reality, a kind of option contract. See more below ...
Hedging with options and the collar strategyOptions contracts are a common way to hedge against volatility. We can
buy a "put option" if we own a good or asset - e.g. Bitcoins or stocks - and want to avoid being surprised by a crash. The seller of a put option gives the buyer the right to sell a good to a certain price, the so-called
strike price. The seller charges a premium for that, because he needs to deal with the risk of the contract. (We will use
American-style options here).
Example: We buy a put option for 1 BTC with a strike price of 9500 USD, with an expiration date of 30 days. This means that we can sell 1 BTC for 9500 USD in the next 30 days, even if it at the spot market the BTC falls to zero.
This way, we are safe from any crash that may happen. But: The premium for a put option for a value of 1 BTC, with strike prices near the spot price, can cost hundreds of dollars (Put options are cheaper if the strike price is lower.). See current prices e.g.
here (Deribit). How do we get that money back?
There is a
second step we can do at the same time:
selling a call option. This means that we sell another person the right to buy BTC to a certain value. Who would buy that? Basically, traders who are speculating with a price increase but do not want to take the risk to buy a full BTC.
Again an example: We sell a call option for 9500 USD with expiration date of 30 days. We give our counterparty the right to buy 1 BTC for 9500 USD, even if it goes to 1 million, and charge a premium for it because we are taking the risk in the contract.
So we can finance a hedge against a crash, if we at the same time limit our potential to profit from a price increase. This strategy is called
"collar".
Obviously, if you want to speculate on a Bitcoin price increase, then a collar is not for you. But there are definitively use cases - above all in the business world. For example, merchants who accept Bitcoin without a centralized payment gateway (like Bitpay or Coingate) need a strategy to manage volatility risk, and a collar is one of the possible options.
Atomic swaps as American-style optionsNow most people would trade options on centralized exchange platforms. But there is an interesting alternative which is (almost) decentralized: Atomic swaps (See
here how they work.)
Why? Aren't atomic swaps meant to exchange currency and not to speculate and hedge? Yes. But they have one characteristic which some find "unfair": one of the two parties can decide if it does not accept the trade. This party can be compared to the buyer of an (American-style) option. (See more on
this interesting paper)
Normally, atomic swaps have short expiration times (like some hours, or a day). But we can perfectly imagine atomic swaps where the "buyer" can wait 30 days to decide if he concludes the trade or not. This would give the "buyer" the right to buy the BTC or the other coin for a fixed price until the expiration.
Basically, the idea is now to use this strategy to implement the "collar" described above in a descentralized way, without a centralized exchange platform. We can use a collar against a stablecoin to mimic the USD or EUR price.
Advantages and disadvantagesAdvantages:
- We don't need any centralized options platform. Nobody can run away with our money.
- We always own the private keys of the Bitcoins we're using.
- No KYC needed (see here why KYC can be a risk), privacy is on the same level than with normal Bitcoin usage.
Disadvantages:
- We can't use fiat currencies directly to hedge. We must use blockchain-based stablecoins, which have their own set of problems.
- Traditional atomic swaps need on-chain transactions which normally cost transaction fees. This makes this method unsuitable for small Bitcoin amounts.
- At this moment, there is low liquidity on atomic swap markets.
- A maybe a bit more technical problem is that we cannot easily use the same BTC we're using for the "call" option swap than the one we use for the "put" option swap. Maybe there is a solution for that though.
DiscussionWhat do you think? Is this idea factible or totally crazy? Is there anyone who is already using this kind of hedging? Are there platforms supporting it? Post your opinions!
(This is part of my current research about a possible "tool set" for the unbanked and other people wanting to live without a bank account (see also this poll/thread), and would allow people who couldn't afford to be caught by a crash live with a Bitcoin wallet.)