1

Coinometrics

Wrestling with Bitcoins volatility
COINOMETRICS Briefing #2
---
Wrestling with Bitcoins volatility
Authors
Jonathan Levin jonathan.levin@coinometrics.com
Andrew Geyl ooc@coinometrics.com
Matthias Wyss matthias.wyss@coinometrics.com
Executive Summary
! Flash crashes on BTC-e and Bitfinex, both offering margin trading contributed to a spike in volatility
! Margin trading in absence of proper risk management can cause cascading sell-offs
! BTC-e and Bitfinex matching algorithms behave differently during market turbulence
! Risk management tools are required to construct responsible margining policies reducing the
probability of such crashes
Introduction
Bitcoins price volatility has often been blamed for preventing widespread adoption of the currency. The
recent flash crashes on Bitfinex and BTC-e also highlighted the risk of running highly leveraged financial
products on top of a volatile underlying asset. Risk management tools must be employed to manage
currency risk and ensure that markets function efficiently.
BitPay pioneered a model that protected merchants accepting Bitcoin payments from its volatility. They
guarantee equivalent payment in dollars in real time for any transaction, a service they now offer free of
charge. For the time that BitPay hold bitcoins, while they process a transaction, they are exposed to
exchange rate fluctuations. This issue is not limited to BitPay, any company that generates revenues in
Bitcoin or has Bitcoin liabilities will always induce volatility into their fiat-denominated books when
transacting in Bitcoin. Risk management tools must be made available to businesses in order to manage this
currency risk.
Derivative products such as options and futures are widely used instruments to manage currency risk for
companies transacting and accounting in two or more currencies. In fact, currency derivatives represent the
second largest category in worldwide over-the-counter derivatives.
1
Derivative exchanges need to fulfil their
purpose of providing a venue where they facilitate the transfer of risk between market participants and offer
mechanisms for price discovery. An important feature of the exchange is clearing, which includes margining,
and netting.
At Coinometrics, we apply industry-leading models to develop volatility forecasts and value-at-risk
measures. Margining policies for leveraged financial instruments require the use of volatility measures.
Furthermore, value-at-risk measures allow companies with exposure in multiple currencies to quantify their
positions and adjust them to suit their risk profile. This briefing will focus on the application of these
sophisticated tools to manage Bitcoin currency risk with specific focus on derivatives exchanges in light of
the flash crashes on BTC-e and Bitfinex.

1
Bank of International Settlements. (2013). BIS Quarterly Review http://www.bis.org/statistics/otcder/dt1920a.pdf
2
Coinometrics

Wrestling with Bitcoins volatility
Margining is a critical component of a derivatives exchange
Margin trading is often used interchangeably with derivative products such as futures or contracts for
difference that do not require the underlying position to be fully funded. Margin in a narrow sense refers to
the amount of cash that a trader needs to deposit as collateral on a derivative position in order to enter into
the contract. In a derivatives contract, if the trader is losing money on their position, they may not have
sufficient funds to cover their losses. This is known as counterparty risk, which needs to be mitigated by
collateral. Therefore, the margin requirement implicitly determines the amount of leverage that can be
assumed. As an example, if a trader is required to deposit $100 into a margin account to enter a long
BTCUSD derivative position at $500, then this achieves five times leverage compared to the same amount
of capital invested BTCUSD directly. The lower the margin, the cheaper it is to enter the position and the
higher the leverage, which can be assumed by the trader.
Margin is usually split into initial margin, which represents the cash to be deposited in order to enter the
derivative position, and maintenance margin, which represents the minimum level of equity to be
maintained over time. Derivative positions are frequently marked to market and if the valuation moves
against the trader such that it approaches the maintenance margin, the trader receives a margin call. This
means that more equity needs to be provided immediately or the derivative position will be forced closed.
If traders run large leveraged positions and the price of the underlying asset moves quickly against their
favour, margin calls may be too high and large positions may be force liquidated in an already distressed
market. This can create a downward spiral not only in the derivative but also in underlying market, leading
to flash crashes as observed recently. Clearly, the amount of margin required by the derivative exchange
and hence the potential levels of leverage that can be assumed by traders have a direct impact on the
probability of a price move large enough to cause such a crash.
Margins therefore both implicitly determine the maximum leverage and act as a buffer to absorb large price
moves that could expose the exchange to counterparty risk. Derivative exchanges need to strike a balance
between setting margins high enough to mitigate counterparty risk but not too high to deter traders and
hence damage liquidity. The low level of sophistication in Bitcoin derivatives markets means that margins
are often either decided on an ad-hoc basis as a constant proportion of the trade notional irrespective of
the prevailing level of volatility in the underlying market or at best estimated with simplistic models.
Figure 1. Bitfinex BTCUSD historical price and returns with forecasted confidence interval

Source: Coinometrics, Bitfinex
3
Coinometrics

Wrestling with Bitcoins volatility
As the market becomes more competitive, exchanges have an incentive to lower margin requirements.
Traders looking for higher leverage will flow to the exchanges that offer the lowest margin requirements. In
such an environment it is important that prudent risk management tools are used to protect exchanges from
counterparty risk with respect to their traders. Determining the adequate margin level for derivative
contracts is dependent on the prevailing market volatility level. This requires sophisticated modelling of the
underlying assets return characteristics. Coinometrics provides such in-depth risk management solutions.
The top of Figure 1 shows the daily closing price of BTCUSD on Bitfinex with a forecasted 99%-confidence
interval for the price on the following day. This interval represents the varying levels of margin that an
exchange should charge on a linear derivative contract depending on the prevailing volatility level. If the
realised price stays within the interval on the following day, the margin absorbs the price move
appropriately. As the bottom graph shows, the margin would have covered the price moves in 99% of the
cases and would have also absorbed the very large but not extraordinary price swing on the 14
th
August.
If margin requirements are high enough, the probability of a self-enforcing downward spiral due to margin
calls is significantly reduced. Managing this risk is the responsibility of the derivatives exchange. The risk
management solutions provided by Coinometrics are not only crucial for margining but also contribute to
the orderly functioning of derivative and the underlying spot markets.
Bitfinex flash crash
The price on Bitfinex crashed on 14
th
August 2014 from $525 to $451 in a matter of seconds. Over $8
million worth of Bitcoin changed hands during an intense period of trading. Figure 2 shows that during this
intense period, 8,400 positions worth $5 million of loans that were being used for margin trading were
returned to the creditors. While this seems likely to be a series of margin calls which forced the closure of
long positions, Bitfinex confirmed that two large sell orders amounting to 9,000 BTC initiated the sell-off
and triggered margin calls of about 650 BTC or 7% of overall volume traded during this period.
2

Figure 2. Bitfinex BTCUSD historical price and returns with forecasted confidence interval

Source: Coinometrics, http://www.bfxdata.com/

2
Interviews with Bitfinex management on Coindesk, published 15 August 2014: http://www.coindesk.com/margin-
trading-crash-price-bitcoin/ and 20 August 2014: http://www.coindesk.com/margin-trading-blame-bitcoins-price-decline
4
Coinometrics

Wrestling with Bitcoins volatility
There is insufficient data to conduct a full market analysis to determine if some of the trade activity was
market manipulation. The swap volumes released by Bitfinex show the total amount borrowed in USD to
buy bitcoins and total amount of Bitcoin borrowed to go short. Traders are able to borrow both USD and
Bitcoin and wait for the opportune moment to execute their trade in the spot market. At times it can also be
shown that the borrowed funds never gets spent and simply gets returned to the creditors. An example of
this can be seen in Figure 2. In the hours before the flash crash, $2 million were borrowed and then $2
million were returned the following hour with very little trade volume in the spot market. Furthermore, on
the 13
th
August, an additional 1,000 bitcoins were borrowed in short positions and some 2,500 shorts were
subsequently closed during the crash. Although Bitfinex should be applauded for the amount of data that
they provide through their API, they do not release anonymised trade data with trader IDs that is needed to
assess whether this was an attempt at market manipulation or simply a coincidence.
Bitfinex did slow down the rate at which trades were executed on the exchange due to a new speed-
bump algorithm, designed to protect market participants. The exchange slows the execution of large
orders that would cause significant price movements also referred to as slippage. This meant that the
matching engine never ceased during the intense period, unlike the BTC-e crash. Although speed bump
algorithms and circuit breakers are useful tools to manage severe market fluctuations, exchanges must be
more transparent about how these algorithms will affect their traders.
While it is unclear whether malicious trading or margin calls triggered the sell-off, it is evident that
appropriate risk management tools must be put in place to prevent high leverage in volatile periods and to
reduce the probability of a cascading sell-off.
BTC-e flash crash
Only a few days after the flash crash on Bitfinex, an even more extreme event occurred on another major
spot and derivatives exchange, the Bulgarian based BTC-e. Within a matter of minutes, BTCUSD and
corresponding currency pairs dropped by almost $150 to a low of $309. The price recovered within minutes
to about $450 as arbitrage traders came in and took advantage of the price differential to other exchanges.
Figure 3. Circuit breaker on BTC-e during the flash crash



Source: Coinometrics, BTC-e
5
Coinometrics

Wrestling with Bitcoins volatility
While there are many similarities between the two crashes involving margin trading, the reaction of the
exchanges had some profound differences. As Figure 4 clearly indicates, trading was halted after every
large price move for 30 seconds. Such circuit breakers are common features on sophisticated derivative
exchanges and should prevent prices to dive drastically during extreme crashes. However, the trading halt
of 30 seconds after a large price move is evidently not long enough for market participants to absorb the
shock and to prevent further slippage. Sophisticated risk management tools must be applied to determine
the appropriate threshold levels and trading halt periods.
Evaluation and concluding remarks
The recent flash crashes on two major derivative exchanges have drawn the attention to margin trading and
the risks associated with leveraged financial instruments. Derivative markets for crypto-currencies are still
nascent and have shown fragility, which has potentially been exploited by sophisticated traders, causing
reputational risk for the exchanges as well as the industry more generally. While the high volatility of the
underlying markets are still a major concern to market participants, sophisticated risk management tools
must be put in place to adequately capture the assets return behaviour and to accurately forecast risk
measures and margin levels. Such tools are being developed by Coinometrics and are not only suitable for
derivative exchanges and traders but also for merchants to risk manage their daily inflows of Bitcoin and the
thus induced return volatility on their books.

While there has been a negative sentiment around margin trading and crypto-currency derivatives in
general, we at Coinometrics strongly believe that such products are vital for the increasing financial
sophistication of crypto-currency markets. However, it is imperative that the necessary risk management
systems are put in place as well as transparency is increased around margin call procedures and the way
derivative contracts are settled. We continue to promote transparency with our exchange survey
http://coinometrics.com/survey.html to strive to our goal of a better, self-regulated Bitcoin community.