Joe, Marco, Andrei and Kevin are students and alumni of Boston University by day, and they are building Alt-Options, a solution to the liquidity challenges in virtual currency markets, by night. Joe was a derivatives trader prior to school, and Marco dabbled in trading and learning about new virtual currencies such as bitcoin.

Alt-options

The four co-founders put their heads together and realized that there was tremendous opportunity for an intermediary player to serve as a market maker. This ambitious feat could be accomplished by connecting asset holders and investors angling for low-risk, low-cost strategies to get into emerging virtual currencies like bitcoin.

The concept is simple at its core:

"Instead of liquidating (selling) virtual currency assets, such as bitcoins, firms that own large quantities of bitcoin can use the underlying assets (bitcoins) to create derivatives and generate financial return or to utilize derivatives to hedge their financial risks."

As the Alt-Options team began validating this idea, they started working with Bitcoin mining companies who owned many bitcoins but needed to make money to keep the lights on and the servers running. Instead of selling their mined altcoins on the spot market, these companies could employ Alt-Options to take a small block of coins and use the Alt-Options trading algorithm to build different types of options that generate income.

One example would be call, which is the option to buy a bitcoin at a fixed price, i.e., the “strike price,” by a set date. The strike price, volatility and other option characteristics would be driven by the risk preference of the mining company or the owner of the bitcoins.

As with any other financial derivative, riskier strategies can offer greater return to the companies holding the underlying assets. The derivatives are then posted in the Alt-Options order book with the intent of collecting the maximum premium at an appropriate level of risk.

Hedge funds, institutional investors, and someday any investor, can then purchase options that suit their investment strategy, without spending millions of dollars buying and holding bitcoin. More importantly, clients can reduce the instability that permeates the market when large blocks of coins are physically traded.

Financial derivatives: how it works

For those of you unfamiliar with financial derivatives, imagine you sign a legal contract that, after the payment of a premium known as the price, gives you the option to buy a single bitcoin at a fixed price of US$250, the strike price, at any time in the next three months. The option is a derivative and the underlying is bitcoin. If the value of bitcoin increases, then so does the value of the option, because it gives you the right (but not the obligation) to buy the bitcoin at a predetermined price.

Suppose that the market price of bitcoin rose sharply in the weeks after signing the deal and a bitcoin is now worth US$350. You could then exercise the option, buy the bitcoin for US$250, and immediately sell it for US$350, netting a profit of US$100, less the price you paid for the option. The option contract is valuable in this case.

Suppose, instead, that the price of bitcoin collapses, and a bitcoin is now worth US$50. The option would then be virtually worthless, and you would not exercise it and lose what you paid to buy the option. However, this price would be significantly less than what you would have lost had you bought the bitcoin at US$250.

Derivatives are incredibly effective financial instruments to transfer risk from one party to another. For the firm that owns the underlying, or the bitcoin, they can earn a premium above interest rates by selling options. For the firm buying the option, they can gain exposure to market fluctuations in price without putting huge amounts of money into acquiring the underlying asset.

For more on derivatives, the Financial Policy Institute offers a primer that is a great resource.

What Alt-Options is Building

“Effectively, Alt-Options will connect sellers and buyers of virtual currency while managing price exposure to reduce the volatility and liquidity risk created by the movement of large quantities of assets.”

Alt-Options will serve as the trading layer where different market participants can connect in new ways without owning actual assets such as bitcoins. The banking layer and trading layer will connect with one another via existing APIs, eliminating the need for Alt-Options to hold large volumes of money or assets.

Outsourcing these services allows customers to secure their deposits with established banking partners and reputable wallet companies. Additionally, Alt-Options will be providing full transparency and proof of solvency by letting clients audit the company’s wallet address.

The team has currently finished the first version of the product, which will focus on providing a handful of test partners with the trading platform. Users will be able to execute derivatives trades with company issued credits. However, the plans don’t stop there. Over the coming months, the team will partner with other exchanges in the space to launch a bitcoin trading competition with the College Cryptocurrency Network.

The company’s next step will be launching the live trading platform that will accept bitcoin for derivatives trading. Likewise, a test version will be released to retail clients, which will offer backtesting through TestNet’s parallel blockchain, and gather feedback on how to build a bigger marketplace open to more liquidity providers and retail users.

Visit Alt-Options to sign up for access to their beta testing.

By Meltem Demirors, MIT Sloan

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