It is still a small market, and the firms say their products aren’t aimed at mom-and-pop investors. But the trend is raising red flags among some market veterans, especially as bitcoin’s rebound above $10,000 has rekindled investor interest in the digital currency.
Craig McCann, a former Securities and Exchange Commission economist, warns that it is a bad idea to take bitcoin—a highly volatile, speculative asset traded on unregulated exchanges—and use it as a building block for complex instruments.
“There are all kinds of problems associated with any structured product tied to bitcoin,” said Mr. McCann, who now leads Securities Litigation & Consulting Group, a firm that provides expert witnesses for companies involved in securities lawsuits. “It doesn’t belong in anybody’s portfolio.”
Cipher Technologies, a crypto hedge fund in Greenwich, Conn., began offering structured products on bitcoin earlier this year. The firm has done several such deals, mainly with entities that manage money for wealthy families and individuals, said Cipher’s founder and managing partner, Gerald Banks.
“We would not fathom pushing this to anyone who would not be fully versed in the risk or in the nature of the underlying asset,” said Mr. Banks, who helped develop Merrill Lynch’s structured-products business in the 1990s and early 2000s.
One of Cipher’s products is a bond-like contract known as a reverse convertible. In such a deal, the client loans money to Cipher in return for monthly interest payments, with Cipher paying back the loan once the contract expires. But before then, if bitcoin falls below a predetermined level—a 19% drop, in one version of the product from earlier this year—then Cipher returns the principal to the client, minus the amount bitcoin has lost.
GSR, a cryptocurrency-trading firm led by former Goldman Sachs Group Inc. commodities traders, has unveiled several new bitcoin structured products since March. These include variance swaps, which pay out for their buyers if bitcoin’s volatility increases, and binary options, which pay out either a fixed sum or nothing, depending on whether bitcoin trades above or below a specified price.
Most of GSR’s revenue comes from algorithmic trading of digital currencies, and the firm has only done a small number of structured-products trades, said the firm’s co-founder and co-head of trading, Richard Rosenblum, a former global head of oil-derivatives trading at Goldman.
Structured products typically involve derivatives created by banks that would otherwise be hard for their clients to buy or sell elsewhere. But the products are sometimes hard to understand and difficult to trade. So abrupt market moves can cause losses, as Wall Street discovered when the U.S. housing meltdown caused a crash in some products tied to mortgages.
Bitcoin’s price moves are even more extreme, adding to the risk. “We’ve seen some players blow up,” said Darius Sit, managing partner of QCP Capital, a Singapore-based trading firm active in cryptocurrency options.
Crypto derivatives traders face another risk: regulation. In 2010, Congress passed the Dodd-Frank Act to rein in the market for off-exchange derivatives, putting most of it under the oversight of the Commodity Futures Trading Commission. Later, the agency said it had jurisdiction over bitcoin.
That means bitcoin derivatives fall under CFTC rules, which require that derivatives trades involving a U.S. firm be reported to swap data repositories. These are giant databases of trades, designed to give the government visibility into what used to be an opaque market.
Edward Woodford, chief executive of Seed CX, a startup that runs a cryptocurrency exchange, said some crypto-derivatives firms use entities domiciled outside the U.S. to book trades and operate as though they are exempt from the reporting rules.
The CFTC says it monitors such trading. “We are closely following how cryptocurrency is being traded, including in its derivative forms that would be subject to our regulatory jurisdiction,” James McDonald, CFTC enforcement director, told The WSJ.
Deliberate efforts to evade the reporting rules by trading through offshore affiliates would attract scrutiny from CFTC enforcement, he added. “You can’t evade our jurisdiction that way,” Mr. McDonald said.