Within the realms of the cryptoasset derivatives market, BitMEX, an exchange and contract issuer stands out as the historical market leader. BitMEX or the Bitcoin Mercantile Exchange — was founded by Arthur Hayes, Ben Delo, and Samuel Reed in 2014. The exchange is best known for its popularization of the perpetual swap contract as a way for traders to easily access leverage and its Ask-For-Forgiveness-Not-Permission attitude towards financial regulation across the globe.
BitMEX is popular for a reason: it provides a service — untethered Bitcoin margin trading — that investors and users want. It’s for this reason that, up until this year, BitMEX was the most popular derivatives platform up until the leading Asian exchanges — OKEx, Huobi, and Binance — entered the fray.
Despite BitMEX’s fall in prominence over the last year, the exchange still has an outsized impact on the entire market, in part due to the structure of its contracts. Moreover, the open interest for its Bitcoin product is still the second largest after OKEx. As we’ll explain in this article, there are a number of problems associated with BitMEX’s outsized influence.
BitMEX’s key product, the heart of its success, and the problems it causes for the crypto asset market can all be related to its XBTUSD perpetual swap contract. You may be wondering: what exactly is a perpetual swap contract? To quote BitMEX verbatim:
A Perpetual Contract is a derivative product that is similar to a traditional Futures Contract, but has a few differing specifications:
- There is no expiry or settlement
- Perpetual Contracts mimic a margin-based spot market and hence trade close to the underlying reference Index Price
Put simply, perpetual swap contracts are futures contracts with no expiration date. They aim to provide notional exposure to the underlying spot cryptoasset such as Bitcoin in XBTUSD’s case — through the use of a Funding Rate.
A Funding Rate, in turn, is a periodic payment exchanged between the buyers and sellers of perpetual swap contracts every 8 hours that vary from positive to negative.
If the rate is positive, then those that are long the contract will pay those that are short the contract and then vice versa if the rate is negative. The magnitude and sign of the Funding Rate are functions of the premium or discount of the perpetual swap in the period beforehand over its index (spot Bitcoin). This means that the Funding Rate is used to keep the perpetual swap contract tethered to its underlying spot reference. You can read more about the exact calculation here.
As we discussed last week within the crypto community, perpetual swap contracts share many similarities with equity and FX contracts-for-difference (CFDs) which also do not settle.
Problem 1 — Convexity
Ask any crypto-derivatives trader or even anyone that follows the markets closely, there have been several noticeable occasions where BitMEX has been the driver of a general crypto market flash crash. The most noticeable example was March 12,2020, but similar events occurred on May 16, 2019 and very recently on June 2, 2020.
The very nature of BitMEX’s XBTUSD perpetual swap makes such flash crashes almost inevitable given spot Bitcoin’s volatility — as we describe below. Let’s look at XBTUSD’s liquidations over the last year — which captures the period of the three flash crashes we mentioned.
BitMEX’s (and other exchanges such as ByBit, Cryptofacilities, and Deribit) perpetual swaps work differently than similar contracts on other exchanges.
Instead of users depositing a USD-pegged stablecoin to collateralize their position, they deposit Bitcoin. As such, the Profit and Loss (PnL) function of one’s position in such perpetual swaps is non-linear — as the contracts are settled in the same asset that an investor was attempting to get excess exposure to.
In simple terms, one’s losses or gains in Bitcoin will not have a one-to-one relationship with the change in the price action of the BTC/USD pair. In other words in a chart, the PnL for XBTUSD will look like a curve, not a line due to the concept of Gamma or Convexity. Gamma simply measures the change in delta of a derivative contract against the change in the price of the underlying asset — or for every $1 increase or decrease in the price of Bitcoin how much the perpetual swap contract's PnL changes. To clarify, we define delta as the rate of change of a derivative's value with respect to changes in the underlying asset's price)
On BitMEX, each XBTUSD contract is worth 1 USD of Bitcoin or 0.0001 BTC at today's rate. So if an investor deposits 1 Bitcoin at a current price of $10,000 then they’d be able to buy 10,000 XBTUSD contracts at a cost of $10,000 or 1 BTC.
Let’s look at two cases: Bitcoin increases by 10% twice over two days and Bitcoin falls by 10% twice over two days. If Bitcoin’s price increases by 10% to $11,000 USD, one contract now would cost $1/$11,000 ≈ 0.000091 BTC and therefore, the investor’s gain is 0.0001 - 0.000091 = 0.0000091 BTC per contract. As the investor was long 10,000 XBTUSD contracts then the total gain is 0.091 BTC.
If Bitcoin’s price rises to $12,000 USD, one contract now would cost 0.000083 BTC per contract. Therefore, the total gain would be 0.0001 - 0.000083 = 0.00001667 BTC per contract. This means that the total gain for the investor that was long 10,000 XBTUSD contracts is 0.1667 BTC from when the price of Bitcoin was $10,000.
This second $1,000 movement will only help an investor gain 0.0757 BTC (0.1667 BTC - 0.091 BTC). This nonlinear PnL relationship for XBTUSD means that an investor will make less money as the market rises and loses more money when the market falls — as the chart from BitMEX below shows — when compared to a theoretical linear PnL.
This fact exacerbates market crashes as longs are more likely to be liquidated on BitMEX than they would on more traditional derivatives platforms. The cascading effect of the XBTUSD’s convexity, coupled with BitMEX’s automated liquidation engine attempting to close out the trader's position before they enter into bankruptcy, would only exacerbate such crashes.
In the case of the March 12 crash, this phenomenon reverberated across the market as arbitrageurs brought the spot price of Bitcoin elsewhere down due to the incentive of negative funding rates on BitMEX and pure arbitrage opportunities. It’s not a coincidence that the price of Bitcoin recovered quickly after BitMEX went offline. The chart below by CoinMetrics shows this point very clearly, with the red bar signalling when BitMEX went offline.
While Bitcoin’s March 12 crash was undoubtedly driven to a large extent by macroeconomic factors, it’s clear that poor market microstructure choices, driven by BitMEX’s perpetual swaps, exacerbated it.
Problem 2 — Excessive Leverage
Leverage is a trend. It’s a trend to the extent that a BitMEX rival, FTX, gave traders the option of trading at 101x leverage (compared to BitMEX’s option of 100x leverage) in a tongue-in-cheek effort to get back at their competitor. While it’s impossible to get accurate data on the average amounts of leverage used by traders on BitMEX, the firm last posted statistics on their users’ use of leverage in April 2019.
Bitcoin’s average daily returns since the start of the year have been 0.14% with a 4.38% volatility on average. If we assume that BitMEX’s current effective leverage is 22x for a long position then it would only take a 4.5% decrease in the price of Bitcoin for the average position to be liquidated. If we assume that returns can be somewhat approximated by the normal distribution, this would mean that any given daily movement of Bitcoin would have a 14.17% probability of liquidating the average 22x long position on BitMEX.
We can be more exact and calculate the exact probability of a 22x long position being liquidated. We’ll assume here that Bitcoin follows a skew normal distribution with a maximum likelihood estimate for mean of 3.39%, volatility of 5.44%, and skew of -1.17. Under this distribution, we calculate that any given daily movement of Bitcoin would have a 14.23% probability of liquidating the average 22x long position on BitMEX. The chart below shows the probability density function of Bitcoin's returns since the start of the year — the distribution is relatively negatively skewed.
While the data for effective leverage on traditional exchanges like CME are not publicly available, the margin requirements are considerably higher — 43% for CME Bitcoin futures which corresponds to a maximum leverage of just over 2x. Given the volatility of Bitcoin, allowing users to take on such amounts of leverage is irresponsible given the near-inevitability of liquidations based on historical data.
Needless to say, we haven’t touched on all the issues with BitMEX and there are a number more associated with legality, compliance, and potential conflicts of interest which have already been covered in great depth. It’s obvious that BitMEX, one of most popular ways for traders to get leveraged exposure is inadequate and, more importantly, causes distinct negative externalities to the industry as a whole.
The increasing use of stablecoins as an option for maintaining margin requirements is an improvement on the current state of affairs; in addition, the introduction of alternative ways for token holders to get exposure to Bitcoin and other cryptoassets such as inverse and leveraged tokens will add much needed competition to the industry. More work needs to be done analyzing the effect of the growing derivatives market on Bitcoin’s market microstructure and we’ll be following up with further data-driven research on this topic.