Coinbase now handles bitcoin transactions for more than 19,000 businesses and 750,000 individuals.
The tiny San Francisco startup offers various online services that help move the digital currency from place to place. At online retailer Overstock.com, for instance, Coinbase helps people buy stuff like patio furniture and smartphone cases using bitcoin. It lets online advertising outfit eZanga pay its partners in bitcoins. And it provides a service that lets people and businesses buy and sell the digital currency.
As a result, Coinbase holds an awful lot of bitcoin in its own digital wallets. That's just part of efficiently moving the currency to and fro -- and at this point, it's a rather risky thing. As the world struggles to come to terms with this very new creation, the value of the digital currency is extremely volatile, with prices shifting as much as 25 percent in a matter of minutes.
>'It's not surprising the people would try to do this. If you're a merchant or a business and you buy and sell stuff, you need to know how much you're getting in return.'
Eric Posner
Founders Brian Armstrong and Fred Ehrsam say the company runs complex software that monitors price fluctuations and responds almost instantly in an effort to avoid serious losses. But they also say Coinbase could benefit from something else, something that businesses so often use to protect themselves when they handle foreign currencies like euros and yen. They could use a derivatives market.
It's something the bitcoin world as a whole could benefit from. And across the net, various services are experimenting with the idea, seeking to give both individuals and businesses a way of guarding themselves against the huge fluctuations in the value of bitcoin. "It's not surprising that people would try to do this," says Eric Posner, a professor at the University of Chicago law school who explores financial markets and other economic issues. "If you're a merchant or a business and you buy and sell stuff, you need to know how much you're getting in return."
Derivatives markets have long played a role in the traditional economy. If you, say, sell a bunch of stuff to Germany and are paid in euros, you run the risk of the euro suddenly dropping in value relative to the dollar. In other words, when it comes time to spend them, your euros could be worth far less than when you received them. But you can protect yourself by purchasing something called a futures derivative -- a financial instrument that pays you money if the value of the euro goes down. "It's basically an insurance policy against fluctuations in exchange rates," Posner says.
What companies like Coinbase need is a place where they can buy similar derivatives capable of protecting their bitcoin transactions -- and generally making their operations more capital efficient. They need a bitcoin derivatives market. "It's very important," says Ehrsam. "People far too often associate derivatives markets with mere speculation, but there are very legitimate businesses that need derivatives to protect themselves against risk."
At least two outfits in Europe are already running what they call bitcoin derivative markets. One, based in Ireland, is called Predictious. The other, in Russia, is known as ICBIT.1 But these are fairly simple markets. What we need is a bitcoin market that operates on a much larger scale, one that's approved by financial regulators.
What the Hell Is a Derivative?
What exactly is a derivative? It's a financial asset that's derived from some other asset. These take many forms, but two of the most common are futures contracts and options contracts. A futures contract is where two parties agree to trade an asset -- like corn or gold -- sometime in the future for a price they set today. An options contract is similar, but one party merely retains the option of making such a trade somewhere down the road.
Like any other asset -- such as a stock -- you can use derivatives merely as a way of betting on the future, a way speculating on where things will go, a way of making money -- or, yes, losing it. But a derivatives market is also the primary means of protecting your investment in foreign currencies. If you're holding yen and it looks like the yen is in trouble, you can buy a future that amounts to a bet that the value of the yen will go down. If it does, you win the bet -- and you make up for the loss you'll take on the yen you're holding.
>'The derivatives, futures, options market is largely undeveloped. You might say the counter-party risk is unacceptable.'
Fred Ehrsam
A bitcoin derivative would let you do much the same thing with your bitcoin investments. Flavien Charlon, who runs Predictious, says his site already provides a market where you can buy and sell such derivatives. "We believe [it] can really help bitcoin investors, traders, and small businesses to reduce the risk of owning bitcoin, especially given the high volatility of Bitcoin," he tells us. So far, the service is used mainly by individuals, not businesses, but Charlon says that could change.
This, however, is not exactly what Coinbase is looking for. "The derivatives, futures, options market is largely undeveloped," Ehrsam says. "You might say the counter-party risk is unacceptable." Part of the concern is that existing services may run afoul of regulators, either in Europe or in the U.S.
A spokesman for the U.S. Commodity Futures Trading Commission -- the organization that oversees derivative markets here in the U.S. -- says that, at least for the moment, the agency is not concerned with bitcoin derivatives because they aren't available on existing, regulated exchanges. In other words, the organization isn't looking at what's happening on new websites across the net. It's only looking at long-standing markets here in the real world. But this may change as more and more people explore the possibilities of bitcoin derivatives.
In addition to Predictious and ICBIT, a group of former floor traders in Chicago is exploring an honest-to-goodess bitcoin derivatives market, though this is still in the early stages. Collin Palmer, one of these traders, believes such a market could not only help stabilize the value of bitcoin, but invite more mainstream financial minds into the digital currency, as opposed to the computer geeks that typically deal in bitcoin.
It certainly could. And eventually, it will. The need is already there.
1Correction 7:33 EST 01/14/14: Originally, this story said that ICBIT is based in Sweden. Though the site uses a Swedish internet domain, records show it is based in Russia.
