Wall Street engineers embark on expanding a Bitcoin derivative

A group of engineers and traders at the crypto prime brokerage SFOX are working on a way to expand access to Bitcoin for banks and big investors. 

SFOX co-founder George Melika said his firm is in talks with large banks and market makers including Jane Street to open a market that facilitates the trading of Bitcoin derivatives. The idea is to use NDFs — non-deliverable forward contracts that are typically used for currency markets — to give banks the wherewithal to expose clients to Bitcoin at a greater scale through a contract, at an agreed-upon price, that settles in cash.

Krisztian Bocsi/Bloomberg

“It’s a product they’re familiar with, it’s regulated, and they can trust they can get exposure to it without holding the underlying,” Melika said by phone, explaining that banks don’t actually have to purchase Bitcoin for clients to be able to trade assets related to the token’s moves. 

Banks have long been wary of buying or trading Bitcoin because of concerns about compliance, “know your customer” rules and market liquidity. Since banks already trade NDFs for other assets, Melika said it may help compliance departments get more comfortable with this newer product. SFOX is also among only a handful of firms dealing in digital assets that have joined the International Swaps and Derivatives Association. 

The conversation around expanding NDFs has existed for years. Goldman Sachs Group last year opened up trading in NDFs, which pay out in cash. The bank used Bitcoin futures to hedge its exposure. However, a number of hedge funds bypassed the bank and bought crypto directly as they became comfortable with the asset class, according to a person familiar with the matter, who asked not to be identified discussing private information. A decision by the Chicago Mercantile Exchange to increase position limits for Bitcoin futures also reduced the demand for NDFs, the person said.

Yet with SFOX creating a new product, more rivals may start trading it — and some may use the spot market for hedging. SFOX said it believes its new product will help to lower margin requirements for clients, while Jane Street also expects that it will satisfy the demands of institutional investors. 

NDFs are products “that many institutions are very comfortable with,” Eric Knight, a crypto trader at Jane Street, said by phone. “A lot of institutions are asking how to get exposure to Bitcoin, whether it’s through ETFs or futures. But there’s no spot ETF at the moment, either.”

Expanding liquidity

SFOX has more than 120 institutional clients, allowing it to expand liquidity to a market for NDFs. The firm is only the latest player in a boom in derivative crypto products, a market that’s been surging amid demand for futures and exchange-traded funds. 

Unlike an ETF, where a buyer typically has to put up 100% of the capital to purchase the security, the NDFs can be bought on margin that’s negotiated among counterparties. For futures, the exchange sets the margin requirements. This allows clients to also have leveraged exposure to the NDFs. Based on current trading volumes for the top banks, SFOX estimates that the cryptocurrency derivative can garner more than $100 million in volumes daily.