Bitcoin and Interest Rates

Understanding the interplay between USD and Bitcoin interest rates is critical to understanding the spot and derivatives market structure. The difference between where you can borrow and lend unsecured USD vs. unsecured Bitcoin can tell you many valuable things as a trader. The rest of this post will explore how interest rates affect the price of spot and derivatives.

Using borrowed money to buy an asset is the bedrock of finance, and is no different with Bitcoin. A trader who is very bullish Bitcoin, would borrow USD, sell USD, then buy Bitcoin. Traders who expect the price of Bitcoin to appreciate more in percentage terms than what they are paying on the USD loan. The second scenario is borrowing Bitcoin to sell it short on the market. The short seller hopes that Bitcoin will fall by a greater percentage than the interest rate on their loan. The differential between USD and Bitcoin interest rates tells traders about whether the market thinks Bitcoin will appreciate or depreciate in the future.

Besides observing USD and Bitcoin interest rates separately, the premium or discount a futures contract trades at signals whether USD or Bitcoin interest rates are higher. For Bitcoin/USD futures contracts, if the future is more expensive than spot it means that USD interest rates are higher than Bitcoin ones. Conversely if the Bitcoin/USD futures contract is cheaper than spot, it means that Bitcoin interest rates are greater than USD ones.

Covered interest rate parity describes the relationship between a futures contract, the spot exchange rate and the interest rates of the home and foreign currency.

F = S * (1 + R_f) / (1 + R_h)

F = Future price; S = Spot; R_f = Foreign currency interest rate; R_h = Home currency interest rate

A simple example will illustrate how this process works. Jane is a foreign exchange trader. The spot price of Bitcoin is $100, while a futures contract expiring in one month has a price of $200. Jane knows she can borrow money from the bank at 100% per month interest. Jane’s friend James is looking to borrow Bitcoin to sell it short. He is willing to pay 25% per month in interest. Jane’s other friend Jack wants to sell Bitcoin in one month’s time for $200 per Bitcoin. Jane sees an arbitrage, if she borrows USD from the bank, buys spot Bitcoin, lends her Bitcoin to James, and then sells it forward to Jack, when the futures contract expires she stands to make $50.

Jane goes to her local bank and takes out a loan for $100. The bank charges her 100% to borrow the money for one month. Jane must pay the bank back $200 in one month’s time. She takes the $100 and buys 1 Bitcoin. James borrows Jane’s 1 Bitcoin and will pay her back 1.25 Bitcoin at the end of the month. Jane promises Jack that she will deliver 1.25 Bitcoin in one month’s time for $250.

After one month, Jane gets her 1.25 Bitcoin back from James. Jane then delivers 1.25 Bitcoin to Jack and receives $250. Jane then pays back her bank loan of $200; the $50 left over is profit.

Plugging in the numbers to the formula, Jane’s arbitrage opportunity becomes obvious.

$100 * (1 + 100%) / (1 + 25%) = $160

If Jane can sell Bitcoin forward at a greater rate than $160, she can make a risk free profit. Are there arbitrage opportunities in Bitcoin like the one presented above? Of course. The USD rate at which speculators are willing to borrow at and margin trade is much higher than the Bitcoin borrow rate short sellers pay. The market believes Bitcoin will appreciate in the future and speculators are willing to pay a high interest rate to leverage their positions.

For the lucky traders who can borrow USD below the rate speculators are paying on margin trading platforms, can make easy risk free profits. Arbitrageurs give up the potential massive upside in Bitcoin’s value for steady non-volatile profits.

Written by Arthur Hayes on August 20, 2014.