Cryptocurrency derivatives? You bet. This trader has 295% return

A Bitcoin (virtual currency) coin is seen in an illustration picture. PHOTO: REUTERS

LONDON (BLOOMBERG) - Jay Smith has little doubt the cryptocurrency market will crash.

The price of bitcoin has increased sixfold in the past year, despite a 25 per cent plunge this month triggered by China's crackdown on digital tokens. Not a week goes by without startups launching new ones to fund everything from dentistry to Las Vegas strip clubs. Even Paris Hilton is tweeting to her 16 million followers about her cryptocurrency investments. If that isn't a jump-the-shark-moment, what is?

Yet Smith, the No 1 cryptocurrency trader at online brokerage eToro, shrugs all that off as he plays the markets from his home in Basingstoke, a suburban town west of London. Every day he looks for reasons to buy more bitcoin and other digital tokens - computer programs that use cryptography to create artificial units of value. He doesn't have much information to size up the prospects of Blackmoon Crypto, Steem, FirstBlood and other coins that have caught his eye, but that's cool with Smith, a high school dropout and onetime professional video-game player. His portfolio is up 295 per cent in the past 12 months.

"I just put in an order for a Tesla, and I don't even know how to drive," said the 29-year-old Briton.

Smith isn't playing with just his own cash. More than 9,000 retail investors heed his advice and copy his trades on eToro, which is licensed in Cyprus and by the UK's Financial Conduct Authority. It's a social trading network that enables clients to track their favorite cryptocurrency traders. In an unregulated, ultravolatile market that few investors understand, eToro injects even more risk into the mix.

The firm is one of several that use contracts for difference, or CFDs, derivatives that allow investors to speculate on the price of cryptocurrencies. Plus500 Ltd offers leverage of 30 to 1 on such bets, while XTB International Ltd, registered in Belize, touts its award as the best cryptocurrency trading provider of 2017.

Unlike futures contracts, CFDs don't trade on exchanges and are largely illiquid. Investors can suffer big losses because they have to put up only a percentage of the value of their trades on margin. While the US largely prohibits retail investors from trading CFDs, regulators in Europe are only now beginning to address the peril they pose.

In June, the European Securities and Markets Authority, the European Union watchdog for capital markets, said it was concerned about the suitability of CFDs and was weighing measures to restrict their use. Combining CFDs with cryptocurrencies is reckless, said Rainer Lenz, chairman of Finance Watch, a Brussels-based public-interest organization, who serves on an advisory group at ESMA.

"We have to put a stop to this," said Lenz. "This is selling a synthetic instrument on top of another synthetic instrument. This is the highest form of speculation. You just can't do that to retail investors."

The fine print in eToro's risk-disclosure statement warns that "If the market moves against you, you may sustain a total loss greater than the funds invested in a specific position."

But Iqbal Gandham, head of eToro's London office, said that in practice the firm uses mandatory stop-loss orders to prevent investors from losing more than their initial deposits. He denied that mixing CFDs and cryptocurrencies is harmful to retail investors.

"You can't lose more than you put in," Gandham said. "And if you don't know what you're doing, just copy someone who does."

That's where Smith comes in. An easygoing man with the air of someone dazed by his luck, Smith dropped out of school at 14. He threw himself into eSports, a competitive form of video gaming that's huge in Asia. Soon enough Smith, who goes by the online handle Jaynemesis, was day-trading tech stocks and then bitcoin. He started buying dozens of them at US$25 each (they cost US$3,944 on Sept 26).

Smith rode out the currency's first big crash in 2013, when it lost half its value in less than three weeks. By early 2017, he'd built a portfolio of coins from Ethereum, Litecoin and other issuers. He also discovered eToro, co-founded in 2007 in Tel Aviv by brothers Yoni and Ronen Assia.

The brokerage handled stocks, currencies and other securities. In 2010, Yoni Assia became infatuated with digital tokens and provided office space to Vitalik Buterin, the brains behind Ethereum. Four years later, Assia added bitcoin trading to eToro, which is based in Cyprus.

In February, the firm expanded into other cryptocurrencies. It also launched a marketing campaign aimed at retail investors with push notifications sent to customers' mobile phones, instructional videos on YouTube and ads in the London subway proclaiming "Crypto Needn't Be Cryptic."

Copy trading is what separates eToro from other CFD firms offering cryptocurrency trading. EToro pays Smith, who's not an employee, at least 2 per cent of the money that follows him. As of Sept 26, that meant he was earning about US$230,000 annually on the US$11.5 million in assets held by his 9,143 copiers. Smith, who allocates about half his portfolio to stocks and the rest to cryptocurrencies, makes more money with every investor he draws to the site.

The fusion of derivatives and cryptocurrencies was probably inevitable in a market that appears to be spinning out of control. Thanks largely to Ethereum, a three-year-old open-source software project inspired by bitcoin's blockchain technology, anyone can create a digital token.

That's spurred startups worldwide to fund their development by minting tokens and selling them to investors via initial coin offerings, or ICOs. The bet is that once an issuer prospers, the value of its company scrip will soar. At the beginning of 2013, there were only seven digital coins worth US$1.6 billion. Today there are 1,228 coins with a market value of US$136 billion, according to CoinMarketCap, a firm that tracks digital tokens. Bitcoin accounts for 48 per cent of the total.

"What we are seeing is pure unlicensed capitalism," said Jon Matonis, a founding director of the Bitcoin Foundation and chairman of Globitex, a cryptocurrency exchange based in Riga, Latvia. "And you just can't keep up with the market anymore."

Regulators are scrambling to catch up. On Sept 4, China outlawed ICOs and moved to shut down exchanges as well. In July, the US Securities and Exchange Commission required companies to register ICOs like IPOs. Russia and Japan are also eyeing new rules.

To many finance pros, cryptocurrencies look too ephemeral to become a real asset class. This month, JPMorgan Chase & Co chief executive officer Jamie Dimon likened them to the 17th century Dutch tulip bulb mania and called bitcoin a fraud.

Yet Wall Street's embrace of blockchain is one reason bitcoin's price has soared. Goldman Sachs, Banco Santander and JPMorgan are some of the institutions investing millions of dollars in related startups and joining industry research groups.

With Ethereum up more than 3,562 per cent this year, the euphoria was running high at a July reception eToro hosted in London's tech haven of Shoreditch. Investors and entrepreneurs jammed into a dimly lit basement space to drink Mexican beer and swap gossip on the hottest ICOs. One impresario handed out fliers for a new token like a promoter at a rock concert.

Smith, with a shaved head and a silver ring embedded in each earlobe, was holding court as eToro's star. A Goldman analyst sought his views on recent moves in bitcoin. Smith, shouting above the din, was happy to oblige.

EToro strives to make trading cryptocurrencies as simple as possible for retail investors. It's as easy to bet on digital tokens as it is to buy merchandise on You just point and click a "buy" tab to go long or "sell" to go short. The firm's algorithms do the rest. While the FCA requires eToro to ascertain whether its products are appropriate for retail customers, they'll have to read the fine print on its website to learn that CFDs aren't good long-term investments.

On Sept 6, eToro announced that investors can buy bitcoin and four other cryptocurrencies directly, so they will no longer have to use CFDs to go long. But customers still have to utilize the derivatives to short the tokens or copy the trades of Smith and others.

For most of the year, Smith's followers have been pumped when he livestreams his trading sessions on Twitch, a social media site.

"Feeling cryptocrazy," one user wrote in the chat box on Sept 5.

"Me cryptodrunk," replied another.

"Just put 10K with you," said a new follower.

Ten days later, with bitcoin and Ethereum having lost more than a third of their value, the mood of his followers had darkened. Smith's eToro portfolio had skidded more than 10 per cent and he'd lost a few hundred copiers. Those sticking with him wanted to know if this was the shakeout everyone, including Smith, had been fearing. Humming to himself as he tapped the keyboard, the trader paused and told them to relax.

"Hopefully you can tell from my calm attitude that I'm not in the least bit phased by this," Smith said. "It will be over in two weeks time, and then the market will start rallying again. Nothing has changed. This just means that the Chinese can't buy tokens so easily now. All that's going through my head is buy the dip."

As Smith talked, bitcoin started surging. Over the next few hours, it skyrocketed 30 per cent from its low of the day.

"Look at it go," he gushed. "It's going insane. Let's buy some more."

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