Thanks for responding. Yeah it is just like options. I'm from an economics rather than a finance background so I use different jargon. Centralized option markets aren't likely to emerge until bitcoin grows big. Volumes in markets you see are likely to small to have much use. Options have a huge payoff variance and there is a big risk that people taking the other side of bets will fail to pay your bets (counterparty risk, remember the financial crisis?). A p2p system could get rid of counterparty risk entirely [except for the integrity of the block chain]. Mining for the contingent claims/options would allow a deep markets to be created despite the small size of the economy. Essentially miners would have to hold them or sell them to someone. No one could fail to pay in bitcoin, even though some people might go belly up in USD.
I don't understand what motivation the existing businesses would have to take the other side of the bet.
Could you please explain?
Not sure which side of the trade you are asking about.
1) Going Long
Suppose that you are Amazon and you need to decide to accept bitcoin. Accepting bitcoin means either a) bearing risk by holding bitcoin inventories or b) paying a lot of exchange fees. Either of these options is costly, and I doubt that Amazon's savings on credit card processing fees and chargebacks would be large enough to recoup these costs.
Thus, Amazon needs an alternative way of profiting from bitcoin. Imagine there are two possible future states of the world: State 1) bitcoin value and difficulty increase dramatically, State 2) bitcoin value (and difficulty) do not increase dramatically.
Amazon could just buy up a whole bunch of vanilla bitcoin before announcing its decision and profiting by reselling the bitcoin later at a higher price. However, this is inefficient. By purchasing standard bitcoin, Amazon is acquiring claims to both future states of the world. Since Amazon's choices can dramatically increase the probability of state 1 occuring, Amazon would earn much more by purchasing claims on state 1 than it would by buying up vanilla bitcoin.
2) Hedging Risks/Going Short
Suppose you are an online casino. Accepting bitcoin means that you Americans will start flooding your site with coins. You need to convert their currency into Euros so they can play with other people on your site.
You will also need to pay them out in bitcoins. This means either a) holding a large bitcoin inventory or b) paying a lot of exchange fees. Holding bitcoin inventories puts you at risk of a large loss if bitcoin drops in value. Thus you would likely to want to exchange claims in State 1 for claims on State 2. If bitcoin goes dramatically up in value, you don't enjoy the rewards. In exchange, you shield yourself from some risk.
The value of bitcoin is inversely proportional to its velocity. If merchants are constantly exchanging BTC for USD after every transaction, the velocity will be high and BTC value will be low. You need to define what sort of transactions contribute to velocity. For instance, if I take money out of my safe and put it on the table and then put it back in the safe, even if I do this millions of times a second I'm not decreasing its value. I think you'll find that currency conversions also don't contribute.
Standard equation in monetary economics:
http://en.wikipedia.org/wiki/Velocity_of_moneyMoney Supply * Velocity = Currency Price * Real Value of Transactions Per Unit Time
As you can see, velocity is directly proportional to price. Velocity is the rate at which transactions occur per unit time. Velocity will be high if businesses sell bitcoin as soon as they get it. If businesses are willing to hold bitcoin inventories, some bitcoin is being held of the market and it costs more to acquire bitcoin for exchange purposes.