Bitcoin Rally Fuels Market In Crypto Derivatives (#GotBitcoin?)
New structured products draw concern as digital currency climbs back above $10,000. Bitcoin Rally Fuels Market In Crypto Derivatives (#GotBitcoin?)
Wall Street has dreamed up an array of derivatives tied to stocks, commodities and mortgages. Now such contracts are being developed for bitcoin.
In recent months, some cryptocurrency firms have begun touting structured products linked to the price of bitcoin, with complex formulas determining how much they pay out.
It is still a small market, and the firms say their products aren’t aimed at mom-and-pop investors. But the trend is raising red flags among some market veterans, especially as bitcoin’s rebound above $10,000 has rekindled investor interest in the digital currency.
Craig McCann, a former Securities and Exchange Commission economist, warns that it is a bad idea to take bitcoin—a highly volatile, speculative asset traded on unregulated exchanges—and use it as a building block for complex instruments.
“There are all kinds of problems associated with any structured product tied to bitcoin,” said Mr. McCann, who now leads Securities Litigation & Consulting Group, a firm that provides expert witnesses for companies involved in securities lawsuits. “It doesn’t belong in anybody’s portfolio.”
Cipher Technologies, a crypto hedge fund in Greenwich, Conn., began offering structured products on bitcoin earlier this year. The firm has done several such deals, mainly with entities that manage money for wealthy families and individuals, said Cipher’s founder and managing partner, Gerald Banks.
“We would not fathom pushing this to anyone who would not be fully versed in the risk or in the nature of the underlying asset,” said Mr. Banks, who helped develop Merrill Lynch’s structured-products business in the 1990s and early 2000s.
One of Cipher’s products is a bond-like contract known as a reverse convertible. In such a deal, the client loans money to Cipher in return for monthly interest payments, with Cipher paying back the loan once the contract expires. But before then, if bitcoin falls below a predetermined level—a 19% drop, in one version of the product from earlier this year—then Cipher returns the principal to the client, minus the amount bitcoin has lost.
KuCoin Launches Bitcoin Derivatives Trading With 20x Leverage
IDG-backed cryptocurrency exchange KuCoin has just launched a platform offering crypto derivatives trading.
Announced Monday, the KuMEX trading venue is now live in public beta and will offer initially a bitcoin perpetual contract (XBTUSDM), quoted in U.S. dollars, with up to 20x leverage.
Aimed to make pricing “more fair and rigorous,” KuCoin said, KuMEX uses a bitcoin spot index providing a volume-weighted average of the U.S. dollar price of bitcoin across six exchanges: Coinbase Pro, Bitstamp, Kraken, Gemini, Liquid and Bittrex.
The spot index also avoids a contract being liquidated “because of the low liquidity of the trading platform or the large price fluctuations of one or two spot exchanges,” the exchange explained.
KuMEX offers some protection from risk with an insurance fund it says is “fully transparent,” with the balance to be disclosed on the platform each day.
“This fund ensures that investors who are forced to close their positions will not lose money that exceeds their position margin,” according to the announcement.
Should the insurance fund turn out to be insufficient to cover losses, KuMEX also has an “auto-deleveraging” system, said to be less “inflexible” than settlement via more standard socialised loss mechanisms.
To encourage new retail investors to get involved with crypto derivatives, KuMEX is offering a lower investment threshold than found at some other providers.
“The XBTUSDM contract value is 1 USD, which enables traders to make a more flexible investment. At the same time, KuMEX offers a negative fee for Makers at a rate of -0.025% with a certain amount of fixed commission, encouraging users to provide liquidity to the platform through making the market and earning some commission as an incentive,” says KuCoin.
KuCoin CEO Michael Gan said:
“Compared to the spot market, derivatives are much riskier due to the leverage used, so we are more cautious in providing such services. KuMEX is a derivative trading platform independently developed by our team, and from its inception, we have positioned it as a genuine and advanced financial product, so that all users can trust the platform and trade on it freely, without worrying about the loss caused by any form of manipulation. ”
After the full launch of the platform, 50 percent of net KuMEX revenue will be assigned for distribution to holders of the exchange’s token, KuCoin, the release states.
Last November, the Singapore-based exchange raised $20 million in Series A funding from investors including IDG Capital, Matrix Partners and Neo Global Capital.
3 Insights On Crypto Derivatives And Risk From Veteran OTC Traders
For all the talk about liquidity, bitcoin and other crypto-assets are thinly traded. Investors that buy and sell large volumes can’t do so directly, without slippage, or a change in the price between order and execution.
They turn to over-the-counter (OTC) desks to manage those trades, whether buying crypto for the first time, or trading to generate alpha (above-market returns).
As a result, these desks handle anywhere from 30 percent to 65 percent of total crypto market volume, depending on whose estimate you believe. To get a look inside this business, CoinDesk Research talked to two veteran OTC traders in a live webinar on Oct. 28.
Martin Garcia is managing director and co-head of trading at Genesis Trading. Yinfeng Shao is a former trader at Circle and now the CEO of a development-stage OTC firm, Reciprocity Trading.
OTC desks take on tremendous, temporary risk. Traders like Martin and Yin are tasked with managing that risk by moving large amounts quickly and offsetting it on derivatives markets, including BitMEX, Huobi, OKEx, CME Bitcoin Futures and Bakkt. (For background, CoinDesk Research has produced a white paper on the state of crypto derivatives markets. You can download it for free here.)
As a result, they are among the most sophisticated traders on crypto derivatives exchanges. Here are a few of the insights Martin and Yin shared during our hour-long conversation.
1. Investors’ Mentality Has Shifted
The mentality of investors has changed since the earlier days of crypto, from venture-like to hedge-fund-like.
“There’s a lot more velocity amongst the traders that are out there, whereas in the early days it was very much more a buy-and-hold” strategy, Martin said. “People these days understand that this market is super volatile and a lot of the different crypto funds and people that are out there, they are trying to add alpha for their shareholders.”
2. Derivatives Markets Move The Spot Market
First of all, market moves get started on derivatives exchanges more often than on spot exchanges.
“Because there are so many trading venues, it’s a constant question of, where is the action starting?” Yin said. “Often it’s starting on derivatives exchanges because that’s where a lot of people have connections and that’s where a lot of the most highly levered bets are taking place.”
“Crypto already is a fairly random, volatile walk in terms of price action and the collection of these derivatives and the exchanges that list them effectively act as leverage on top of that,” he went on. “Whenever you start to make a move, there’s a good chance it will get exacerbated because of the amount of open bets that are out there.”
In isolated examples, like the May 17 flash crash, a small amount on spot markets can cause a large move on the offshore derivatives markets, specifically BitMEX, allowing traders to manipulate the spot price in favor of their derivatives markets position.
Theoretically, that’s possible on regulated crypto derivatives markets like CME’s, but it’s more expensive and difficult because the leverage is not as high.
That’s Not The Only Way Derivatives Markets Can Fail.
“Where things tend to break down a bit and you get a lot more slippage is when you’ve simply exhausted everybody’s ability to really use the derivatives instruments to hedge, so whether that’s the amount of collateral that everyone’s posted is insufficient, or the market conditions are such that you really can’t get access to some of these platforms,” Yin said.
3. Two Products Dominate Derivatives
The most popular product is the perpetual swap, reputedly invented by BitMEX. Crypto futures are a close second. A handful of OTC desks can provide swaps and custom derivative products, including contracts for difference, but those two products have dominated market volume so far.
Bitcoin options are emerging, but remain a small percentage of overall volume. As providers including Bakkt and CME have announced plans to bring options on bitcoin futures into the markets, Yin and Martin said these may prove attractive for large investors entering crypto, looking for a hedge against a big downside in a volatile market.
“I think it means there are more sophisticated hedging strategies. It allows people to be more comfortable with spot exposure, if it can be more easily hedged out,” Martin said. “These markets move really quickly and a lot of the bigger places that want to start trading, there’s a significant amount of headline risk attached to this. How do they protect against the crazy downside move? Options may very well help eliminate some of those risks for them.”
Listen to the full webinar for Yinfeng and Martin’s unfiltered opinions on risk, liquidity and derivatives in crypto markets.
Tassat Gets CFTC Approval To Issue Bitcoin Derivatives In US
New York-based financial technology firm Tassat — formerly known as trueDigital — has succeeded in overcoming the first hurdle in its bid to launch a fully-regulated crypto derivatives exchange.
According to an announcement from the United States Commodity Futures Trading Commission (CFTC) on Nov. 7, the regulator has approved the transfer of a swap execution facility (SEF) registration from fellow New York-based financial services firm trueEX to Tassat.
Tassat had first reached the agreement in principle to acquire — subject to CFTC approval — trueEx’s SEF registration back in July of this year.
The company is now waiting for news regarding its prospective acquisition of trueEx’s Designated Contract Market (DCM) registration, which would allow it to operate an exchange listing futures or options contracts with oversight from the CFTC.
Physically-delivered BTC Derivatives For Institutional Investors
In its press release, the CFTC stated that trueEX and Tassat fulfilled the requirement for transferring a SEF registration by providing evidence that Tassat would be able to operate in compliance with the provisions of the U.S. Commodity Exchange Act and related CFTC regulations.
The agency revealed that there are now a total of 19 registered SEFs, including Tassat, and noted that TrueEX had been granted its registration as a SEF by the CFTC on Jan. 22, 2016.
The registration brings Tassat closer to launching a crypto derivatives exchange with full oversight from the CFTC, where it hopes to list physically-delivered Bitcoin (BTC) derivatives for institutional investors. As CEO Thomas Kim said in July when the plans were first unveiled:
“Adding the exchange to our ecosystem delivers a complete end-to-end offering, currently unavailable today, that encompasses tokenization, payments, market data and settlement for the benefit of our clients and partners.”
In March, Tassat — when it was still known as trueDigital — had partnered with crypto data firm Kaiko and digital assets analytics company Inca Digital Securities to widen the distribution of its over-the-counter reference rates for Bitcoin and Ethereum (ETH), the latter of which it created in partnership with ConsenSys.
TrueDigital was initially established as a subsidiary of TrueEx, which has long been active in the crypto space and was the first in the industry to secure a DCM registration for Bitcoin swaps from the CFTC back in 2012.
This summer, another crypto exchange ErisX, procured a derivatives clearing organization license from the CFTC as part of its plans to make digital asset futures contracts available for trade on its regulated derivatives market later this year.
Crypto Derivatives: A Corner of the Market or the Market Itself?
Emmanuel Goh is co-founder & CEO of skew. – a financial technology startup headquartered in London since 2018. These opinions are his and do not necessarily reflect the view of CoinDesk.
The following article originally appeared in Institutional Crypto by CoinDesk, a weekly newsletter focused on institutional investment in crypto assets. Sign up for free here.
The Race Is On
One business day before the much-awaited ICE/Bakkt launch, the CME announced it would be listing bitcoin options in Q1 2020. ICE returned the favor by announcing it would also be launching options contracts but in December this year/
Why are two of the largest exchanges in the world competing so openly for a space that was considered, until recently, as secondary by most industry insiders?
Almost every week, a new player is announcing its intention to enter the increasingly crowded crypto futures market. Most recently crypto behemoths Binance and Bitfinex launched their own futures products, with varying degrees of success.
This optimism wasn’t always there. The rise of Hong-Kong based BitMEX – home to the most liquid bitcoin contract globally – was for a long time met with skepticism by industry leaders, who dismissed the product as only serving gambling addicts with the use of high leverage.
The crypto futures market really took off in 2018. Volumes increased by a factor of ten compared to 2017 levels – a year widely seen as the peak of the crypto market. Bitcoin futures and other perpetual swap instruments are now trading, on average, 10x more volume than the underlying bitcoin spot market according to data compiled by skew and Bitwise.
In hindsight, it is relatively simple to explain why. As the market entered a prolonged downturn starting in 2018, market participants looked for ways to profit from, or at least hedge against, the falling prices. The growth in futures markets came from that need to short the market.
The market evolved rapidly from very little two years ago. In Q4 2017, the Financial Times published, in a well-researched article, how shorting the stock of chipmaker Nvidia – the products of which were very popular with cryptocurrency miners – could be one of the most convenient ways to get short exposure to cryptocurrencies.
A Crypto Anomaly? Not Really…
Traditional markets also experienced a “derivatives moment” in response to increased volatility in the market. The seventies were a period of incredible financial turbulence as Richard Nixon abolished the Bretton Woods system in 1971, moving to a fiat monetary system, and allowing all currencies to float. The world subsequently went through the first oil shock in October 1973, sending the price of black gold skyrocketing in what was previously a quiet market.
A few months prior, in 1973, in a (not so) curious twist of events, Fischer Black and Myron Scholes found a simple analytical formula to price options, which won the 1997 Nobel Prize two decades later. The conjunction of those two events is widely seen as having started a glory period in derivatives products across all asset classes.
It wasn’t just a fad. The Office of the Comptroller of the Currency in Washington estimates banks currently have exposure to more than $200 trillion notional of derivatives. Derivatives have gradually become the place where the majority of interested parties are coming to trade – across all markets.
“We Will Tame Bitcoin” – Emeritus CME chairman Leo Melamed
Should We Believe The Prediction From The Legendary Futures Trader?
There has been a consensus view that bitcoin is too volatile to be a medium of exchange – triggering a wave of “stable coin” projects in 2017 and 2018. The inelastic supply function of bitcoin is, by construction, indifferent to demand or supply shocks – making all the adjustment occurring through price and creating volatility as a result. Good logic, but not necessarily true in practice. For instance, this argument is also valid for gold, which is one of the lowest volatility assets around, with an average daily move of 0.6% in 2019 according to data obtained from the Federal Reserve of Saint Louis.
There are a number of factors that contribute to an asset’s volatility. One of them is its market structure. Academics have extensively researched the impact of developing derivatives markets on the volatility of underlying assets and have overwhelmingly concluded that derivatives help to stabilize prices.
This is particularly true for options, as flows are usually dominated by call overwriting (selling calls to overlay an underlying position) as investors are looking to generate extra yield. The income fund launched by LA-based Wave Financial is a first step in that direction within the crypto markets.
Bitcoin’s volatility will decrease structurally as those markets keep growing.
Derivatives rhyme with leverage, which essentially allows you to do more with less. That’s great, but only to a certain extent. As Warren Buffet famously said, derivatives are financial weapons of mass destruction and require careful risk management.
Regulators have as a result been working on curbing the use of leverage globally. In May 2019, Japan’s FSA asked bitFlyer to reduce leverage for its perpetual swap product. The UK FCA is taking even more drastic action by planning to ban the offering of crypto derivatives to retail investors. The regulator also asks retail brokers to warn their customers of the risks of investing using derivatives products, across all asset classes.
“CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 72% of retail investor accounts lose money when trading CFDs with this provider.” – Welcome message on a popular retail brokerage platform
If 72% of investors lose money trading CFDs on low volatility underlyings, what could go wrong trading 100x levered products on the infamously volatile bitcoin?
It is likely that, over time, regulators or simply Darwinism will increasingly put the derivatives market in the hands of professionals.
Not Only About Volumes
Most participants – including us at skew. – spend probably too much time worrying about volumes. Derivatives volumes are mostly a function of leverage. When Japan’s FSA asked bitFlyer to reduce the maximum available leverage from 15x to 4x on the 28th of May, its volumes declined overnight by at least 50%.
Derivatives are zero sum contracts between two counterparties. Traders and investors have to maintain collateral against those open positions. Leading venue BitMEX asks for a minimum maintenance margin of 0.5% and a minimum initial margin of 1%. The CME on the other hand asks for 37% of initial margin. That means if you would like to open a $1 million long position on BitMEX, you can post as little as $10,000 in collateral versus at least $370,000 at CME.
The total $ amount of bitcoin futures contracts opened – called open interest – at CME currently stands at $150 million contract in comparison with $1.1 billion at BitMEX. Because of margin requirements it is likely there is a similar amount of money “working” to trade Bitcoin derivatives at CME and BitMEX despite the later trading 10x more volumes. The “herd” might be closer than people think.
This is a great setup for the offshore exchanges which are able to make significantly more money from the same amount of capital as they collect their fees from the volumes traded.
An Increasingly Central Question: What Is The Price Of Bitcoin?
Victims of their own success, derivatives venues were hit in 2019 with a first-world problem.
As trading occurs on margin, derivatives exchanges have been careful to design a spot price index derived from the price of what were, initially, much larger physical exchanges. The index is used to settle the contracts at expiry, and decide when to initiate margin calls. It was a smart way of preventing manipulation of the then not-so-liquid crypto derivatives contracts.
However, as the derivatives market has grown exponentially, we have now entered a period where the underlying physical exchanges are much smaller than the derivatives exchanges – only 10% of total volumes in aggregate. It has become tempting to try to manipulate the less liquid underlying exchanges to yield some profits trading the derivatives.
This was most visible earlier this year in May when a relatively small-size order on physical exchange Bitstamp triggered a wave of liquidations at BitMEX and took the entire market down.
Exchanges seem to have been increasingly aware of the problem and have been attempting to strengthen their indices – sometimes with unfortunate consequences, as with a recent miscalculation at Deribit costing the exchange $1.3 million.
“There’s a whole ocean of oil under our feet! No one can get at it except for me!” – There Will be Blood’s Daniel Plainview
With the CBOE officially out, expect the competition between CME and ICE to be heating up in 2020 as the two exchanges roll out their options offering.
It would be particularly encouraging to see corporate hedging flows taking off, led by mining companies and supported by physically delivered and options contracts. The Mexican government is said to have spent $1 billion on put options this year to hedge its 2020 oil production. Still some way to go for crypto derivatives.
Former Morgan Stanley Developers Launch Crypto Derivatives Exchange
Eight former core developers from financial services company Morgan Stanley have launched Phemex, a new cryptocurrency derivatives trading platform, in Singapore.
In a press release shared with Cointelegraph on Dec. 4, the former Morgan Stanley developers claim the platform is ten times faster than traditional crypto trading platforms, while offering 100x leverage to both retail and institutional investors in Bitcoin (BTC), Ethereum (ETH) and Ripple (XRP) perpetual contracts.
Exchange Is “On Par With Nasdaq”
In the near future, these contracts will reportedly also be backed by traditional financial products, such as stock indexes, interest rates, foreign exchange, agricultural commodities, and metals and energy. Phemex co-founder Jack Tao said:
“We are the first exchange to truly bring Wall Street level sophistication to the worldwide crypto derivatives markets. Our matching engine, trading engine, and risk engine were six months in the making, putting the platform technically on par with Nasdaq.”
Tao, who spent 11 years as an executive at Morgan Stanley, told Cointelegraph that the platform was looking to add options trading soon. In launching Phemex, Tao assembled a team of more than 30 senior developers. He explained:
“We’re not just providing the functionality for trading. As executives from Morgan Stanley, we know what kind of ways, what kind of direction, or what kind of architecture can support high-frequency trading, stability, and low latency. This is where Phemex excels — our expertise allows us to compete with and outperform existing platforms.”
Tao told Cointelegraph that since the Nov. 25 launch, Phemex has seen volume of around 1000 BTC per day on BTC/USD contracts.
Singapore Regulators Take A Closer Look At Crypto Derivatives
In November, Singapore’s central bank and financial regulator, the Monetary Authority of Singapore (MAS), proposed to bring crypto derivatives trading under its purview. The MAS’ proposal would make the trading of derivatives based on underlying assets like Bitcoin and Ether subject to the city-state’s Securities and Futures Act. For Phemex, a Singapore-domiciled company, the proposal by the MAS comes at a perfect time as it may soon allow cryptocurrency-based derivatives to be traded on regulated platforms.
Retail Investors Aren’t Interested In Crypto Derivatives, Says eToro Executive
Despite being one of the largest crypto derivatives platforms, an eToro executive said he isn’t losing sleep over the U.K.’s proposed retail ban.
Over breakfast in a central London restaurant, inside what used to be the Midland Bank, Iqbal Gandham, eToro’s U.K. managing director since 2016, said the country’s decision to ban retail access to all crypto derivatives would likely have a “minimal” impact on its business.
With more than 10 million users worldwide, eToro is one of the largest trading platforms in the world. Gandham said the company has noticed a shift in the behavior of retail traders, who value the fact they can buy an actual cryptocurrency asset and transfer it out into their personal wallets.
“Two years ago people didn’t understand real [assets] and derivatives, they just thought they were buying bitcoin. Now people are more comfortable in owning their own wallets and transferring crypto, they understand that if they can’t transfer it out then it can’t be real,” Gandham said.
The U.K.’s chief financial watchdog, the Financial Conduct Authority (FCA), surprised the industry last summer when it unveiled plans to ban the “sale, marketing and distribution to all retail consumers” of crypto derivatives, including contracts for difference (CFDs).
At the time, the regulator said retail investors were “ill-suited” to such products because they were unable to “reliably assess the value and risks of derivatives or [exchange-traded notes] that reference certain cryptoassets.”
Although regulated platforms, such as Hargreaves Landsdown, have already banned retail access to crypto derivatives, the FCA isn’t expected to make a final decision until later this year.
eToro first offered bitcoin CFDs in 2014. It gradually increased the number of supported cryptocurrency-based options, but only allowed users to buy the underlying asset in September 2017.
“Had you asked me this question in 2016/17, I would have said ‘a really, really big impact, we need to change our business,'” Gandham said. But the majority of eToro’s customers now buy the underlying crypto, rather than any CFD product.
eToro currently offers retail users crypto assets or crypto CFDs at a maximum leverage of 2:1. A spokesperson told CoinDesk approximately 87 percent of eToro’s retail users buy the asset. In the first month of 2020, that number increased to 90 percent.
In the case of catering to retail investors, eToro is “moving away from the derivatives market,” Gandham said.
Few crypto derivative providers share eToro’s sanguine attitude to the upcoming ban. Daniel Masters, executive chairman at CoinShares, which is the owner of XBT Provider, one of the largest crypto derivatives developers in Europe, told CoinDesk the company had “vigorously resisted” the FCA’s proposal.
During the consultation phase in Q4 2019, CoinShares spearheaded a campaign against the ban and criticized the regulator for cherry-picking data and for an overall “lack of understanding” concerning the asset class.
“Banning such instruments has many adverse consequences,” Masters told CoinDesk. The ban “will not protect investors,” but will push them to offshore providers with little to no investor protection, he added.
Gandham agreed the ban will likely be a net negative for investor protection. “I don’t understand the premise of banning [retail crypto] derivatives,” he said, because a blanket ban would push trading underground and overseas, which would likely expose consumers to more risk.
Still, Gandham is convinced the ban will only have a muted effect on cryptocurrency trading in the U.K. Crypto derivatives, in his view, are better suited for institutional or professional traders who aren’t affected by the ban and who want exposure to the asset but would be burdened by having to hold the physical asset.
Of course, there will always be a handful of retail investors wanting 100x leverage on platforms like BitMEX, Gandham said. But he believes the vast majority of eToro’s clients, who are in it for the long haul, will not even notice the difference should the ban come into effect.
Startup Vega Tests Blockchain Focused on Derivatives Trading Products
Blockchain startup Vega has launched the testnet for its protocol, which allows parties to build trading products on a decentralized network.
Over the last two years, Vega has been “working on building a protocol that allows people to deploy and run networks that can trade decentralized derivatives effectively,” Vega co-founder Barney Mannerings told Cointelegraph in an interview.
Vega received over $5 million during its 2019 funding round, seeing investments from players such as Pantera Capital and Ripple’s Xpring.
Vega Opens Its Test Network
Vega has launched a testnet for this software, offering partners and investors the opportunity for involvement before opening the offering to the entire community, Mannerings said. He added:
“Over the next few weeks and months we’re going to allow people to start using that test network to understand how that protocol works and to give us feedback on what’s been built, and that’s effectively part of a roadmap that leads up eventually to the release of a production-ready version of that software.”
The Protocol Allows Folks To Build Trading Products
Vega has its own blockchain, tailored for markets and trading products, offering participants the chance to launch trading products on something other than the currently-available broad spectrum blockchains.
Current blockchain’s such as Ethereum are not specifically made to host trading markets built on top of them. Vega’s blockchain specifically caters to this niche, according to Mannerings.
Vega’s Solution Is Similar To Amazon’s AWS, But Not Really
Vega’s offering is essentially infrastructure software, Mannerings explained, although it is different than what Amazon Web Services, or AWS and others are doing in their brick and mortar-type offerings.
“AWS is operated by Amazon, whereas what we’re building is kind of like the node software that can be used to run that blockchain, but once it hits the production environment, that won’t be operated by us,” Mannerings said. “It will be operated by the participants and the people who want to use it.”
Mannerings continued, pointing to one similarity with AWS. “Once people deploy this and start to use it, they will be able to create and trade on derivatives markets in whatever they want,” he said.
Vega’s co-founder likened the operation to infrastructure software that allows easy access for entities to build trading products and markets. “That’s sort of a bit like how AWS enables people to create web applications or databases without having to know as much about the underlying hardware,” he explained. Mannerings again, however, specified the difference that Vega is not running the servers and data centers behind the operation.
Vega aims for its software to be an open network similar to Bitcoin or Ethereum, allowing interested parties to build on it, although the software is not open-source quite yet.
Decentralized finance, or DeFi, has gained prominence in the market over the last few years, with projects such as Celsius offering participants access to crypto-based loans, away from centralization. Vega adds to the DeFi space, offering another way people can engage in alternative finance.
Synthetix Exchange May Soon Offer Derivatives Trading On Ethereum
Ethereum-based synthetic asset issuance platform Synthetix is adding new features, which includes derivatives trading.
In a March 10 blog post, Synthetix announced plans for trading in binary options in the third quarter of this year. Binary options are a type of derivative financial product where the buyer either receives a payout or loses their investment.
“Synthetic binary options will likely generate significant trading volume as they will be able to leverage the liquidity of the debt pool, allowing a trader to take a large position almost immediately without needing to find a counterparty.”
In addition, the non-custodial crypto exchange listed several improvements to its existing products, including the “launch of sX v2, new crypto Synths and crypto index tokens.”
New Features Include Leveraged And Futures Trading
For its second quarter, Synthetix is supporting new assets like “equities and exchange-traded funds.” The exchange is planning to offer leveraged trading on tokens.
“Leveraged trading drives a significant amount of volume on crypto exchanges, and while synthetic futures will compete directly with centralised futures platforms, there is a lot of value in supporting tokenized leverage. We will initially test leveraged tokens using fiat currencies like the Euro and AUD. We expect to support 5x and 10x BTC tokens both long and short soon after we launch fiat leverage tokens. Following the rollout of BTC we will expand the offering to other large cap crypto tokens.”
The Ethereum-based platform revealed its plans for several features in 2020, including optimistic rollups, Ether/DAI/BTC collateral, trading incentives, advanced order types, and synthetic futures. For these futures, Synthetix said it would support any asset:
“Synthetic futures trading will be much more flexible and will support any asset on sX. This opens up the possibility for leveraged trading on many different asset classes simultaneously, including cryptoassets, equities, and commodities. We expect leverage will initially be capped at 10-20x…”
Crypto Exchanges Considering Binary Options
Synthetix isn’t the only crypto exchange seeing the potential of offering derivatives trading. Even before the Supreme Court of India lifted a ban on banks dealing with crypto, the Unocoin exchange was planning to launch derivatives options on its platform.
Crypto Synthetic Assets, Explained
1. What Is A Synthetic Asset?
The term “synthetic asset” refers to a mix of assets that have the same value as another asset. Traditionally, synthetics combine various derivative products — options, futures or swaps — that simulate an underlying asset — stocks, bonds, commodities, indexes, currencies or interest rates.
For example, rather than purchasing a stock, an investment firm may purchase a call option and sell a put option on the same stock. The use of synthetic assets here allows the firm to make use of multiple financial vehicles rather than a single investment asset.
The high-end estimate for the value of all derivative contracts is upwards of $1.2 quadrillion — a number exponentially bigger than global real estate ($217 trillion), the global debt ($215 trillion), global stock markets ($73 trillion) and the world’s supply of gold ($7.7 trillion).
On one hand, derivatives can be used to help take price risk out of a variety of assets like commodities to debt. On the other hand, derivatives can promote and exacerbate market inefficiencies, encouraging a zero-sum game among traders rather than creating true market value.
The use of derivative products allows investors to earn returns without a physical settlement, arbitrage trade, transfer risk and hedge against price fluctuations.
2. What Are Crypto Synthetic Assets?
Cryptocurrency-based synthetic assets aim to give users exposure to a variety of different assets without needing to hold the underlying asset. This could be anything from fiat currencies, such as the United States dollar or the Japanese yen, to commodities like gold and silver, as well as index funds or other digital assets.
By using these unique synthetic assets, investors can still hold tokens that track the value of some assets without needing to leave the cryptocurrency ecosystem. Crypto synthetic assets also offer users all the benefits of decentralization, as they are open to all users across borders by using secured smart contracts and other instruments, and the data is stored on distributed ledgers.
3. What Kinds Of Crypto Synthetic Assets Are There?
Abra is a decentralized investment platform that allows users to use their cryptocurrency as collateral to create synthetic assets. Abra’s synthetic asset model leverages smart contracts enabled with Bitcoin (BTC) and Litecoin (LTC).
In practice, if an investor wanted to buy Google stocks worth $1,000 through Abra, the firm would peg $1,000 of the user’s BTC against the price of Google’s stock. If Google goes up or down, the equivalent amount of BTC will be added or subtracted from the user’s contract.
In the above example, the investor would essentially be taking a short position on BTC while taking a long position on Google, the hedged asset. Meanwhile, Abra would take a long position on BTC while shorting Google.
Synthetix is an Ethereum-based platform that allows investors to mint and trade synthetic cryptocurrency on its peer-to-peer platform. This enables users to gain access to synthetic products that simultaneously give them exposure to non-cryptocurrency assets such as gold, USD and stocks. There is currently more than $69 million locked in synthetic derivative contracts.
Synthetix currently has three decentralized apps: the Synthetic exchange, Mintr — which enables users to stake the platform’s native SNX token so they can earn fees and mint Synths — and a Dashboard that presents an overview of the entire Synthetix Network.
The Synthetix team has built a multi-tier issuance platform, an exchange and a type of collateral, creating a market for cryptocurrency-backed synthetic assets. Synthetix allows users to issue various synthetic assets, including fiat, derivatives, cryptocurrencies and different asset classes. Examples could be Bitcoin, euro, USD, Tesla stocks, gold, etc.
The user puts collateral, in the form of SNX tokens, in order to create these synthetic assets. Then the user would be able to swap or exchange one synthetic asset for another, repricing the collateral through an oracle without an intermediary.
Universal Market Access is a decentralized platform for financial contracts that utilizes a “provably honest oracle mechanism” and smart contracts to empower users to create their own financial products.
Essentially, UMA users can create financial products, using protocols such as ERC-20 to create tokenized derivatives that grant them exposure to real-world underlying assets similar to how traditional exchange-traded funds function.
4. Why Are Crypto Synthetic Assets A Big Deal?
Cryptocurrency-collateralized synthetic currency models powered by smart contracts can have enormous implications in the traditional finance industry. In their essence, these models offer cryptocurrency holders the leverage to trade traditional assets as well as their derivatives while remaining in the digital ecosystem.
Decentralization grants open-access to a global community of investors. Before products such as Abra, Synthetix and UMA became available, only a select few institutional investors could access the global derivatives market. Now, anyone with a smartphone and an intermediate understanding of the synthetic asset underworkings can access these powerful investment vehicles.
With cryptocurrency synthetic asset platforms opening the doors to derivatives for thousands of new investors, only time will tell what kind of impact a potential flood of new cryptocurrency-collateralized derivative contracts will have on the traditional financial landscape.
Surviving Crypto Volatility With Derivatives Contracts
Different forms of derivatives trading could become the next step toward crypto mass adoption and give investors more transparency.
Volatility has been the dominant theme in financial markets lately. As uncertainty around COVID-19 and its impact on the economy deepens, markets have been swinging wildly. We’ve seen the S&P 500 falling off a cliff as well as risk assets across the board taking a beating.
Cryptocurrency markets have been no different and have exhibited extreme volatility. Amid the pessimism, Bitcoin (BTC) broke below the $4,000 mark on Black Thursday and fell nearly 50% from recent highs.
It’s been over a month since the crash, and though we have seen prices bouncing back sharply, the sentiment has not improved.
There is still a fair amount of fear among traders, and they continue to stay hawkish. Such sharp moves hurt market confidence, and it will take some time before traders get comfortable carrying overnight risk again.
It is hard to say how long it will take for the markets to recover and for the true impact of the current crisis to be visible. Some estimates suggest that it will take as long as 12–18 months for the world economy and markets to fully overcome this shock.
Given the backdrop, it’s fair to say that markets should remain choppy for some time and that the volatility is here to stay.
Volatile Markets Increase Directional Risk
Extreme volatility in the markets spells trouble for traders caught on the wrong side of price swings. On March 12, the price of Bitcoin dropped by over 40% and subsequently recovered 16% the next day. Over $750 million worth of positions went into liquidation amid these swings.
Bitcoin implied volatility spiked to 250% per annum in March, and though it has cooled down to about 70%, it still remains quite rich.
Carrying directional trades in such volatile market conditions is very risky. In fact, the higher the volatility, the higher the directional risk for traders. If traders don’t maintain enough margin in their positions, there is a chance of getting caught on a price whipsaw and getting liquidated. Violent price swings have been a regular feature since Black Thursday. This has made directional trading difficult not only for new traders but also for veterans.
Isolating Directional Risk From Volatility Risk
In calm market conditions, traders look to profit by catching the momentum of the market direction. If they predict the market direction correctly, they register a profit. Similarly, if the market moves against them, there will be losses. The amount by which a trader’s portfolio is going to get impacted per unit movement in price is called “delta” — a measure of directional risk. There is another risk to a trader’s portfolio, something that most traders tend to ignore during calm market conditions: the risk of price swinging up and down while it drifts in a particular direction. This risk to a trader’s portfolio is called “vega” and measures the risk against change in volatility.
Just as traders use futures contracts to position themselves for directional risk, options are useful for protecting against rising or falling market volatility. Traders can also use options to remove directional risk from their portfolios, partially or completely, and bet on market volatility alone.
Some exchanges are at the forefront of innovation here and are offering products that allow traders to trade the volatility risk without taking any directional risk. Hence, should a trader believe that the market is going to stay volatile, they can buy volatility without exposing themselves to the effects of which direction the market moves in.
Growth In Crypto Options Segment
As crypto derivatives markets mature, we are seeing more and more traders participate in options markets and trading volatility. In traditional markets such as equities, the volumes on options contracts can be multifold of those on futures contracts. Though crypto options markets have existed for a few years now, the volumes have been slow to pick up.
Most crypto traders find options trading difficult to understand and intimidating. There is a need to package options in a way so that traders can easily understand the payoff profile without diving into the nitty-gritty. This would help reduce the friction and increase the demand for crypto options trading. A MOVE contract is one such product. Herein, a trader holds a straddle: a multilegged options position that will benefit from higher market volatility irrespective of market direction.
The Straddle Strategy, Simplified
One of the ways to own volatility is to buy a straddle. A straddle is nothing but a call and a put option combined together.
Hence, one can create a long straddle position by buying a call option and a put option that have the same strike price and maturity. If the market rises, the call option becomes profitable; should the market fall, the put option starts to payoff. Building a straddle position by oneself can be complex for traders. Not only do they need to find liquidity in both the call and put options, but they must also execute both the legs of the trade simultaneously.
MOVE contracts are nothing but a packaged straddle position. Thus, when a trader is buying a MOVE contract, they are essentially buying a call and a put option with the same strike and in equal amount.
The Crypto Equivalent Of Trading The VIX
Cboe has an index called the Volatility Index, or VIX, which is also known as the fear index. The reason the VIX is called a fear index is because its value rises when market uncertainty or fear is high and falls when the market is calm. Investors can’t directly invest in the VIX, but they can bet on the VIX going up or down by trading futures on the VIX or by purchasing VIX-related products such as VIX futures exchange-traded funds. In cryptocurrency markets, trading MOVE contracts is the equivalent of trading VIX products, as it gives investors pure exposure to the volatility of crypto.
Removing Settlement Currency Risk
Another important aspect of any derivatives product is the settlement currency — i.e., the currency in which the final profit or loss is realized. The default settlement currency for most crypto derivatives products is Bitcoin. This is understandable, given that when the crypto derivatives ecosystem was starting, stablecoins were still not commonplace. Thus, products that allowed payoff in Bitcoin or other cryptos were innovated. This was also partly driven by customer demand, as traders focused on increasing their count of Bitcoin. Things have changed a lot in the last 12 months, and we’ve seen a strong demand for stablecoin settlement in the crypto derivatives segment.
Gold Futures, Stablecoin Futures And The Growing Demand For Stable Assets
Other ways to combat a volatile market include switching to low-risk assets such as gold. Futures contracts on gold-backed coins have provided crypto traders with a way to protect their portfolio value in times of widespread uncertainty. These derivatives have also opened a new sector of trading that allows crypto traders access to physical gold. They have been in high demand on many derivatives exchanges because of the recent gold price spike in the backdrop of the coronavirus scare and global markets sell-off.
Futures contracts on stablecoins are also getting popular, as there are arbitrage opportunities for traders to earn profit in a stable token’s value while taking minimal risk. Overall, the industry has seen a surging demand for a stable digital currency amid fears of an economic recession and will continue to rely on stablecoins as a safe haven.
Derivatives provide a way for traders to hedge in times of high market uncertainty, isolate and protect against different kinds of risks, and aid in true price discovery. In the long run, a healthy derivatives market helps to reduce the long-term volatility of an asset class.
The crypto derivatives segment has seen huge growth in the last two years, but we’ve only scratched the surface as of yet. For mature asset classes, derivatives markets are four to five times the size of spot markets. Currently, Bitcoin perpetual swaps make for the lion’s share of the crypto derivatives segment. As crypto derivatives markets grow, we will see increased demand to trade futures on other coins beyond Bitcoin and for options, as they provide a way for traders to manage volatility risk.
Total Crypto Derivatives Volume In Q1 2020 Spikes 314% From Q4 2019’s Average
Total futures trading volume skyrocketed during the first quarter of 2020 in comparison to 2019 data.
A study by TokenInsight indicates that the total futures trading volume in the crypto industry reached over $2.1 trillion in Q1 2020. This is an increase of 314% from the 2019 Q4 average.
According to the “2020 Q1 Cryptocurrency Derivatives Exchange Industry Report”, except for a slight decline in Q4 2019, the trading volume of cryptocurrency futures grew in 2019. The total market turnover in Q1 2020 is roughly eight times than Q1 2019.
For trading volume analysis, TokenInsight included BitMEX, OKEx, Huobi DM, Binance Futures, Deribit, Bitget, Binance JEX, FTX, Gate.io, BFX.NU, BitZ, and KuMEX, in addition to some emerging derivatives exchanges.
Average Daily Trading Volume Skyrocketed
The average daily trading volume of the whole market during the first quarter of 2020 hit $23.3 billion. This represents an increase of 274% from 2019.
Researchers Who Were In Charge Of Preparing The Report Commented On The Following:
“We believe the cryptocurrency futures have already possessed some attributes of market-leading indicators, and spot market participants can refer to futures trading volume for position management.”
The study also highlights that the correlation coefficient between futures and spot trading volume fell to 0.31. This is compared to the 0.76 registered in the fourth quarter of 2019. Researchers concluded that this phenomenon explains that futures market participants “may have been relatively independent” from the spot.
Futures Markets’ Trading Correlated With Spot Market Fluctuations
When the futures market is abnormally traded, the study highlights that the spot market is exposed to significant fluctuations.
Following The Same Line, The Report States:
“At this time, investors need to adjust their positions. Besides, in the market downturn, only when the future volume finally shrinks, the market may experience a meaningful rebound.”
A study quoted by Cointelegraph on April 21 reported that Binance Futures emerged as the biggest winner in the futures market, following the Black Thursday sell-off.
At that time, Binance reached $2.8 billion in just 24 hours of Bitcoin futures volumes. Their results surpassed that of both BitMEX ($2.1B) and Huobi ($2.46b).
According to data provided by Coin Metrics, Binance Futures’ Bitcoin (BTC) open interest share jumped from about 10% in mid-March to nearly 25% by April 12.
Here Are the Options: Bitcoin Derivatives Give BTC Halving Insight
The Bitcoin price is surging as the halving approaches, but options data can shed some light on what experts think Bitcoin will do next.
With the halving just six days away, the crypto community is collectively holding on to their proverbial hats and counting down the days until the historic event takes place. Looking back, it’s quite amazing to see what has been achieved in the past four years since the last halving and how much the industry has matured.
Regulation has taken giant leaps, venues have become more sophisticated and transparent, and institutions have begun to dip their toes in the once murky waters of crypto. Along with a reduced supply, all the conditions are perfectly aligned for a post-halving bull run, and that is exactly what many crypto enthusiasts are expecting.
One noticeable proponent of such a result for the halving is PlanB, the anonymous analyst behind the famous stock-to-flow model. Recently tweeting about the event, PlanB expects the Bitcoin price to rise tenfold in the next two years, thus proving that his model can indeed predict the long-term direction of BTC’s price.
Forget The Hype, Here’s The Data
With the price of Bitcoin rallying ahead of the halving and the crypto community being generally optimistic about the upcoming event, others are taking a more sober stance on the price action following the halving, given all the hype surrounding the specific date being an event where people “buy the rumor and sell the news.”
As the price rises in the days leading to the halving, it’s possible that traders will take profits immediately after the event. So what to make of all this? Supply and demand is just one of the things to take into account, and it is, of course, the pillar on which long-term valuation stands, but short-term price volatility does not adhere to that logic, as fear, greed and other man-made factors come into play.
Derivatives data can be extremely insightful, as more complex instruments such as options contracts produce datasets that simply do not exist in the spot markets. As such, here is a closer look at the Bitcoin options data to shed some light on the situation.
Being a highly complex market, Bitcoin options market participants are often considered the most knowledgeable players, and the data sets produced by this complex market can shed a light on where these experienced traders think the price is headed post-halving.
Implied Volatility: Tables Are Turning?
For example, the implied volatility metric can tell a lot about the expected price of Bitcoin within the options market.
When there is a higher premium for a certain strike price on an options contract, it means there is greater demand for these contracts. Data from the largest options market, Deribit, shows that options market players think the downside risk is higher than the potential upside.
However, this can also mean that traders are protecting their long positions on spot markets, including miners, who are inherently long on Bitcoin. Matt D’Souza, CEO of Blockware mining, told Cointelegraph:
“If Bitcoin is further adopted in, mining will likely be more commoditized and institutionalized which will reduce volatility in the price of Bitcoin. Present commodities like gold, oil or soybeans have large, institutional suppliers (Bitcoin miners are the present suppliers). In mature commodities like oil and gold these suppliers hedge their supplier which reduces volatility. This is just starting with Bitcoin. CME futures and options, Bakkt etc. so Bitcoin will mature and volatility will get reduced especially as more institutional players control the supply.”
Looking at the historical data can give an even better insight of how the sentiment is changing with time. The chart below shows that puts are more expensive than calls, which can mean the market thinks the security has a greater chance of falling than it does of rising. However, the trend is starting to favor calls (the upside), so it’s important to keep an eye on how this trend progresses.
According to James Li, analyst at CryptoCompare, the current data favors a cautious outlook on Bitcoin, but that is changing rapidly. He told Cointelegraph:
“With the recent rally, near terms expiries saw implied volatility picked up, whilst longer term expiries dropped. The 15th May contracts which expire right after the halving suggest prices can go both ways, with 25-delta only skewed very slightly to the put side, which means the demand is somewhat stronger on the downside. Longer term expiries, however, remain skewed on the put side but if we see persistent rallies, the sentiment can flip to the other side.”
Put-call Ratio: Bullish Or Bearish?
Another metric to keep an eye on in the Bitcoin options market is the put-call ratio, which has been increasing, rising from 0.62 to 0.70 in the last week. While a rising put-call ratio can be looked at as a bearish sign at first glance, it may also point to a risk-averse market. Bitcoin trader and popular YouTuber Tone Vays told Cointelegraph:
“I think the majority of the people are wrong. A rising put/call ratio should be bullish for BTC price as most of those puts will expire worthless. Puts are also a good hedging (aka insurance) instrument so people that are hodling Bitcoin might be scared that mining will be in trouble and they are buying puts to protect their positions.”
In fact, many advanced traders shared the same perspective as Vays, especially if the ratio goes too far in either direction. D’Souza, who is also a hedge fund manager at Blockchain Opportunity Fund, shared a similar outlook on options, telling Cointelegraph:
“A rising put to call means many investors are buying downside protection. I love it as a contrarian indicator. So when put/call gets extreme or greater than usual, I actually get bullish because I take a contrarian position. I like to do the opposite of the herd. This is most importantly, take the other side for the most part when the ratios go too far in either direction.”
The Elephant In The Room
Although the options market and other metrics can give insight into what traders and other market players expect the BTC price to do, its interpretations should always be taken with a grain of salt. However, as Bitcoin continues to solidify its position as a new asset class, its “classical” volatility and unpredictability will continue to fade away.
In the meantime, it’s also important to take the “elephant in the room” into consideration — that is, the COVID-19 pandemic and the massive wave of unemployment that has come with it. With this in mind, it’s possible that many will be hoping to cash out after the halving in search of safe haven assets.
Bitfinex Derivatives Launches Bitcoin Dominance Perpetual Swaps
The derivatives platform for Bitfinex cryptocurrency exchange is launching a new perpetual swaps product today that enables traders to speculate on Bitcoin dominance.
The derivatives platform for Bitfinex cryptocurrency exchange is launching a new perpetual swaps product today, May 6, that enables traders to speculate on Bitcoin (BTC) dominance.
Dominance, which refers to Bitcoin’s share of the total market capitalization for all cryptocurrencies, is a measure closely eyed by many in the community — whether they be altcoin developers and traders or diehard Bitcoin maximalists.
According to data from Coin360, BTC dominance stands at close to 67% as of May 5.
Bitfinex Derivatives’ Bitcoin Dominance Perpetual Swap (BTCDOM) is ostensibly the first such contract to launch in the market. The exchange claims it is “more capital efficient and cost effective than an outright long or short futures trade, while also being less volatile.”
The latter argument is persuasive, given that Bitcoin’s share of total cryptocurrency market capitalization has varied relatively less than its spot market price. BTC dominance one year ago was a little under 58% and has remained range-bound between 60–70% since late June 2019 — with one notable flash exception on March 12, 2020.
Trading for the contract went live at 9:00 AM UTC today and remains limited to traders in eligible jurisdictions.
A Bitfinex Representative Told Cointelegraph:
“Bitcoin has proven time and time again to be a safe haven for traders and it is continuing to be seen as digital gold. Since global markets crashed in March as the COVID-19 crisis took hold, we have seen a huge increase in trading volume, reaching over $2B over a 24-hour period during the crash on March 13th. We believe the demand will still be there after the halving whilst the supply will be halved.”
Bitfinex Diversifies Products Even As Parent Firm Mired In Legal Action
As reported, Bitfinex launched its own social network last month, “Bitfinex Pulse,” to encourage communication between traders.
While its parent company, iFinex, was dealt a class action lawsuit for alleged market manipulation at the start of this year, the exchange has been continuing to broaden its offerings, unveiling staking services in early April.
Bitcoin Volatility Expected As $328M In BTC Derivatives Expire Friday
On May 29, CME BTC contracts expire, meaning Bitcoin price could experience volatility before and after the expiry.
CME Bitcoin (BTC) futures and options markets are set to mature this Friday and traders are closely watching to see how spot prices will react to this event. The contracts expire every two months and according to market analysts, they negatively influence BTC’s price in spot markets. In fact, recent data from Cointelegraph and Arcane Research found that there is a 2.3% drop ahead of CME expiry.
Although some investors claim manipulation could have been behind the price drops preceding CME contracts expiration, the futures average daily volume has been around $380 million.
More importantly, the instrument is cash-settled, meaning no Bitcoin is effectively changing hands. This brings forth the question of whether investors should be worried about Bitcoin’s price action on May 29. If so, what indicators can be used to predict eventual price swings?
Investors Must Look Past Volume
Open interest is actually a much better metric to understand professional investors’ actual positions as it measures the total number of contracts held by market participants.
An investor could have bought $50 million worth of futures and sell the entire position a couple of days later. This $100 million in traded volume does not currently represent any market exposure, therefore it should be disregarded.
As per the above chart, CME Bitcoin Futures open interest soared from a mere $130 million in late March to $386 million this month. That’s far more significant than Bitmex and OKEx 50% growth.
Also, it should be noted that there’s no way to know if an unregulated venue’s figures are inflated, especially when there’s little to no KYC involved.
Closely Observe What Happens In The Options Markets
Options markets are an entirely different derivatives contract. There are endless strategies traders employ, but in the most basic one the buyer of a call option can acquire Bitcoin for a fixed price on a predetermined date.
As recently reported by Cointelegraph, institutional investors’ growing appetite for CME Bitcoin Options saw a 1000% increase in open interest.
Total open interest for the May 29 expiry options is currently sitting at 32,000 BTC, although only 19,000 BTC between $7,500 and $10,500 strikes which equates to a little over $170 million.
Interestingly enough, at CME, open interest for this Friday is almost entirely composed of call (bullish) options. The same pattern can be seen at LedgerX, another regulated venue for institutional traders.
Measuring The Potential Impact Contracts Expiry
Undoubtedly, such large open interest both from futures and options will almost certainly create a huge arm wrestle between buyers (long) and sellers (short). The problem is, there’s no way to know exactly how much of those derivatives are exclusively used for hedging.
An investor holding 1,000 BTC may have recently been spooked about Bitcoin’s halving or the possibility of a price drop due to the decreasing hashrate. While selling their stake is an option, another strategy would be to sell a $7,000 strike put option.
Doing this allows the investor to be paid upfront, therefore acquiring more cash as long as BTC closes above $5,000 on May 29.
The same problem occurs in the futures market. For every trade there must be a buyer (long) and a seller (short) of equal size no matter if the exchange is BitMEX, CME, OKEx, Binance or LedgerX.
The once catch is there’s no way to know if the short seller holds an equally sized long position in the spot market or at another futures venue.
Futures Contracts Roll Over
To better gauge the potential impact of the upcoming expiry, traders should monitor CME open interest for the May contract. Investors typically roll over the position over the last few weeks.
In order to carry a long position one needs to buy the June contract and sell the one from May, thereby reducing short-term contract open interest. This is unlike perpetual contracts that make up the lion’s share of BitMEX and OKEx volume.
If these investors decide to not roll over their positions, this would likely increase the odds of additional volatility during expiry.
The latest data from CME shows an open interest of 3,473 ($158 million) contracts for May with each contract representing 5 BTC, so this amounts to $158 million.
Investors should keep an eye on this figure as CME average daily volume seldomly surpasses $400 million in a single day.
A significant change in open interest could lead to more intense movements by investors.
Crypto Derivatives Volume Just Hit A New Record High
Crypto derivatives monthly volume hit a new all-time high of $602 billion in May.
Crypto derivatives monthly volume increased by one-third in May to hit a new all-time high of $602 billion, according to U.K.-based data aggregator CryptoCompare.
The new record is only just a shade past the previous one of $600 billion, registered in March. However, derivatives are becoming ever more popular and now account for 32% of the crypto market — up from 27% in April. In percentage terms, the monthly volume increase in May for derivatives was six times larger than the increase in spot volumes, which was up 5% to $1.27 trillion.
Huobi, OKEx and Binance accounted for about 80% of May’s derivatives volume combined. In percentage terms, CME saw the largest monthly increase of 59%, though its $7.2 billion in volume was dwarfed by market leader Huobi — posting a 29% monthly gain in volume with $176B.
Considering The Options
Institutional options volumes on the regulated platform CME also hit record levels in May — increasing a massive 16 times from April’s figures to a new monthly high of 5,996 contracts traded. The platform also broke a new daily record on May 28, withCME trading 1,418 Bitcoin options contracts. Derebit’s options volume more than doubled in May to $3.06B.
There Can Be Only One
CryptoCompare’s report highlighted some noteworthy shifts in the world of stablecoins, with USDC and PAX both seeing massive declines in volume against BTC — with USDC down 78% this month while PAX lost 97%. USDT represents the overwhelming majority of stablecoin to BTC trading with 98%.
The biggest day of the month, as you might expect, was Halving Day Eve on May 10, which saw a huge spike in spot trading volumes to $64.7 billion. To put that into context, it’s just under the top trading day in April ($66.2B) and considerably less than Black Thursday in March ($75.9B).
Two Sides Of The Same Derivative: Comparing Traditional And Crypto Markets
Here’s how the crypto derivatives market compares to the traditional derivatives one.
Crypto derivatives volumes have hit a new record high in May 2020. The early generation of crypto investors mostly worked with a hold-and-sell perspective. With the inevitable evolution of the market and the advent of cryptocurrency derivatives, investors with varied agendas — such as the desire to trade Bitcoin (BTC) volatility in both directions, hedging against major market movements, mitigating risks, etc. — began to flock to this asset class.
Derivatives are complex financial instruments that enable these agendas but often prove to be overwhelming for inexperienced and uninitiated investors to manage. As derivatives are pegged to an alternative asset class such as cryptocurrencies, these instruments are made even more challenging for an average investor to comprehend and thus, makes them more skeptical of these investments as compared to traditional derivatives that are also complex in nature.
In spite of this, the crypto derivatives market has rapidly expanded, especially in the years since the crypto bull run of December 2017. The stage they have reached in their lifecycle can be compared with the early evolution of derivatives in the traditional capital markets, such as the Chicago Board of Trade becoming a part of the Chicago Mercantile Exchange, whose current underlying assets are mainly equities, bonds, currencies, commodities, major indexes and even interest rates.
Evolution Of Crypto Derivatives
Since the early development of crypto derivatives on elementary trading platforms like ICBIT in 2011, they have garnered considerable interest from staunch believers in the crypto market, hitting average volumes of about 1,500 BTC a day. Back then, the only product available to traders were BTC futures, they enabled a trading price arbitrage based on future prices and even helped them to mitigate price volatility of BTC.
Fast forward nearly a decade to the COVID-crisis-affected world of 2020, and crypto derivatives hit a record high of $602 billion in May, with major exchanges like OKEx, BitMEX, Huobi, and Binance maintaining their dominance. Among them, Huobi accounted for the largest trade volume, at $176 billion and up 29% month-on-month, followed by OKEx and Binance with $152 billion and $139 billion trades’ worth, respectively. However, it is worth noting that in the same month, CME’s futures saw a 44% drop in volume, which is indicative of the lack of institutional trust in crypto derivatives during times of economic uncertainty.
Differentiation From Traditional Derivatives Markets
Higher volatility in the crypto derivatives markets due to larger movements in the underlying currency allows for a higher return. According to research by Eurekahedge in 2019, crypto funds have an average return of 16% as compared with the 10.7% return from hedge funds, which are typically the top-performing funds in the traditional capital markets. Pankaj Balani, CEO of Delta Exchange — a Singapore based cryptocurrency derivatives exchange — discussed this difference with Cointelegraph:
“Returns have to be looked at in conjunction with per unit risk taken to generate that return. The volatility of an asset class is a measure of the risk that an asset class carries. Crypto certainly carries a higher risk than mature asset classes and hence returns have to be higher in order to attract capital.”
However, with the increased price stability of BTC, the scope for these abnormally high returns are bound to reduce over time. Unlike most derivatives markets, crypto derivatives indexes pull data from markets that are open 24 hours a day, seven days a week, allowing for longer trading periods for investors in various time zones.
As the cryptocurrency market is mostly limited to currency-based derivatives, there are only a certain number of products that exist: perpetual contracts/swaps, futures/forward contracts and options. In traditional markets, the number of products are endless due to the various types of underlying assets, and even those are evolving at a rapid pace due to the tranching capabilities of some of those products, such as collateral debt obligations.
Even when up against foreign exchange derivatives, the volumes are not comparable due to the difference in the number of established fiat currencies and cryptocurrencies. However, the increased interest in options in recent times is acting as a launching pad for many new American and European options products in exchanges such as Bitmex, OKEx, CME, CBOE, Deribit and Ledgerx. The graph below shows the monthly derivatives volumes in comparison to the average monthly figure of $13 trillion just for FX derivatives.
Currently, crypto derivatives markets are largely unregulated. While this is lucrative for a segment of high-risk, alternative investors, it proves to be a deterrent for conventional orthodox investors mainly due to the ambiguity in settlement (high counterparty risk), whereas traditional capital markets operate using custodians or central clearing counterparties — highly regulated institutions that take on and manage counterparty risk, such as the Options Clearing Corporation.
Various crypto exchanges have also been making efforts to mitigate this counterparty risk and make collateral transfers faster, while Deribit has launched an external custody solution. Meanwhile, Binance and BitMEX have created insurance funds to prevent the auto deleveraging of successful traders’ positions. That being said, these efforts are still in their nascent stages and the mechanisms have not proven their worth just yet.
In the derivatives markets, institutional investors rule the roost in terms of volumes due to the capital requirements that came about with the Volcker Rule. However, in the case of crypto derivatives, institutional investors are just beginning to enter the market amid heavy skepticism. Co-founder and CEO of capital market platform Cross Tower, Kapil Rathi commented to Cointelegraph on the issue:
“One feature that is consistently different when digital assets are compared with traditional assets is the private key, which raises intricate questions as to what constitutes ‘possession and control’ and ‘custody.’ U.S. regulators are now evaluating these very complex questions. As the crypto market matures and answers to these regulatory questions develop, the same will hold true for the derivatives market. We believe the CFTC’s recent guidance with respect to the meaning of ‘possession and control’ will allow for the development of certain products in the retail market.”
On the nature of individual and institutional investors as well as their respective requirements, Kapil further commented that institutions may have different reasons behind including derivatives in their portfolios, as they may be “hedging their derivatives exposure in real-time or engaging in multi-leg transactions,” and therefore factors such as speed and liquidity of the platform will be critical. He further added:
“Growth and mainstream adoption of every asset class requires the participation of both individual and institutional investors. Within the two categories of individuals and institutions, there are subsets of users who require different types of tools and capabilities to execute their strategies. For example, within the category of individual investors, certain sophisticated investors are not afraid to build their own automated trading strategies and connect to exchanges via low latency gateways and interfaces.”
Pricing is another aspect to consider. Traditionally, equity futures are typically priced using variables such as risk-free interest rate and dividends, and currency forwards are priced based on foreign and domestic interest rates of the two currencies in the transaction. Additionally, equity options are typically priced using the Black-Scholes option pricing model and currency options are priced using the Garman-Kohlhagen option pricing model.
Since cryptocurrencies are their own asset, this makes a point of debate: whether to price as a commodity or a currency. Currently, BTC derivatives are traded at different prices on various exchanges, creating ambiguity as to which of these prices should be used to price the options contracts. Uniform pricing techniques need to be developed along with seamless technology to encourage broader institutional involvement.
Balani commented that prices can vary between venues due to different spot indexes, cost of capital for market makers and demand-supply dynamics on an exchange, he added:
“The prices for options contracts on any exchange are linked to those of futures on that exchange or the spot index price used on that exchange. This information is easy to factor-in and any gap in pricing can be easily adjusted for. Having said that, different venues will have different pricing for implied volatility and whichever exchange has the most aggressive pricing will eventually attract the volumes.”
Despite the many differences in the two markets, there are several points at which they converge due to the inherently similar nature of derivatives as an instrument. Generally, derivative volumes are often a function of leverage/margin, as a higher margin allows investors an opportunity to have larger speculatory and hedging positions that usually only institutional investors have access to due to the related capital requirements.
This is a phenomenon also noticeable in crypto derivatives. When Japan’s FSA asked BitFlyer to reduce the maximum available leverage from 15x to 4x on May 28, 2019, its trade volume declined overnight by at least 50%, similar to the drop in trade volume after the Volcker Rule was passed under the Dodd Frank Act, introduced in the aftermath of the 2008 financial crisis.
Since 2018, there has been an increasing use of the Financial Information eXchange, or FIX, protocol among crypto exchanges, which is a platform used for communications in the traditional capital markets to exchange real-time information related to transactions and markets. This enables the exchanges to increase their efficiency and speed of transactions, as FIX is able to process hundreds of messages every second in each session.
Evolved Crypto Derivatives Markets
Continuous evolution of products in the derivatives world is inevitable, making it difficult for regulators to keep pace, like with the role of collateralized debt obligations or mortgage-backed securities in the 2008 financial crisis. An increase in regulations globally like in the case of the United States Securities and Exchange Commission and the Commodity Futures Trading Commission working on the Crypto-currency Act 2020 will allow for better price discovery and price stability, as seen in the case of Bitcoin from the evolution of perpetual swaps and futures contracts, hedging and risk management for investors. This, in turn, will increase investor confidence in cryptocurrencies as an asset class.
The launch of crypto derivatives exchanges that are backed by major institutions will also provide a major boost to investor confidence. For example, Bakkt is an exchange owned by the Inter-Continental Exchange (which is the company that owns NYSE) and trades both in physically settled and cash-settled futures. A Binance exchange spokesperson commented on the matter: “All adoption will contribute to increased investor confidence.
Adoption and participation from traditional institutions usually get more media attention, partly because of their legacy brand, and that in itself can be a good thing.”
The lack of physical settlement across the board in exchanges proves to be a major deterrent for investors, as cash settlement allows for market or price manipulations from large, single players. Physical settlement resolves this, as it allows for a more sophisticated arbitrage mechanism between the contracts and underlying spot prices. Thus, to encourage more traditional investors to join the market, it is essential that physical settlement is provided across all major exchanges along with cash settlement, as they are both lucrative to different sections of investors.
Unlike the underlying assets of traditional markets, the supply of cryptocurrency is limited. This allows for derivatives prices to fluctuate even more, as the instruments are inherently highly sensitive to supply-demand factors of their underlying asset. The scarcity of cryptocurrencies also gives room for higher price speculation opportunities due to increased volatility, but also a higher chance of price manipulation at the same time.
Still A Waiting Game?
In the current scenario, where there is high volatility in the market and a continually increasing interest in crypto derivatives coming from the likes of JP Morgan and Morgan Stanley as they launch FTX Derivatives in Africa and crude oil futures. What’s more, even the BTC miners might get into the mix to improve their supply-demand stability, making it clear that crypto derivatives will experience growth in subsequent years.
Despite the promise of growth that crypto derivatives show, there are gray areas that need to be addressed by regulators in various global markets as they are in Singapore, whose financial regulator proposed crypto derivatives being allowed on domestic exchanges. To discuss the matter further, Cointelegraph spoke to Jay Hao, CEO of OKEx, which deals with derivatives. He opined that regulation is a key factor:
“For more institutions to enter the space, they need to be sure that the correct procedures are in place for their clients. They also need to work closely with exchanges to establish a proper definition of crypto within the regulatory framework. The classification of the underlying is the basis of the discussion related to crypto derivatives. […] Some ways regulators can work with exchanges without stifling their growth are adopting a suitability test, restricting leverage, examining the Margin rule and clearing. Most of this can somehow be adopted by existing derivatives frameworks.”
To enable traditional retail and institutional investors to flock to the crypto derivatives market in volumes comparable to the traditional derivatives markets, it is essential that regulators step in with a reasonable set of policies eliminating the shortcomings of the current system but are not detrimental to the growth expected in the near future. However, according to a recent Fidelity survey, 36% of institutional investors in the U.S. and Europe have digital assets in their portfolio, compared with 22% in 2019 — a highly encouraging sign.
Options Trading Is a Huge Step for the Crypto Derivatives Market
Different options trading will help to diversify the market, making it flourish on the global financial scene.
For those of us involved in the cryptocurrency space, we’ve gotten used to the fast-paced nature of this rapidly growing industry.
New technology quickly becomes old, bright shiny projects lose their luster, and what started out as a few privacy advocates sending “magic internet money” to one another has mushroomed into a whole new asset class with a robust infrastructure established around it. Every new product, application or financial instrument that we add has value and attracts more participants. Options trading is a huge step for the crypto derivatives market — and it’s already proving its worth.
How The Crypto Space Has Grown
Cast your mind back to 2017 before the Chicago Mercantile Exchange or Chicago Board Options Exchange entered the cryptocurrency space with their Bitcoin (BTC) futures offering. Back then, the most common expression you’d hear (time and time again) about crypto was that it was just like the “Wild, Wild West.” Lawless, volatile, full of scam projects and initial coin offerings over-promising and underdelivering, or even outright stealing investors’ money.
Even though Bitcoin had been around since 2009, it was very new to most people then. Some of the gains being made were phenomenal — and the losses utterly devastating. Many banks were calling Bitcoin a scam including (perhaps most infamously) JPMorgan’s CEO Jamie Dimon, who said it was a fraud back in September 2017.
Fast-forward to today and every bank wants to integrate blockchain technology (or already has) to enhance efficiency and reduce costs. JPMorgan and its boss have shown a complete 180 degree turn, going as far as launching their own JPM Coin to facilitate instantaneous payments.
The United States’ largest financial institutions have even opened bank accounts for major U.S.-based cryptocurrency exchanges, while governments around the world are either researching or actively piloting their own version of a cryptocurrency backed by their central banks.
The point is that cryptocurrency can no longer be ignored. With improved regulation and decisive action, we have managed to weed out many of the bad actors and scam projects to grow the space almost beyond recognition.
The Rise Of Crypto Derivatives
The derivatives space has now attracted investment from institutional players and, last year, a landmark move from a New York Stock Exchange-backed company to enter the market with its physically-settled Bitcoin futures contracts. Indeed, the growth of crypto regardless of bull or bear markets has been exponential and now, derivatives are leading the charge. Yet, we still have a long way to go.
The entire cryptocurrency market cap is still under $300 billion today. Compared to gold at $9 trillion or the global stock market at almost $100 trillion, it’s clear that crypto is still in its infancy.
When looking at traditional markets, derivatives typically account for more than four times the trade volumes of the underlying asset. Yet, in crypto, spot trading is still much larger. That won’t be the case for much longer. At OKEx, it is our belief that derivatives will outgrow the spot quickly to become four or five times larger over the coming years. And this growth will be further fueled by more sophisticated offerings such as options trading.
The Importance Of Options Trading
Options are so important, as they give traders more versatility and a great way to hedge their risk. Like futures, with options contracts, traders can buy or sell an agreed amount of the underlying asset on a fixed date in the future at an agreed-upon price. However, unlike futures, options give the buyer or seller the right, rather than the obligation, to buy or sell on the date.
This depends on whether the trader buys a “call” option or a “put” option. Briefly, the difference between the two is that with the former, the trader can exercise the right to buy Bitcoin (or the asset in question) and with the latter, she or he can exercise the right to sell. Since these are rights and not obligations, many traders feel more comfortable trading options especially in such a highly volatile market as crypto.
Options are a relatively new feature. Deribit was the only exchange offering crypto-backed options until mid-2019, followed by Baakt in December 2019 and OKEx and CME launching BTC options soon after. Despite their brief time in the space, crypto-backed options are already being widely used by BTC traders to generate an income and shield their holdings from rampant volatility.
They are also particularly useful for miners right now due to the Bitcoin halving. They can use options to lock in future revenue and secure an acceptable price for selling mined Bitcoin, much like farmers in ancient Greece did to secure their income in the event of a bad harvest. We saw this happening leading up to the halving in April as the BTC price turned bullish again and BTC options registered a one-month high, with OKEx topping the leaderboard.
As with every innovation and product offering, the market becomes more interesting, more mature and more reflective of traditional markets. And allowing traders to keep their pricing strategies more flexible is more appealing to institutional traders.
Beyond Bitcoin Options Trading
Of course, Bitcoin’s dominance in the market is undeniable. Of the thousands of cryptocurrencies that have grown up around it, Bitcoin dominance still remains at around 65%. Bitcoin is also more widely accepted and better understood. It will be the gateway for most people and institutions into crypto trading and derivatives. But that doesn’t mean there isn’t a place for other crypto options as well.
At OKEx, one of the main reasons that we have continued to thrive and become a leading exchange is through our sheer diversity of products. After seeing the high demand for BTC/USD options, OKEx is adding ETH/USD options for traders this week as well, and we believe it will gain traction fast.
All these alternatives help to diversify the market, make it more colorful, rich and interesting. The crypto derivatives space is becoming more competitive with new entrants coming in all the time. This can only be a good thing for the space. Over the coming years, we will witness the volumes go from the billions of dollars to the trillions, and crypto will become a major contender at last.