Crypto Derivatives Market Hits Record High Amid Evolution

Crypto derivatives volume surged to a new record in May 2020. This surge reflects a broader market evolution beyond the initial investor focus on simply holding and selling cryptocurrencies. As the market matures, investors with diverse strategies, such as speculating on Bitcoin (BTC) price movements in both directions, hedging against market downturns, and mitigating financial risks, are increasingly turning to this asset class.

Derivatives, by their nature, are complex financial instruments. For novice investors, they can be overwhelming to manage. When these instruments are tied to an asset class as dynamic and sometimes opaque as cryptocurrencies, the complexity is amplified, often leading to skepticism compared to their more traditional counterparts.

Despite these challenges, the crypto derivatives market has experienced rapid expansion, particularly following the significant bull run in December 2017. The current stage of its development can be likened to the early days of derivatives in traditional finance, such as the growth of exchanges like the Chicago Board of Trade into the Chicago Mercantile Exchange, which now handles a wide array of assets including equities, bonds, currencies, commodities, and indexes.

The Evolution of Crypto Derivatives

The journey of crypto derivatives began with rudimentary trading platforms like ICBIT in 2011. Even in these early stages, they attracted considerable interest from dedicated crypto market participants, averaging around 1,500 BTC in daily volumes. At that time, Bitcoin (BTC) futures were the primary product, allowing traders to speculate on future price movements and manage BTC’s price volatility.

Fast forward to 2020, a year significantly impacted by global events, and crypto derivatives reached an astonishing $602 billion in trading volume by May. Major exchanges such as OKEx, BitMEX, Huobi, and Binance continue to lead this market. Huobi notably processed the largest share of trades, reaching $176 billion, a 29% increase month-over-month. OKEx and Binance followed closely, with $152 billion and $139 billion in trades, respectively. In contrast, the CME experienced a 44% drop in futures volume during the same period, highlighting potential hesitations from institutional investors regarding crypto derivatives during times of economic instability.

Distinguishing Crypto Derivatives from Traditional Markets

The inherent higher volatility in cryptocurrency markets, driven by significant price swings in underlying assets, presents an opportunity for potentially higher returns. Research from Eurekahedge in 2019 indicated that crypto funds yielded an average return of 16%, outperforming traditional hedge funds which typically achieve around 10.7%.

“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.”

Pankaj Balani, CEO of Delta Exchange

However, as Bitcoin’s price becomes more stable, these exceptionally high return potentials are likely to decrease. Unlike most traditional derivatives markets, crypto derivatives indexes draw data from markets operating 24/7, providing extended trading opportunities for investors across different time zones.

The crypto derivatives market, largely focused on currency-based products, offers a limited range of instruments: perpetual contracts/swaps, futures/forward contracts, and options. Traditional markets, however, boast an almost endless variety of products due to the diverse underlying assets and the ongoing innovation, such as the tranching capabilities seen in products like collateralized debt obligations.

Even when compared to foreign exchange derivatives, crypto derivatives volumes are currently not comparable due to the sheer number of established fiat currencies versus cryptocurrencies. Nevertheless, the growing interest in options trading is paving the way for new products on exchanges like Bitmex, OKEx, CME, CBOE, Deribit, and Ledgerx. The chart below illustrates monthly derivatives volumes compared to the average monthly figure of $13 trillion solely for FX derivatives.

Currently, the crypto derivatives market operates with minimal regulation. While this environment is attractive to high-risk, alternative investors, it poses a significant barrier for conventional investors due to uncertainties in settlement and the inherent counterparty risk. Traditional capital markets, in contrast, utilize custodians and central clearing counterparties – highly regulated entities that manage such risks, exemplified by the Options Clearing Corporation.

Several crypto exchanges are actively working to mitigate counterparty risk and expedite collateral transfers. Deribit, for instance, has introduced an external custody solution. Binance and BitMEX have established insurance funds to protect traders from the auto-deleveraging of their positions. Despite these efforts, these mechanisms are still in their early stages and have yet to be fully proven.

In traditional derivatives markets, institutional investors dominate trading volumes, largely due to capital requirements influenced by regulations such as the Volcker Rule. In the crypto derivatives sphere, however, institutional participation is just beginning and is marked by significant skepticism. Kapil Rathi, Co-founder and CEO of capital market platform Cross Tower, shared his perspective:

“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.”

Kapil Rathi, Co-founder and CEO of Cross Tower

Rathi further elaborated on the differing needs of individual and institutional investors. Institutions might integrate derivatives into their portfolios for various reasons, such as hedging their derivatives exposure in real-time or engaging in multi-leg transactions, making platform speed and liquidity paramount. He 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.”

Kapil Rathi, Co-founder and CEO of Cross Tower

Pricing is another critical factor. Traditional equity futures commonly use variables like risk-free interest rates and dividends for pricing. Currency forwards are priced based on the interest rates of the involved domestic and foreign currencies. Equity options typically employ the Black-Scholes option pricing model, while currency options use the Garman-Kohlhagen model.

As cryptocurrencies are a unique asset class, their pricing methodology is a subject of debate: should they be treated as a commodity or a currency? Currently, BTC derivatives are priced differently across various exchanges, creating ambiguity. The development of standardized pricing techniques and seamless technology is essential to encourage broader institutional involvement. Balani noted that price discrepancies between venues can arise from differing spot indexes, market maker capital costs, and exchange-specific supply-demand dynamics. He further commented:

“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.”

Pankaj Balani, CEO of Delta Exchange

Shared Characteristics

Despite their differences, crypto and traditional derivatives markets share fundamental similarities stemming from the nature of derivatives themselves. Typically, derivative volumes are influenced by leverage and margin. Higher margin availability allows investors to establish larger speculative and hedging positions, which often require substantial capital, typically accessible to institutional players.

This dynamic is also observable in crypto derivatives. When Japan’s Financial Services Agency (FSA) mandated BitFlyer to reduce its maximum leverage from 15x to 4x on May 28, 2019, the exchange saw its trading volume drop by over 50% practically overnight. This mirrors the decline in trading volume observed after the Volcker Rule was implemented as part of the Dodd-Frank Act following the 2008 financial crisis.

Since 2018, there has been a growing adoption of the Financial Information eXchange (FIX) protocol among crypto exchanges. This protocol, widely used in traditional capital markets, facilitates the real-time exchange of transactional and market data. FIX protocol enhances trading efficiency and transaction speed, capable of processing hundreds of messages per second.

The Evolving Landscape of Crypto Derivatives

The continuous innovation in the derivatives world makes it challenging for regulators to keep pace, much like the role collateralized debt obligations and mortgage-backed securities played in the 2008 financial crisis. Increased global regulation, such as the efforts by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission on legislation like the Crypto-currency Act of 2020, can foster better price discovery and stability, as seen with Bitcoin futures and perpetual swaps enhancing hedging and risk management. This, in turn, is expected to boost investor confidence in cryptocurrencies as an asset class.

The launch of crypto derivatives exchanges backed by major financial institutions is poised to significantly enhance investor confidence. Bakkt, for example, an exchange owned by the Inter-Continental Exchange (parent company of the NYSE), offers both physically and cash-settled futures. A spokesperson from Binance commented, 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 scarcity of physically settled products across many exchanges remains a considerable deterrent for investors. Cash settlement, while convenient, can allow for market or price manipulation by large single players. Physical settlement, on the other hand, enables a more robust arbitrage mechanism between contract prices and underlying spot prices. Therefore, to attract more traditional investors, it is crucial for major exchanges to offer both physical and cash settlement options, catering to the preferences of different investor segments.

Unlike the underlying assets in traditional markets, the supply of cryptocurrencies is finite. This inherent scarcity can lead to greater fluctuations in derivatives prices, making them highly sensitive to supply and demand dynamics. The limited supply also creates opportunities for higher speculative plays due to increased volatility, but concurrently raises the risk of price manipulation.

A Market in Waiting?

In the current market environment, characterized by high volatility and growing interest from major financial players like JP Morgan and Morgan Stanley—who are launching businesses like FTX Derivatives and venturing into crude oil futures trading with crypto—the future of crypto derivatives appears promising. Even Bitcoin miners are exploring the use of derivatives to stabilize their supply-demand dynamics, indicating clear growth potential for crypto derivatives in the coming years.

Despite this growth outlook, regulatory ambiguities persist in various global markets. Singapore, for instance, has proposed allowing crypto derivatives on domestic exchanges. Jay Hao, CEO of OKEx, a prominent derivatives exchange, emphasized regulation’s pivotal role:

“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.”

Jay Hao, CEO of OKEx

For traditional retail and institutional investors to participate in the crypto derivatives market at volumes comparable to traditional markets, regulators need to implement a clear and balanced policy framework. This framework should address the current shortcomings without hindering anticipated near-term growth. Encouragingly, a recent Fidelity survey revealed that 36% of institutional investors in the U.S. and Europe hold digital assets in their portfolios, a significant increase from 22% in 2019, signaling growing institutional acceptance.