How Derivatives Amp Up Already Heady Crypto Markets
Bitcoin has long been known for its violent swings in price. But the volatility isn’t just driven by tweets from Elon Musk or warnings from Chinese regulators: It’s also fed by a massive derivatives industry that has boomed on the back of voracious demand for leverage and speculative tools in cryptocurrency markets. In some ways it’s a tale as old as Wall Street, but now in a new digital wrapper. For instance, when Bitcoin plunged as much as 30% in a day in May, leveraged-up positions in futures and options were wiped out, with the expected consequence of amplifying the sell-off as they had boosted the rally earlier.
1. How big is the crypto derivatives market?
It’s pretty massive. In one 24-hour period ending July 19, for instance, Binance, the largest crypto exchange, recorded $42 billion of derivative volume, more than four times the activity in spot trades, Coinmarketcap data show. For context, CME Group Inc. saw an average $104 billion worth of energy contracts change hands every day in April. At the peak of the crypto euphoria in April, outstanding Bitcoin futures reached as high as $28 billion and have since plunged to $12 billion, Bybt data show. In June, more crypto derivatives were traded than actual coins, the first time that had happened in 2021, according to data tracker CryptoCompare.
2. What are they used for?
Old-timey derivatives like futures and options were invented long ago to give traders ways to hedge their positions, that is, to make side bets that would lessen the pain if the market turns against them. Of course, they have long been put to more speculative purposes, often as ways to add leverage to trades -- and sometimes with spectacularly destructive effects, as was seen in the 2008 financial crisis. Hedging happens in crypto, too, especially by those with an economic stake such as miners, but it’s safe to say “to the moon” is largely the name of the game when it comes to crypto derivatives trading. That’s evident from the fact that most of the time on the top exchanges -- especially before the recent drawdown -- bullish positions exceed bearish ones. Major crypto exchanges like Binance where much of this derivative trading takes place have loudly advertised the ability to gear up positions by more than 100 times.
3. What are the common crypto derivatives?
The biggest ones are taken directly from mainstream markets. These include:
- Options: A largely retail product that can offer both bullish and bearish exposure.
- Regular futures: Contracts with different expiry dates, similar to those for commodities.
- Non-deliverable forwards: Futures with no physical settlement, in which the two parties settle the gap between the spot and forward price. Bloomberg News has reported Goldman Sachs Group Inc. started trading these in April.
- Leveraged tokens: Assets that offer a bullish or bearish exposure to cryptocurrencies, with a fixed leverage ratio on FTX and a floating one on Binance. Similar to leveraged exchange-traded funds, these allow traders to make big bets without worrying about collateral or margin requirements.
- Perpetual futures: Also known as perpetual swaps, or just perps, they’re a kind of futures contract that has come into its own on crypto exchanges.
4. How do perps work?
They were proposed for other purposes by the Nobel laureate Robert Shiller three decades ago, but their use in crypto was pioneered by the derivatives exchange BitMEX. (BitMEX’s founders were indicted last October and charged with skirting U.S. laws preventing money laundering.) Perps are futures without an expiry date, so traders can keep a position open without worrying about rolling one contract into another. Instead, perps are kept in line with the spot rate with a funding-rate mechanism: At any given interval (in practice, typically one or eight hours), investors on one side of a bet pay those on the other depending on whether the instrument is trading above the spot or below.
5. What other tools do traders use?
They’re not derivatives, but a number of regulated vehicles have become popular that allow investors to gain exposure to crypto on mainstream trading venues without holding the actual digital asset. They range from the Grayscale Bitcoin Trust BTC to the exchange-traded Bitcoin Tracker in Europe, both of which track the cryptocurrency’s price. Another category involves so-called tokenized versions of traditional assets. For instance, exchanges like FTX and Binance have offered tokens backed by popular stocks like Tesla Inc., though Binance said in mid-July that it would phase them out under regulatory pressure. There are, in turn, also futures on these tokens. In the decentralized-finance (DeFi) corner of crypto, there are also synthetic equities, tokens based on shares traded entirely on the blockchain.
6. Where are these instruments traded?
The regulated Bitcoin futures and options are on CME. Beyond that, the derivatives catering to retail traders mostly change hands on unregulated crypto exchanges like Binance, FTX and Huobi. Deribit is where the majority of crypto options is traded.
7. What other strategies have migrated into crypto markets?
For the pros, the frenzied activity around cryptocurrency derivatives has invigorated a slew of traditional quantitative strategies. One trade popular earlier in the year, for instance, was to take advantage of bullish sentiment by going short on the futures -- the CME ones or the perps -- and long on spot, since the two tend to eventually converge. Another play is to sell options, which is to take the other side of the bet. Because of crypto assets’ high volatility and retail-dominant investor base, sellers get to earn rich premiums, though they also face a higher risk of paying out on the contract, akin to being an insurer in an earthquake-prone region. Some quant funds known as Commodity Trading Advisors -- that mostly ride trends across futures markets -- have also turned to momentum trading in crypto contracts.
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