Crypto Derivatives: The Future of Financial Markets

The crypto space has grown by leaps and bounds, from being an obscure payments network to becoming a force to be reckoned with not just in Financial markets but also in other industry sectors.

So much so, that world’s first cryptocurrency Bitcoin is being hailed as the “ King of the asset class” in 2019, according to Boutique analysis firm Delphi Digital. 

Why?

It’s simple maths — name any other global asset and you can be sure that Bitcoin has performed better than it, in 2019.

Courtesy of Delphi Digital

At a time when other asset classes are experiencing broader weakness — owing to the rising trade war tensions, waning sentiment for economic growth in 2019 and plateauing earnings expectations.

On the other hand, Bitcoin has performed incredibly — clocking in great returns which is significantly higher than any other asset class with its prices briefly touching $9000 in May. And it’s not just Bitcoin, almost all the major altcoins observed green last month.

Coincidentally, along with Bitcoin’s and stellar performance another financial instrument is quickly gaining traction — cryptocurrency derivatives trading. And the moment the most popular form of “crypto derivative” is Bitcoin futures. But before we jump into the details of Bitcoin Futures, what are crypto derivatives? 

Crypto derivatives 101

In the financial world, as you might already know, a derivative is a financial instrument (investment contract) whose value is “derived” from an underlying asset or set of assets. A derivative is essentially a contract between two entities that specifies a buying/ selling date of an asset but at a predetermined price and specific date. Usually, the underlying assets include — stocks, market indexes or currencies. But in a crypto derivative, the underlying asset is obviously the cryptocurrency token.

But by itself, a derivative is objectively useless, instead, the value is derived from the underlying asset. The most common type of derivatives includes Futures contracts, swaps, and options.

So what are crypto derivatives? 

Similar to the traditional financial world, crypto futures are a way for individuals to trade on the future price action of crypto assets like Bitcoin. But this doesn’t mean when the contract expires the value of the contract has to be paid out in Bitcoin, there are cash-settled Bitcoin futures which pay out the value in cash instead of Bitcoin.

How did we get here?

Following the devastating market crash in 2018 which witnessed the price of Bitcoin fall by over 65% from Jan 2019 to Feb 2018, traders and investors were desperate to squeeze out some value from the depreciating assets.

Prices of BTC, ETH, and XRP in 2018, the three biggest coins by market cap, through Sept. 7. (Chart: Daniel Roberts/Yahoo Finance)

Nearly $342 billion in market capitalization was wiped out during the first quarter of 2018 alone, so you can imagine how dire the situation was and by November 2018, the price of Bitcoin was down by nearly 80%. 

“Anyone sitting on a stockpile of tokens saw in the bear market of 2018 that their business is at the mercy of crypto prices,” said Sam Bankman-Fried, chief executive officer of Alameda Research, a quantitative trading firm for digital assets in San Francisco. “It can be crucial for those players’ survival to have some cash if digital asset prices go down.”

In essence, following the bear market of late 2018, ICO management teams and miners had to get creative to keep their business running, trading crypto derivatives was a response to this need. In an interesting turn of events, a growing number of ex-Wall Street professionals have quit traditional assets for crypto which consequently propelled options trading to the limelight.

A primer to crypto derivatives market

Much like the traditional financial market, the cryptocurrency space is also divided into two — the spot market and the derivatives market. 

The spot market refers to the transfer and settlement of the actual assets (crypto/traditional assets). Here the ownership of assets like crypto are immediately executed between market participants. If you’ve bought some crypto tokens from an exchange, then that’s the best example for trading on the spot market. 

But the derivatives market is a whole different ball game, often only done expert traders. Here, market participants often trade contracts (futures, swap or option) than the actual asset themselves. 

So where do participants trade crypto derivatives? 

LedgerX, an institutional exchange platform for digital tokens, was the first to introduce Bitcoin derivatives — as swaps and options. But the catch is only accredited investors and institutional players can leverage its platform.

Although, Bitcoin futures trading were previously available on exchanges as unregulated assets — the regulated Bitcoin Futures was introduced by Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) as early as December 2017, right before the 2018 market crash. As much as 20% of the world’s total derivatives volume is handled by CME. 

So what’s the current state of crypto derivatives?

In May 2019, all the major crypto derivatives trading platforms have witnessed increased investor interest — marking record volumes when compared to previous months, according to a report by Diar.

Bitcoin derivatives trading volume on CME. Source: Diar

Specifically, Bitcoin derivatives trading has reached an all-time high on the Chicago Mercantile Exchange has hit all-time highs, two months in a row. Reaching $4.8 billion and $6.6 billion during the April and May 2019, respectively. 

During the initial months of 2019, the trading volume remained relatively stagnant at around $1.4 billion on average but then witnessed a staggering increase of 300% during April 2019 and a further increase of ~38% during May 2019.

It’s clear that given the regulatory risk still associated with investing in crypto and ICO projects especially in countries like the USA that crypto derivatives are an innovative way forward for investors, as it helps protect investors from the extreme price volatility of crypto assets.

But what does the does the future look like? A CBOE spokesperson recently confirmed that its Bitcoin futures market is closing for good (source). We’ll cover that and more in part two of this series.

Investors are bullish for crypto derivatives 

“The overstatement of trading volumes by cryptocurrency exchanges, and by implication the understatement of the importance of listed futures, suggests that market structure has likely changed considerably since the previous spike in Bitcoin prices in end-2017 with a greater influence from institutional investors,” — A Bloomberg report summarizes on June 15th.

This report comes on the heels of another report by Bitwise Asset Management that claims — through their investigation, they’ve come to the conclusion that as much as 95% of volume on unregulated cryptocurrency exchanges is fake or non-economic in nature or in-plain crypto lingo — wash traded.

A staggering amount!

Source

The reported Bitcoin trading volume is at a whopping $6 billion but the Bitwise report argues that the actual volume is only 4.55% of that amount or only $273 million. But given the actual reported volume, Bitwise also notes that the numbers are indicative of a healthy asset on par with that of physical gold. Bitcoin has a daily turnover of 0.39% while Gold has a turnover of 0.55%. 

While this is shocking to say the very least, there is a silver lining. The report argues that the Bitcoin Futures market is significant. Why? Because together the CME Bitcoin futures volume and CBOE futures trading volume amounts to nearly $91 million which is nearly as much ADV as the largest spot market Binance at nearly $110 million.

Source

When compared to the reported volume by exchange the Bitcoin futures markets doesn’t seem so significant, right? True. $95 million is barely 1.6% of the spot volume but if the Bitwise report is to be taken seriously then the Futures trading volume constitutes 35% of the spot trading volume. Note that the actual trading volume is 95% less than the reported volume.

Source

The graph represents the futures volume expressed as a percentage of global spot volume. We can observe that the futures volume really started gaining pace as early as in March 2018, when it crossed 10% mark for the first time — following which is depreciated in Q3 2018. Now here’s the interesting part, in February 2019 Futures volume jumped to a whopping 35% which is more than double the volume during the previous month.

Notably, the daily global spot Bitcoin volume of Binance exchange is at a whopping $110 million but the Daily futures trading volume of CME group is approximately $85 million — it’s almost as big as the spot market. If we were to make a comparative study of the top ten exchanges by daily spot Bitcoin trading volume and of the futures trading volume of CME and CBOE group, we’d find that Binance would rank 1st (obviously), followed by CME group, Bitfinex, Kraken and so on and so forth.

On top of this, the arbitrage between the CME group’s future price and the global price is already confirmed from the graph. From early 2018 to nearly a year later, despite the incredibly unfavorable bear market conditions — the global spot price and CME group’s futures price has remained fairly constant. 

So what’s a trading strategy that can be leveraged while trading Bitcoin Futures?

source

The Blue areas of the graph represent the seven-day period before the expiry of the CME futures and the red area represents 7- day period before CBOE futures expires. From a purely graphical analysis, we can observe that there is a common perception that the Bitcoin price tends to drop just before each futures expires and there is recovery after contract fixing. But is this true?

This trend is mainly being observed after April 2018, hence a deeper regression analysis is required before making any conclusions. So does a relationship exist between Bitcoin returns and futures expiry dates? The data used for this part of the article is borrowed from Cindicator’s report on the same.

source

Cindicator used pairwise return correlations between contracts in order to confirm the presence or absence of patterns before and after contract expiry. Correlation in the 7-day period before the contract expires shows very little correlation which confirms the absence of a linear relationship among returns. Similar non-existence of any correlation is observed when calculating the hourly return correlation matrix for the seven-day period following the expiry dates.

To conclude, the common idea that the price of Bitcoin is always dumped before a contract expires and is pumped right after the contract is fixed is generally false. But it is valid during certain market conditions, notes Cindicator. 

Contrary to conventional wisdom, “ Fast market phases” with prices trading at close proximity to critical resistance or support levels or following bearish trends pay less attention to futures expiries and therefore betting on Bitcoin futures trading strategy solely based on this parameter would be ineffective. 

But what could shake up the market is the entry of institutional investors, given the increased interest in recent months, notes Cindicator. Given the illiquidity of futures, their trading halt mechanisms and other inefficiencies are important to investigate.

On the other hand, Chicago Board Options Exchange (CBOE) will reportedly settle the last Bitcoin futures contract on June 19th. The trading of derivatives is expected to be officially closed down. Notably, CBOE was the first U.S exchange to introduce Bitcoin futures trading and has stated is “reassessing” the way forward with Bitcoin derivatives. 

The company said in a statement “CFE is not adding a Cboe Bitcoin (USD) (“XBT”) futures contract for trading in March 2019. CFE is assessing its approach with respect to how it plans to continue to offer digital asset derivatives for trading. While it considers its next steps, CFE does not currently intend to list additional XBT futures contracts for trading.” 

So while the future of Bitcoin futures seems bright and investors are bullish, there still seems to be some technicalities ironed out.