In March 2018, President of Cboe Chris Concannon revealed his exchange’s plans to build a “crypto-complex” and added that digital currencies were “here to stay.”
At the same conference, Cboe CEO Ed Tilly said that the exchange was interested in launching cryptocurrency-related exchange-traded notes (ETNs) and exchange-traded funds (ETFs). Now we can observe the market achieving an average daily volume of Bitcoin futures of more than 5,000 contracts, with a cumulative value of approximately $177 million, and the largest derivatives contract exchange, BitMex, setting a new record of $8 billion in daily volume. Impressive indeed, especially if we take into consideration that the cryptocurrency market has been in a recession since the beginning of 2018, when the general prices of coins and tokens plummeted by more than 85%.
Derivatives in layperson terms
Before analyzing the market of cryptocurrency derivatives, you need to know what derivatives actually are and why people trade them.
A futures contract is a form of derivative investment. The main idea behind using contract trading is to benefit from the price changes of the underlying asset without actually owning it. The term “contact for difference” refers to the difference between the prices when the trader enters and ends a transaction.
Futures trading is facilitated through brokers, where the broker often offers margin opportunities to clients to increase leverage and to speculate more on the underlying asset.
It is absolutely critical to highlight that in a futures position, the trader does not own the underlying asset. It can be thought of more like a contract between the broker and trader, where the broker agrees to pay the difference between the beginning and end price of the deal. There could be a variety of reasons why traders might not want to own the underlying asset directly, from regulatory aspects to trading strategies.
The most popular reason to pursue futures positions is to benefit from the high leverage opportunities. On the market of the underlying asset (which can be anything from stocks and bonds to cryptocurrencies), the amount of available leverage is usually limited by the nature of the product. However, the margins on futures are much higher, as brokers may decide on their own how much leverage to offer to clients. With the help of leverage, the amount of profits can be easily multiplied – but at the same time, the accumulated losses can be significantly higher as well compared to owning and trading the underlying directly.
Furthermore, a lot of people are afraid of the technical side of cryptocurrency, which is why they prefer trading futures. Some feel intimidated by creating wallets or verifying their identity on cryptocurrency exchanges. On the other hand, brokers are well prepared for newcomers and feature established, easy-to-set-up accounts. This can also be a highly appealing point to clients who already use futures brokers for other products and would just like to also benefit from the price movements of cryptocurrencies, just like, for example, gold or stock trading.
To sum up, futures are complex instruments that come with a high risk of losing money rapidly due to leverage. About 90% of investor accounts lose money when trading futures. You should consider whether you understand how futures work and whether you can afford to take the high risk of losing your money.
Bitcoin futures pioneered on institutional exchanges
It all started with LedgerX, the first regulated institutional exchange that introduced Bitcoin derivatives in the form of swaps and options. Bitcoin futures were first introduced by the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) in December 2017. CME is the world’s largest derivatives exchange, handling over 20% of the total global derivatives trading volume.
The launch of cryptocurrency derivatives might have seemed like a development unrelated to crypto trading at numerous institutional exchanges, but it has a direct bearing on cryptocurrency markets in two ways.
First, cryptocurrency derivatives could boost the liquidity and trading volumes of coins other than Bitcoin. More vectors for investing through derivatives could make both institutional and regular investors more comfortable with other cryptocurrencies and generate cash infusions into their markets, which, in turn, could result in less volatility in their prices.
Second, the introduction of more derivatives by private players could increase pressure on regulators to take a second look at their concerns regarding cryptocurrencies. Already, there is talk of bringing cryptocurrencies under the regulatory umbrella. All major exchanges in the United States have expressed optimism regarding the state of cryptocurrencies. Derivatives regulated by government agencies might not be such a bad idea and could help clamp down on their volatility.
And then came the perpetual contracts
In July 2018, crypto exchange BitMex launched the first Bitcoin perpetual contract. This meant that traders did not need to worry about rolling their positions at a fixed point in the future, since there was no expiry. It is analogous to having a position in the underlying spot market, but with the leverage that only perpetual contract trading can provide. A wave of high-leverage contracts spread across the market, with Huobi, OKEx, Xena Exchange, OKCoin, Kraken, and others launching derivative engines.
As the main idea behind a derivative trade is to pay out the price difference between the start and the end of a trade, it is crucial to verify that the exchange uses reliable trading data to show and execute prices.
Xena Exchange offers Bitcoin perpetual contracts based on an index formed by the prices of three exchanges – Coinbase, Kraken, and BitStamp – with an hourly clearing. At the same time, the exchange has released a highly unusual derivative for an asset that has yet to enter exchanges – the GRAM token by the Telegram TON network. The idea behind this contract is to provide people with an opportunity to run a “price discovery” procedure before the initial asset is listed on trusted platforms:
“Once GRAM is listed on spot exchanges, the price of the Xena Listed Perpetuals contract on GRAM will depend on the index based on the spot exchange rates. We do not offer GRAM spot trading, but we do provide market participants with an opportunity to get a long or a short position on the GRAM contract and let the market run the initial price discovery. A great deal of small buyers are there waiting to get into long positions, which is likely to rebound positively on GRAM.”
CEO Xena Exchange
In the near future, Xena Exchange plans to release contracts for Bitcoin mining complexity (BTCMNG) and volatility (BTCVAR), expanding the number of cryptocurrency-settled contracts available on the market.
Cryptocurrency-settled derivatives beating out spot
Numbers are the most reliable kind of data when it comes to comparing markets. Let’s have a closer look at the trading volumes for Bitcoin and Bitcoin contracts on spot and derivative exchanges.
As of June 4, 2019. Source: coinmarketcap.com, CME
Crypto exchange Huobi was one of the first on the market to launch a derivatives engine. When asked about the incredible growth, Huobi’s CEO Livio Weng stated:
“This is proof that the Huobi derivatives market is accurately responding to our clients’ needs. We are receiving very positive feedback from clients on our lack of clawbacks and HBDM’s capacity to help advanced traders manage the risk of spot market fluctuations. In my humble opinion, those are the biggest reasons for our record growth, even in the middle of this prolonged bear market.”
When choosing a contract to trade, many traders pay special attention not only to the expiration and index of a contract but also the initial and maintenance margins.
The Initial Margin (IM) is the amount of collateral required to open a position and thus is calculated for new orders. The Maintenance Margin (MM) is the amount of collateral required to keep a position opened.
Comparing cryptocurrency-settled contracts
Futures contracts have a linear payoff wherein a price movement in the underlying asset of a futures contract translates directly into a specific dollar value per contract.
An inverse contract is structured such that its contract size is defined in its quote currency (whereas the size of a direct contract is measured in the base currency or in the units of the underlying). Historically, the first contract launched on Bitmex was an inverse contract, so most Bitcoin perpetuals on the market are inverse contracts as well.
Even though the crypto trading industry doesn’t have much experience in margin trading, it’s something that traders demand. Margin trading is currently the domain, from the inherent conflict of interest to the differing business models that attempt to mitigate these conflicts and all the regulatory hurdles involved in offering these services in as accountable a manner as possible.
This is a process that the industry has already undergone. What we have here is an opportunity to consolidate a vital share of the crypto market by adding much needed liquidity to this space in the process.