Crypto Derivatives Market – Marco Manoppo
The Impact of Derivatives Market on The Digital Asset Environment
The derivatives market essentially consists of financial products that are derived from other assets, such as futures contract, options, and many more. In fact, the most recent data from the Bank of International Settlements stated that the gross market value of the derivatives market is approximately $12.7 trillion, with more than $500 trillion of total notional amount outstanding for contracts. This data emphasizes the importance of the derivatives market for the underlying assets. On one side, it provides market participants the ability to speculate in order to reap maximum profits (typically done by hedge funds and other financial institutions) or to hedge against the volatility of the underlying assets (done by corporations to maintain their manufacturing costs). Nonetheless, the derivatives market also received a lot of scrutiny, especially after the 2008 financial crisis. In short, the infamous mortgage-backed security (MBS) is a derivative product, and it was primarily responsible for the last financial crisis.
BTC Dominates The Derivatives Market
In the cryptocurrency market, derivative products were arguably popularized by BitMEX, a cryptocurrency trading paltform that’s based in the Seychelles. Its flagship product, the perpetual swap contracts, enable traders to speculate on the price of BTC (and other digital assets) by using leverage up to 100x. As the majority of the cryptocurrency market participants are traders and investors with a higher risk-tolerance, this product became a big success and in the year of 2019, BitMex holds the record as one of the largest platform in the world. Other exchanges are now trying to follow the success of BitMex by launching their own sophisticated financial products which primarily revolves around BTC as it has the best liquidity in the market. As a result, BTC dominance soared back up in 2019 and crushed the price of altcoins as market participants realized that they can avoid the extreme volatility and unc ertainty surrounding certain altcoins while still capitalizing on BTC price movements by using leverage, futures, and options.
Nonetheless, the derivatives market is prone to manipulation, especially when the market capitalization of most digital assets are still extremely low in comparison to the traditional fiat market. In fact, the price of BTC dropped right after the Chicago Mercantile Exchange (CME) launched its BTC futures product, Many studies have since pointed out possible price manipulation by wealthy players due to the fact that the CME BTC futures product is cash settled instead of physically settled.
Physcally Settled BTC Futures To The Rescue
Cash settled futures are prone to price manipulation with multiple research outlining strategies such as “banging the close/open”, in which investors will create market activity by buying or selling the spot price of the underlying assets in the physical market to affect the price in the futures market. In essence, since the futures contract is cash-settled, market manipulators can utilize their physical BTC to push the price in the physical market to the direction that they want. The obvious solution to this problem is to launch a physically-delivered BTC futures product, a project that’s currently one of the main focus of BAKKT, a digital currency start-up that’s backed by Intercontinental Exchange. With physically delivered BTC futures contract, market participants need to actually store and transfer their BTC to the other party on the expiry date of the contract, preventing them from using that same BTC to manipulate the price in the physical market.
Note: In this write-up, we’re not going to dive into options as it requires an entire article on its own to explain the complexity. Also, the impact of BTC options have on the crypto market is still quite trivial.