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The crypto derivatives market is fast becoming the crypto market of choice

As many analysts have forecasted, professional traders will gravitate away from traditional crypto exchanges where low liquidity is the name of the game. Institutional investors have already demonstrated a proclivity for the OTC desk of their favored broker, but the issue goes deeper than this situation. The better avenue would be where one is not constrained by the supply of Bitcoin, but can still take positions on the underlying asset without owning it. Yes, suddenly futures contracts, options, swaps… you name it – derivatives are now the name of the game.

It has not happened overnight. The BitMEX exchange took a lot of heat from analysts, who claimed they were only serving wild-eyed gamblers, but this Hong Kong-based exchange is now the volume leader in this arena. BitMEX also experimented with high multiples of leverage, which infuriated many purists, but fueled the volume growth on its exchange and filled its coffers with fees based on total volume. Binance and Bitfinex have now entered the fray, as well, with mixed results.

Per Emmanuel Goh, co-founder & CEO of skew. – a financial technology startup headquartered in London since 2018, in an opinion piece with Coindesk, stated that: “The crypto futures market really took off in 2018. Volumes increased by a factor of ten compared to 2017 levels – a year widely seen as the peak of the crypto market. Bitcoin futures and other perpetual swap instruments are now trading, on average, 10x more volume than the underlying bitcoin spot market according to data compiled by skew and Bitwise.”

Hindsight may have perfect vision in the case of why derivatives suddenly became the market instrument of choice. Their advent in 2017 was a market response to both volatility and an inflated Bitcoin market. Investors and traders had no easy way to short the market at the time. The price of BTC was too easily moved by hype without the presence of shorting pressure. When the CBoE and CME entered the market with cash-settled futures contracts in late 2017, a sea change occurred. Most Bitcoin advocates and analysts attribute Crypto Winter to the appearance of CME and CBoE on the crypto scene. Professional shorting was now commonplace.

There are numerous academic studies that confirm that the advent of derivatives can be an extremely important component in a market’s structure, which can corral volatility and lead to stabilized prices. It has taken some time, but the volatility of Bitcoin has not been as big a topic of discussion of late, although the digital asset can still blast about, as it did a few weeks back when it rose 42% in one day from trough to peak.

As another gauge of current popularity, so to speak, Goh adds: “The total $ amount of bitcoin futures contracts opened – called open interest – at CME currently stands at $150 million contract in comparison with $1.1 billion at BitMEX. Because of margin requirements it is likely there is a similar amount of money “working” to trade Bitcoin derivatives at CME and BitMEX despite the latter trading 10x more volumes. The “herd” might be closer than people think.”

Due to such rapid growth, these derivatives exchanges now have a pressing problem related to how they determine “price”. There has always been a need for an accurate representation of price in order for margin calls to occur and for contracts to settle at a price free from manipulation. Early designers in this field smartly developed their own pricing indices, based on prices from physical exchanges. The “basket” approach was a clever way to prevent Whales and other large volume traders from distorting local price points within the exchange in question.

The problem now is that the volume of these derivatives markets dwarfs the size of the physical exchanges being used for their “independent” indexes. Exchanges are now in the process of beefing up their indexes to prevent problems from occurring, but a few have already encountered sizable losses in the process. All eyes are currently on the CME and the Bakkt exchange in the United States, as each has decided to go head-to-head in the options market, Bakkt to start in December and the CME, soon thereafter in 2020.

Observers have also noted that the focus has now shifted almost entirely back on Bitcoin, at the expense of altcoins. AMBcrypto delivered this opinion from one unnamed observer: “Despite having periods of altcoin mania in the past, it’s possible that the derivatives market will drain those altcoin speculators and refocus them on Bitcoin derivatives. Derivatives offer specialized ways to invest in the Bitcoin market, and offer investors ways to invest that were previously unavailable. This should open up the market to both the skittish and the bold.”