Cryptocurrency derivative markets have seen a huge surge in popularity following the Covid-19 market crash as speculators attempt to capitalise on the volatility in both price and trading volume. In the lead up to this event, the range of markets available were increasing significantly despite mediocre trade volume. Although, following both the bitcoin halving and increased volatility, the types of contracts on offer as well as the wider range of trading features have resulted in a closer alignment to traditional derivatives trading. When you look at current equity and foreign exchange markets, derivative markets contribute between 5 to 7 times more capital than spot markets.1 The current crypto spot volume still sits higher than the derivative volume, indicating that the market cap is likely to see a serious increase. At a time when institutional investors are dominating the space, the development of crypto derivative markets increases the value offering phenomenally and contributes significantly to the necessary market growth required to position digital assets alongside major traditional markets.
History of Derivatives
Many would argue that the concept of derivative markets only rose to popularity during the 1970s as financial markets saw increased risk following the abandonment of the gold standard in America. Although, the origin of such markets can be traced back to the 4th century BC in Mesopotamia. There is evidence that commodity futures were commonplace among trades people and business owners in order to hedge risks such as reduced crop yields or transport issues. Contracts were usually established for long distance trade deals or to guarantee the purchase of crops by city leaders or wholesale distributors. In these instances, other commodities were often used to transact, typically seeds, animals or precious metals. Over time, the prominence of derivatives slowly moved west, becoming a staple in financial markets globally over the course of centuries. 2
In December of 2017, the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) launched Bitcoin futures, just as the crypto bull market was reaching its peak.3 This offered investors a risk hedge that was previously unattainable and contributed to softening the blow of the subsequent bear market that followed. With these derivatives, the sophistication of the cryptocurrency market has increased and the availability of various financial instruments are continuing to position the market alongside its traditional counterparts, furthering the case for broader scale adoption.
The primary function of futures is to lock-in future prices at a competitive rate through speculation on leverage that generate outsized returns (and losses). The success or failure of this endeavour is dependent on an array of internal and external factors. One fundamental component of the contracts that determine results is risk premium. This is defined as the difference in value between the spot price at a future date and the price of a futures contract set to mature on the same date.4 This premium is usually dependent on the cost of carry of an asset as well as any depreciation effects. Depending on the positive or negative relation to the spot price, the futures price can be defined as in contango or backwardation. Contango occurs when an asset spot price is expected to rise over time. Contrarily, backwardation occurs when the price is expected to fall over time.5 This is important as it provides opportunities to gain an understanding of speculative projections of future asset pricing as well as potential arbitrage opportunities.
Bitcoin Futures Landscape
The Bitcoin futures premiums often fluctuate between the two aforementioned positions, with extreme values being recorded a number of times since the development of this market. Distinct patterns in behaviour have allowed speculators to more accurately determine trends as a result of these codependent markets.
The Bitcoin futures market operating in contango offers big players an incentive to sell futures contracts in order to hedge risk and lock in future asset value. When the market moves into extreme contango, the motivation by those with substantial holdings to sell off futures dramatically increases as premiums of US$500+ per bitcoin become commonplace. As a result of institutional/hedge fund futures contract hedging, extreme contango is typically limited and momentum is quickly stalled. This positions short term speculators as some of the only futures buyers, ultimately dampening volatility which we have been seeing since the inception of futures markets.6
Alternatively, backwardation occurs when speculators short aggressively or when an aggressive downturn in the futures or spot market causes liquidations and a reversal of contango. A market operating in backwardation is an opportunity for large investors to buy futures contracts at a discount, closing out their hedges and taking increased profit. As futures have low value when trading at a discount to the spot price, investors can sell their holdings in the spot market and purchase discounted futures to maintain exposure. This structure leads to limited periods of backwardation.
The most recent example of these market forces in play was prior to the Covid-19 crash in March when much of the world was ignorant of the effect that the virus would ultimately have on markets. On February 12th 2020, a number of futures markets moved into extreme contango, listing premium differences in excess of US$500. In the days following, the Bitcoin spot price run slowed and peaked at just under US$10,500 before beginning its downturn. Just one month later on March 12th, the BTC price went into freefall and the futures contract price went into a ~19% backwardation sitting at a US$400 discount. Over the following days, the market hit a peak low at just under US$5,000 before recovering quickly.7 This was partially due to a significant uptake in Bitcoin futures purchases by large-scale investors.
Impact of Futures Market on Bitcoin and its Investors
From a long-term standpoint, the introduction of the bitcoin futures market has little to no impact on price – as long term value is driven by core fundamentals (adoption, use-cases etc.). However, the futures do strengthen the integrity of the market, by limiting volatility and providing deeper liquidity for institutional participants. As it provides investors another lens to analyse the bitcoin market through, they can more effectively determine market sentiment and act accordingly. It also gives an opportunity to hone in wild speculation and as shown above and assists in price discovery. The introduction of derivatives to the bitcoin market was a positive move that ultimately solidifies the financial framework of the asset. By increasing market capitalisation and trade volume, the additional access points have allowed investors to treat BTC holdings as they would a traditional investment. This brings more interest to the space and contributes to the establishment of bitcoin as a strong investment choice.
The Impact of Futures Trading on OTC Firm Yield Generation
Futures trading opens up doors for investors with large holdings as they can leverage their existing balance sheet and capitalise on arbitrage profits, yield from their holdings. This method is of particular use to OTC crypto firms as they can use their custody holdings to generate interest for their clients. While the capital gains value of bitcoin and ethereum is strengthening by the day, the real advantage of futures lies in the contract’s ability to shield from black swan events and other major price influencers, or simply earn delta-neutral yield. By securing their holdings with futures contracts, firms limit their downside while boosting upside tremendously for their clients.
Derivative markets have been fundamental to trade and finance for centuries, playing a key role in the management of market cycles and asset volatility. The value that futures derivatives add to the increasingly mature bitcoin and cryptocurrency space is immense. Not only does it aid in legitimising the asset class, but it also provides an additional method of investing in the space. This makes the market more attractive not only for speculators but fuels institutional investment activity. With a spectrum of investor profiles all capturing the value that these markets can provide, the credibility of the crypto space and bitcoin is set to strengthen further in the coming years.
1. McIntosh, R. (2020). Crypto Derivatives Getting Ready to “Explode”: Delta Exchange CEO Speaks. Retrieved from Finance Magnates: https://www.financemagnates.com/cryptocurrency/interview/crypto-derivatives-getting-ready-to-explode-delta-exchange-ceo-speaks/
2. Weber, E. (2008). A Short History of Derivative Security Markets . Retrieved from The University of Western Australia: https://www.rdi.uwa.edu.au/__data/assets/pdf_file/0003/94260/08_10_Weber.pdf
3. Bradley, E. (2019). Derivatives in Crypto, Explained. Retrieved from Coin Telegraph: https://cointelegraph.com/explained/derivatives-in-crypto-explained
4. Stenner, N., & Hambur, J. (2016). The Term Structure of Commodity Risk. Retrieved from Reserve Bank of Australia: https://www.rba.gov.au/publications/bulletin/2016/mar/pdf/bu-0316-7.pdf
5. Chen, J. (2020). Contango. Retrieved from Investopedia: https://www.investopedia.com/terms/c/contango.asp#:~:text=In%20contango%2C%20investors%20are%20willing,over%20a%20period%20of%20time.
6. BTSE Academy. (2020). What Does The Bitcoin Futures Basis Tell You? Retrieved from BTSE Academy: https://www.academy.btse.com/post/bitcoin-futures-basis#:~:text=The%20basis%20for%20Bitcoin%20is,the%20spot%20price%20(premium).
7. Coindesk. (2020). Bitcoin Price Graph. Retrieved from Coindesk: https://www.coindesk.com/price/bitcoin