by Dr. Nicholas Blasco and Nicholas Fett
This article will attempt to lay out the economic effects the introduction of derivatives has on the crypto market. For those that don’t know, the term ‘derivatives’ includes futures, swaps, forwards, options and the less official ‘prediction markets’.
The reason we care is because we just had the Mainnet launch of our company, the Decentralized Derivatives Association (DDA), which creates long and short tokens for cryptocurrencies on top of the Ethereum network. As much as we’d like to say we’re the first to market with a derivatives product, recent launches of prediction markets Augur and Gnosis, as well as some products in the traditional centralized exchange space, have slightly different products that compliment and can give different risk profiles than DDA’s product. Most notably, the CME and CBOE launched futures products on Bitcoin near the end of 2017. There’s been a lot of FUD recently around derivatives, but hopefully by the end of this long-winded article, you’ll have a better idea as to the relationship between the introduction of a derivatives product and the underlying market (crypto prices).
Cause for concern
As you can see in Figure 1, and something most people have figured out, is that the peak Bitcoin price occurred the day that futures were introduced on the CME.
The History
For those who don’t know, the anarcho-capitalists OG’s of the bitcoin world have a spotted history with derivatives. Long before bitcoin, precious metals (gold specifically) served as the doomsday currency of choice; and for a large majority of them it still does. These precious metal aficionados have quite vocally decried the use of derivative markets for artificially suppressing these commodities. This was very apparent right after the last recession, when gold prices disappointed their moon expectations.
The theory goes something like this:
The “Powers That Be” hate gold because it threatens their institutional oligopoly. So, they use derivatives to sell short the metals to suppress the price.
These theorists argue that derivatives give investors the ability to go “short” or “long” on gold without actually holding the gold. People can ‘sell’ that which they don’t have and ‘buy’ without actually buying; effectively just a big paper shuffle to systematically keep down the prices.
Although, on the surface, there is some truth to the ‘paper shuffle’ aspect of derivatives. The good news is that this theory of direct manipulation has been thoroughly debunked by academics and by regulators. The CFTC even held a hearing on it a few years ago: https://www.youtube.com/watch?v=8L4j20WhpmQ (warning really long).
To summarize the findings, short term manipulation is indeed possible with these derivatives, but long-term suppression is very difficult to maintain due to the laws of supply and demand. The conspiracy theorists have even recognized this, to some extent, and have been calling for an explosion in the price for over a decade now.
There is some credit to the fact that paper derivatives don’t force buyers to buy the underlying (thus reducing demand in the cash market), but the effect of this is nuanced as the paper market might actually increase demand as buyers can hedge positions or purchase the asset without the hassle of the physical good (it’s hard to tell what percentage of the buyers would actually go out and buy the physical asset).
The Literature:
So, we must warn you that the research feels much like every other academically studied topic on the planet: “On the one hand this, but we’re not certain and given other assumptions, it could be that.” And unfortunately for traders, research economists are more concerned with things like ‘liquidity’, ‘stability’ and ‘price-discovery’ rather than whether or not a price goes up or down. All are excellent things though when it comes to the long-term viability of an asset (crypto).
To get some basics down, the idea of whether or not derivatives are a good thing breaks down into three features:
· the ability to short;
· the ability to have exposure to an asset without owning an asset;
· increased opportunity for speculation;
Now before we just jump into the analysis, let’s take the last feature, speculation, and discuss it a bit.
Speculators, therefore, have a highly useful office in the economy of society; and (contrary to common opinion) the most useful portion of the class are those who speculate in commodities affected by the vicissitudes of seasons. If there were no corn-dealers, not only would the price of corn be liable to variations much more extreme than at present, but in a deficient season the necessary supplies might not be forthcoming at all. Unless there were speculators in corn, or unless, in default of dealers, the farmers became speculators, the price in a season of abundance would fall without any limit or check, except the wasteful consumption that would invariably follow.
– John Stuart Mill[1]
The idea that “speculators” are bad is probably not really a concern for those in the crypto space, but believe it or not, historically this was one of the reasons that regulators were even called to get involved. Speculators were often demonized, and the idea was that they were just middle men who made the market more inefficient. Unfortunately for this theory, these “evil speculators” provide liquidity and are such a crucial part of our market economy and global orderbooks that we wouldn’t really want to imagine life without them. We’ve actually even come full circle as we now have a weird world, where the ‘speculator’ is actually the one being “protected” by the regulations (think all of those damned ‘accredited investor’ rules).[2]
So now that we have that piece out of the way, let’s break down the effect of derivatives by our three topics:[3]
· Risk / Volatility
· Price / Returns
· Volume
RISK
Risk, or as usually termed, volatility, remains an untamed beast in the world of digital currencies. Often the very reason traders get involved with the mistress that is crypto, it goes without saying that virtual currencies are insanely volatile.
Derivatives in their purest form are used to hedge price risk; meaning they lock in the price and remove the threat of price volatility for the investor. But what if the simple introduction of derivatives had an impact on the overall volatility of a market?
One paper by Staffan Lindén, analyzed a number of different effects after the introduction of options.[4] To get right to the point, they found that risk (both idiosyncratic and systematic) decreased as a result of option introduction. Some studies reviewed by Lindén saw reductions in risk of over 30%. Of the 17 studies reviewed in the paper, only 1 study reported an increase in risk. Therefore, the fears of a grandmother losing her entire pension actually decreases once derivatives are introduced in a given market.
Another paper by Mayhew analyzed a number of different assets and commodities to determine whether the adoption of derivatives affect the volatility of the market.[5] Like the first paper, this one also shows the introduction of derivatives and speculative trading tends to stabilize markets and decrease volatility in the asset. In his review of the literature, Mayhew, found 13 previous studies which analyzed 15 different commodities before and after commodities futures was introduced. Ten of the 15 commodities decreased in volatility, four showed no change in volatility, and only one commodity increased in volatility.
In addition to single asset derivatives, Mayhew looked at the volatility after the introduction of stock index futures. Mayhew, reviewed 27 separate studies that analyzed 43 different indices. A slim majority of the indices analyzed (23), showed no difference in volatility after the introduction of derivatives. Seven showed a reduction in volatility, but seven showed an increase in volatility, while a few indices showed mixed results. These results provide a rather ambiguous conclusion. However, diving deeper down the rabbit hole, we see increased volatility appeared in markets that were highly developed. Given the fact that cryptocurrency and tokens are a new asset class (to say the least), the markets may respond positively to index funds and derivatives. This would mirror underdeveloped markets around the world reviewed by Mayhew where volatility decreased when index futures were introduced.
Lastly, Mayhew summarized the volatility of single stocks after an option listing. The majority of stocks saw a statistically significant decline in volatility. Of the 31 studies reviewed by Mayhew, 16 studies reported a decrease in volatility, only one study reported an increase in volatility, while the remaining studies reported mixed results.
These studies demonstrate that derivatives introduced to an underlying asset will likely lead to a decrease in volatility.
PRICE & RETURNS
One seemingly odd occurrence involved in investing is that announcements have a big impact. Usually good, “adoption” stories in crypto lead to nice little price increases. This was witnessed in true fashion in the crypto space when the CME and CBOE futures were announced. Shortly after the announcement of the CME and CBOE future, a parabolic bull run started. However, whether due to the derivatives themselves or the lack of actual adoption, the introduction date of the futures marked the end of that bull run.
To summarize this next section for you, this is actually consistent with the previous literature. Jennifer Conrad, published a paper in 1989 detailing the introduction effect options.[6] Conrad showed a price increase in the asset three days before the introduction of the option but no other changes after the options’ introduction. Lindén, also observes an introduction effect, in which the price of the asset and the amount of returns change their current pattern. The past literature indicates that returns level off and cease to increase after the introduction of the derivative. However, there is no significant decrease in excess returns either. Unfortunately, there was a significant decrease in the price of Bitcoin following the actual introduction of the CME and CBOE futures.
Examination of Nordic markets found that an introduction of an options market actually causes an increase in prices![7] This is great news for crypto but may only be part of the story. When looking at equities (like the paper), vehicles to short them were already in place. So, the only thing options really introduced was the ability to issue covered calls (selling an option on an asset you own) or provide better information about expected returns…both of which help to increase the price.
This is really where crypto differs. For most other assets, you usually have some option for shorting. And if you don’t have a direct option, a lot of stocks and commodities usually have high correlations with other assets that you can short. Therefore, these papers may not directly relate to derivatives on crypto.
A recent article by the Fed’s Fostel and Geanakoplos, highlights this point by showing the uncanny similarities between the complex mortgage-backed securities market and Bitcoin.[8] The crux of their analysis is that it was hard to bet against Bitcoin prior to the futures introduction, so once the derivative was introduced, pessimists had a chance to push the price lower and they did just that. The optimism of bullish Bitcoin speculators and the inability for pessimists to rain on the Bitcoin parade may have contributed to the Bitcoin bubble and its correction in December of 2017.
To formulate our findings:
· Easier access for financial institutions => Big money getting into Bitcoin => more volume=> $ Profit $
· or maybe: more derivatives => Better informed markets => less volatility=> less risk=> more use cases and users => $ Profit $
· or conversely: ways to go short appear => Increased pricing efficiency => an overvalued asset being reduced to its true value
Which formula has the strongest pull here is still up for debate, but I think it’s safe to say that price is the toughest aspect to predict upon introduction of a derivatives product.
VOLUME
The last category is a little shorter. The literature basically says that overall volume can increase, but volume ≠ liquidity and it’s nuanced in its effect. Mayhew used actual data to provide evidence suggesting the theory that the introduction of a derivatives improves liquidity. Lindén, noted the studies that recorded changes in volume after the introduction of derivatives (options). Volume simply refers to the amount of money flowing in and out of assets. Only six of the 17 studies included in the compiled literature measured differences in volume before and after the introduction of options. Four of the 6 reported an increase in volume while only two reported no change.
Looking at data on Bitcoin volume(Figure 3), we can see that overall volume (bottom) has increased, but actual cash volume (green part on top) is flat to down. This is because a lot of the traders and activity actually don’t need the underlying but just rely on the derivative. We can expect this to continue in the cryptosphere, but as with any asset, a market that has a tight arbitrage to the underlying cash market will increase liquidity and provide a tighter spread for all market participants.
So now that we have our research down, let’s summarize our findings and let you know our opinion.
Summary and Theories
Despite the rhetoric, all literature and theory points to the fact that regardless of initial price movements, an introduction of a derivatives market is an excellent thing for an asset. It helps to pop bubbles before they form and provide more opportunities for people to signal the true value of an asset.
That said, derivatives on CME or CBOE are different than the kind of derivatives that the space needs. Although speculators are a good thing, a large market dominated by players who have little to no actual crypto hedging needs, leads to a bunch of speculators who likely aren’t in the industry. They can initially push a price down (which was probably a good thing), but the true “hodlers” will just be buying it up waiting for the market to recover. As observed during the last exponential growth in Bitcoin value, most people were buying the underlying asset (Bitcoin) not the futures product provided my CME and CBOE.
Back in August, Joseph Young, published a piece in CCN entitled “Will the First Bitcoin ETF Make the Crypto Market Even More Volatile?”.[9] While the majority of article focused on the thoughts and opinions of other cryptocurrency analysts, Young made this interesting claim of increased volatility in the last section of his article. Young’s claim may seem logical to him, but it is completely inconsistent with the current literature. This is a prime example of the importance of doing independent research instead of taking any kind of advice from crypto “news” sources. Volatility in crypto, and Bitcoin in particular, is at a yearlong low and while this may change in the short-term, the data indicate that volatility will decrease as the crypto space continues to develop and derivatives are introduced.
Conclusion
A good derivatives platform for hedging cryptocurrency will be targeted at the actual users of crypto. Augur, Gnosis and other prediction markets are providing some of these tools, and DDA is building a tailored hedging platform to address the needs of crypto users and not solely speculators. Don’t listen to naysayers and doubters, derivatives are a great thing for any asset if they improve user’s ability to speculate and hedge price risk.
[1] https://ebooks.adelaide.edu.au/m/mill/john_stuart/m645p/book4.2.html
[2] Not really the topic of this article, but just rather ridiculous that we can now legally gamble on sports, but god forbid we let someone invest in a startup.
[3] The current paper only addresses the effects of derivatives on volatility/risk, price/returns, and volume. To understand how derivatives’ features (ability to short, exposure without owning, and increased opportunity for speculation) individually impact aspects like volatility would require a more exhaustive review of the literature.
[4] Staffan Lindén,”The Price and Risk Effects of Option Introduction on the Nordic Markets” Economic Papers 434. December 2010 http://ec.europa.eu/economy_finance/publications/economic_paper/2010/pdf/ecp434_en.pdf
[5] Mayhew, Steward. “The Impact of Derivatives on Cash Markets: What Have We Learned”. February 2000. http://media.terry.uga.edu/documents/finance/impact.pdf
[6] Conrad, Jennifer. “The Price Effect of Option Introduction”. The Journal of Finance. June 1989
[7]Lindén.
[8] Fostel, Ana, and John Geanakoplos. 2012. “Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes.” American Economic Journal: Macroeconomics 4(1), pp. 190–225.
[9] https://www.ccn.com/will-the-first-bitcoin-etf-make-the-crypto-market-even-more-volatile/
