A History of Futures & Options & Their Role in an Age of Digital Assets

At firstminute capital, we recently published a post on “A History of Money & The Role of Central Banks in an Age of Digital Assets”. Our conclusion was that the core functions of money are unlikely to change, however, it has over the centuries adapted to the changing needs of governments and individuals.

The latest evolution has been digital assets and cryptocurrencies — security tokens, utility tokens and exchange tokens. It is still unclear how tokenised assets will play out.

Over time we could begin to see equities, debt and physical assets tokenised via distributed ledger technology. This could democratise access to financial markets, which have ultimately been the domain of large institutional players. We could see transaction costs radically reduced and markets that are currently illiquid and difficult to access opened up to investors globally.

Utility tokens could also take-off, allowing individuals to access products or services offered by third parties via a digital asset. Difficult to imagine right now but the decentralised web could become a real possibility, especially as individuals increasingly become suspicious of the dominant role played by the centralised profit-hungry Google’s and Facebook’s of the world.

Exchange tokens are potentially one of the most interesting areas as payments has historically been complex, expensive and riddled with intermediaries. These are increasingly being taken seriously by regulators and central banks as illustrated by an IMF paper last month reviewing the pros and cons of a state-sponsored digital currency. The following countries are currently exploring this: Australia, Brazil, China, Eastern Caribbean, Norway, Sweden, Uruguay, Bahamas, Canada, Ecuador, Israel, Philippines and the UK.

In our opinion, there could be three paths here. The first path is that tokenization fails to take off and the value that it brings is simply not worth the cost. The second path is one where traditional financial institutions, governments, regulators and central banks forge a path of tokenization that uses the existing infrastructure within financial services reducing the need for the cryptocurrencies that have appeared over the last 10 years. In this scenario, distributed ledger technology becomes a core technology but crypto itself falls by the wayside. The third path is there are two parallel financial systems — a tokenised economy run by traditional financial players and a tokenised economy run by crypto native projects. We think the third path in the first instance is the most likely evolution in the next decade.

If the second and third path do take off and real institutional capital begins to flow into the space, we believe that derivatives will play a crucial role. Infrastructure facilitating the trading of derivatives associated with underlying digital assets will be required to enable market participants to manage and take risk. To illustrate this point, we wanted to share some thoughts around the history of derivatives in the traditional financial markets, what is currently taking place in the digital asset markets and how we think the space will evolve. For simplicity, we will look at two core derivative products: futures and options.

The Rise of Futures

A future is a contract between two parties that carries the obligation to buy or sell an asset at a fixed price on a designated date in the future. Once you enter into this contract, you are obliged to either deliver the underlying asset or pay-out a cash settlement.

References to futures are said to date back to the Sumerians, one of the earliest civilisations who inhabited what is now Iraq. Sumerians had jugs filled with clay tokens in the shape of the crops and livestock they had in their possession. These tokens represented a future promise of delivery — similar to a modern day futures contract.

Illustration of the Sumerians trading goods

Fast-forwarding to “modern day”, futures were established within the commodities market. Exchanges appeared in Japan in 1710 (Dojima Rice Exchange), the US in 1848 (Chicago Board of Trade) and Britain in 1877 (London Metal & Market Exchange). Other markets followed suit culminating in some of the largest futures exchanges today including the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX) facilitating futures in foreign currencies and eventually underlying stock market indices.

The London Metal Exchange

The Rise of Options

An option is a contract that provides the right but not the obligation for a party to buy or sell an asset at a fixed price by a designated date.

Again options contracts are said to date back to ancient civilisations but in modern day financial markets, these types of products took longer to gain traction. Whilst futures are relatively simple Delta One products (meaning that the price of a future is directly correlated to the associated underlying asset), options are far less standardised and more complex in their pricing. It wasn’t until the 1973 that the Chicago Board of Trade expanded into options offering a venue for trading, clearance and settlement (Chicago Board Options Exchange). At the same time, Fischer Black and Myron Scholes paved the way for options to move into mainstream markets by creating a model for the pricing of these options.

Fischer Black & Myron Scholes

Path to Market Dominance

In traditional financial markets, futures and options now dominate trading volumes. In 2017, the following volumes were traded…

  • 14.8bn futures contracts
  • 10.4bn options contracts

…split by the following categories:

  • 7.5bn on stock market indices
  • 4.8bn on individual equities
  • 4bn on interest rates
  • 3bn on currencies
  • 2.2bn on energy
  • 2bn on metals
  • 1.3bn on agriculture

…driven by exchanges across the globe:

  • Chicago Mercantile Exchange (USA)
  • National Stock Exchange of India (India)
  • Intercontinental Exchange (USA)
  • Chicago Board Options Exchange (USA)
  • B3 (Brazil)
  • Nasdaq (USA)
  • Eurex (Germany)
  • Moscow Exchange (Russia)
  • Shanghai Futures Exchange (China)
  • Dalian Commodity Exchange (China)

Source: FIA

Chicago Mercantile Exchange in 1997

Suffice to say the market is huge and global.

At its core, futures and options are used by market participants to manage risk and take risk. It allows you to allocate your capital efficiently, leverage your existing assets to generate higher returns and gain exposure to underlying assets that cannot be physically traded (e.g. volatility).

Lets take two examples.

Corporate A has operations in the US, Europe and Asia. In order to manage their foreign currency exposure to the euro, sterling and yen, corporate A could buy futures or derivatives to neutralise this exposure — using the gains and losses on the contracts to offset the change in the dollar equivalent of their foreign currency holdings. The corporate has successfully managed its risk.

Hedge Fund B thinks that Apple stock will reach $200 in a month’s time (currently trading at $165). Instead of acquiring apple stock, the fund can call up their broker and buy an option. Whilst the fund holds the contract, premiums are paid to the seller of the option until the contract is closed out or settled. The fund has successfully allocated its capital efficiently.

Futures in the Digital Assets Ecosystem

In the digital assets market, corporates and investors need financial products that can facilitate this type of trading, yet up until a few years ago, there were very few places that would allow you to trade futures and options in either a regulated or unregulated venue.

However, this has slowly been changing and just like in the traditional financial markets, futures were the first type of derivative to really take off. As we discussed earlier, futures are easy products to understand and since digital asset markets are dominated by retail investors currently, this evolution therefore makes sense.

A number of centralised and decentralised futures exchanges (both regulated and unregulated) have sprung up, generating huge volumes and printing significant amounts of cash. Some of the most well known we’ve highlighted below for reference.

Centralised and Regulated

Centralised and Unregulated

Decentralised and Unregulated

Where are the options?!

To date, options volumes are still tiny in comparison to the cash and futures market. Some rough numbers below to really drive home this point:

Monthly volume of cash markets: $120bn

Monthly volume of futures markets: $175bn

Monthly volume of options markets: $171m

Whilst Bitmex, Deribit and LedgerX facilitate crypto options, because the space is dominated by retail, these minimal volumes are unsurprising.

However, as the infrastructure in the digital assets space improves (particularly around custody), regulation becomes clearer, and investors increasingly become educated about the space, we expect increased institutional capital to flow into digital assets over the next 12–24 months. If this happens, demand for options should pick up, liquidity should improve and the product offering should increase. We expect this demand to come from crypto corporates (e.g. miners sitting on huge amounts of digital assets who need to manage their risk efficiently), market-makers (e.g. trading houses who facilitate the trading of digital assets and can make money on the spread between buyers and sellers) and speculators (e.g. hedge funds taking a view on a directional price on the underlying digital assets).

Bring on 2019 and lets see what happens…

PS: Check out Skew for great content on crypto options and digital assets more broadly.