Crypto Exchange Growth: Why Derivatives are Not the Answer

Granted, Crypto is a “cash” market, and at first it seemed impossible to profit in a bear trend (ask most Crypto Funds launched in 2017–2018). How do you sell an asset that you don’t have?

Framed like this, the natural problem solver will look into his archives and conclude that this problem has been solved before. With Equities, derivatives come in handy to allow users to go short without any prior inventory. The analogy is reassuring, as it illustrates that there are solutions, but which one should we use?

The Shortlist:

• CFD’s (Contract for Difference) were popular for stocks in Europe but got their wings clipped by the European regulator with a 2x cap on leverage. They are also not legal in the USA.
• NDF (Non-Deliverable Forwards) are bespoke OTC products for professionals only. They are not fungible most of the time, and a ripoff when you try to close positions with the same provider you initiated it with.
• Futures seem attractive, but require Exchange licensing plus a Clearing House market structure, and very high capital requirements. They require tricky specifications that most Crypto specialists won’t gauge as important. And the competition? There are two giant gators in this bayou!

But why derivatives in the first place?

We want to go short without prior inventory. We want leverage for short term trading. We want capital efficiency. We prefer not to deal with the on-Chain complexities, just the P&L.

In Crypto markets, volatility is high. The public is not deprived of trading opportunities as it is — a move on the scale of a first day tech IPO every morning, every day of the year (24h/365).

On the other hand, leverage is essential for institutions who are servicing the market with liquidity. It is not economical to mobilise 100% of the nominal value of a Crypto trade if a Liquidity Provider firm will hold it for just a few seconds: a $1M trade that will generate a P-and(or)-L of $200–300 over such a short time frame should be lighter on capital for financial institutions.

If you jump onto derivatives, then futures are the natural and most efficient product format.

But as you raise awareness and educate market participants to these instruments, you also clear the path for CME and ICE to capture the market.

Now that Crypto has decidedly entered its institutionalisation phase, the benefit of infrastructure, distribution, banking relationships, regulatory experience, ecosystem and “savoir faire” will guarantee the incumbent duo, complete domination before a full year passes. Why would you enter this back alley if you know you’ll be mugged?

So what’s best for our Crypto market then? Take the FX model !

We need to leverage the peculiarity and idiosyncrasies of Crypto and on-chain settlement — cherish this “headache”, it is our highest value add. A miracle of process simplification that is the envy of everyone in old finance!

The delivery aspect of Foreign Exchange has managed to make everyone agree that “FX is different”, meaning as a result that Spot-FX (Cash markets) is still the benchmark.

Crypto is an asset class that is truly different, high-tech and ground-breaking. We must give it the tools that the institutional market needs to fulfill its potential.

A Lending Market for Crypto Leverage

Lending (or repo in equities) is used to complete the toolset of Crypto as an asset class. Going short in equities is possible with short term lending instruments. In FX, most participants borrow the full value of their trades in a very efficient swap market that is so tight that Bid/Offer spreads are a fraction of the spot market itself.

We need to partner with natural allies: the wallet operators and Crypto custodians who are entering the user experience (UX) phase. Institutions won’t play with USB keys to settle multi-million $ trades, get a grip !

We don’t need to “invent”, as the most difficult has already been done. Taking a page from the FX notebook will do…

And as if we needed another warning… the CME recently acquired NEX, the company operating EBS (Electronic Broker System) which is the largest institutional Spot-FX marketplace.

We don’t need Derivatives to grow the Crypto markets.