Retail Interest in Crypto Gives Way To The Rise of Derivatives
As retail interest in cryptocurrencies wanes, exchanges have been pushing out derivative products to increase leverage and maximize trading strategies.
In the spring of 2017, Andy Speldman, a graduate from the University of Arizona was working a dead-end job bagging groceries at a local Safeway in the desert city of Casa Grande.
Despite being a computer science graduate, Speldman bounced from one dead-end job to another, content to drift aimless while logging copious hours on the popular online game Fortnite.
When one afternoon, an ex-high school classmate of Speldman’s suggested he take a look at initial coin offerings — or ICOs as a way to make a quick buck.
With Speldman’s minimum wage, he didn’t have a lot by way of spare cash, but figuring that a thousand bucks wasn’t going to change his life anyway, he went all-in on an obscure ICO at the time that returned him some 5,000%.
Speldman could not believe his fortune, but instead of the countless others who got greedy and doubled down, he sold as much of the ICO as he could, converted the digital dollars into physical ones and bought property in Tuscon’s rapidly rising real estate market.
Today, Speldman is a major landlord in Tuscon, enjoying the fruits of his digital harvest, but even he admits,
“I was lucky. I knew that from the start, which is why I was convinced that this (ICO bubble) wasn’t going to last.”
“I saw my Dad blow a fortune during the last dotcom bubble and bust and I knew that I didn’t have the expertise or sophistication to time this market. So the minute I made some money I got out.”
And it appears that Speldman was not alone.
Been There Done That, Bought The Bubble
As the ICO bubble rapidly deflated in 2018, cryptocurrencies and Bitcoin have certainly fallen out of favor with retail investors, as evidenced by search patterns on Google Trends.
When Bitcoin hit a an all-time high of near US$20,000 in December 2017, countless legions of retail investors poured into the space and Google search was their gateway to the world of digital asset investing.
But that initial interest in Bitcoin and other cryptocurrencies has since fallen dramatically, flattening in 2018 when these nascent digital assets fell some 85% off their peaks.
Yet that waning interest has not stopped the cryptocurrency market from evolving and developing.
While many cryptocurrency projects and companies have gone bust and even more were outright scams, those industry players that have persisted are continuing to develop more ways for investors and traders to participate in the market and to utilize their digital tokens.
Dancing With Derivatives
Despite the malaise in the cryptosphere, one area which has seen growth has been cryptocurrency derivatives such as futures and options contracts, which allows traders to long and short cryptocurrencies.
These cryptocurrency derivatives also allow traders to hedge positions or speculate on the direction of cryptocurrency prices, but what makes them even more attractive is the leverage — as much as 125 times the amount staked — which has been made available to retail investors.
To be sure, such complex and exotic instruments are generally not suited for retail investors, or for the faint-hearted for that matter.
Options are contracts which give investors the choice (but not the obligation) to buy or sell a cryptocurrency at a specific price in the future. The key of course is the price of that option.
A futures contract is similar to an option in that it is a future agreed price for a commodity, such as a cryptocurrency, but differs in that it can either be settled in cash or with physical delivery. For example, Bakkt’s physically-settled Bitcoin futures contracts must be settled in Bitcoin, as opposed to cash, where an investor pays the difference between the futures price and the actual price at the expiry date of that futures contract.
Derivatives are generally considered complex financial products and pricing them is both art and science.
Now imagine applying leverage to such complex financial instruments and we really start to push the speculative boundaries of cryptocurrencies.
Take for instance a widely used options pricing model known as Black-Scholes, which many cryptocurrency traders have been using and which attempts to determine the fair price or theoretical value for a call (buy) or a put (sell) option based on six variables, including volatility, type of option, underlying price of the asset, time, strike price and the risk-free rate of return.
Here’s the formula,
Mind you, this formula isn’t even foolproof, but gives a sense of just how much of the traditional financial markets is spilling over into the cryptocurrency space.
Yet the low cost and ease with which cryptocurrency derivatives can be written and sold and the unregulated nature of these products has led to a proliferation across the cryptocurrency space.
In September, Binance, one of the largest cryptocurrency exchanges in the world by trading volume, launched its futures platform, allowing the trading of Bitcoin and Ether futures.
In February, U.S.-based Kraken, another popular cryptocurrency exchange, acquired London-based cryptocurrency futures trading start-up Crypto Facilities for an undisclosed price, but which many analysts put at about US$100 million.
Singapore-based Huobi, another major cryptocurrency exchange launched its derivatives market in selected countries in November, which has since gained significant traction.
According to data from CoinGecko, there are no less than 20 cryptocurrency exchanges offering over 100 cryptocurrency derivative products, excluding traditional, regulated exchanges such as the Chicago Mercantile Exchange, as well as Bakkt’s physically-deliverable Bitcoin futures on the Intercontinental Exchange.
This explosion in cryptocurrency derivatives comes on the back of several trends shaping the crypto industry as a whole.
Where Have All The Retail Investors Gone?
Retail interest in cryptocurrencies has been waning, which has led to a dramatic fall in trading in the spot markets, where retail investors purchase the underlying asset such as Bitcoin or Ether.
Cryptocurrency exchanges, looking for new sources of revenue have had to increasingly branch out to derivatives to look for growth and to also facilitate the demand from investors and traders who are looking to execute more sophisticated trading strategies.
Then there are institutional traders, who are looking to derivatives which are easier to manage (no cold or hot wallets), work on regulated exchanges and which may not take an ultimate position on the price direction of the cryptocurrency markets.
Such cryptocurrency derivatives allow traders to take both long and short positions and to quickly change up their positions algorithmically and with low latency.
And the availability of leverage allows traders to supercharge their bets to levels unheard of in the traditional markets for stocks and other futures.
Take for instance perpetual swap futures, which have been gaining in popularity.
Perpetual swap futures are essentially futures contracts without an expiry date and are designed to derive their price from their underlying asset — hence the name “derivative.”
BitMEX, one of the world’s most popular venues for cryptocurrency derivatives, was one of the first exchanges to offer perpetual swap futures contracts that allow traders to leverage up to 100 times! In other words, a one dollar bet yields a hundred dollars worth of sway.
And it’s not stopping there.
Some cryptocurrency industry players are now looking into futures contracts that will allow investors to leverage up to 1,000 times the value of their bet.
To put that into perspective, that means a hundred dollar bet at a blackjack table would essentially be amped up to a hundred-thousand dollar bet.
And given the inherent volatility of cryptocurrency markets, the rate at which that hundred dollar bet could go up in smoke could be near-instantaneous.
Because the lure of leverage is a double-edged sword — it can make one an enormous amount of money in a very short period of time, but could also wipe one out in the blink of an eye.
Yet most cryptocurrency exchanges may simply be taking their cue from the foreign exchange markets, where levels of leverage as high as 3,000 times are available, with one very significant caveat — those markets are heavily regulated, with such levels of leverage often restricted to institutional and accredited investors only.
Leverage Is As Leverage Does
The proliferation of leverage in the cryptocurrency markets has been driven in large part because they are unregulated and the settlement terms are in digital assets such as Bitcoin and other cryptocurrencies, which are also unregulated in most jurisdictions.
For now at least, the take up of cryptocurrency derivatives has remained relatively constrained to a small, sophisticated corner of the cryptocurrency trading market.
Given that most cryptocurrency derivatives are relatively new, it remains to be seen whether these adoption numbers are likely to grow. Bakkt’s experience with its physically-deliverable Bitcoin futures product should be indicative of the glacial pace of institutional investor participation in the space.
That retail investors have not jumped in wholesale to maximize their access to leverage from cryptocurrency derivatives, suggests that cooler heads have prevailed, but it could also simply be a function of the sideways movement of cryptocurrency markets.
Although Bitcoin, for all intents and purposes, has had a stellar 2019, more than doubling its price for the year, that run up is a shadow of the speculative boom experienced in 2017.
Perhaps cryptocurrency investors are indeed getting more sophisticated, not in the sense of participating in exotic digital asset derivatives, but more in adopting a more measured and rules-based approach to investing in cryptocurrencies in general.
If so, this is a promising trend.
Given the generally unregulated nature of cryptocurrency derivatives, these exotic and complex instruments are best left to those who can both comprehend them and stomach the substantial risks they bring to bear.
Yet that’s not to say that the proliferation of cryptocurrency derivatives is completely without merit beyond speculation.
Cryptocurrency futures for one, are good for cryptocurrency miners who can lock in revenue and profit, as they work to secure the cryptocurrency blockchain.
Meanwhile, investors who are looking to gin up their returns using cryptocurrency derivatives are best advised to look beyond purely technical analysis to calculate risk.
There is value in performing substantial due diligence on the people behind cryptocurrency exchanges, their background, history and the jurisdiction in which these exchanges operate in.
Given the global nature of cryptocurrencies in general, investors cannot expect regulators to step in should things go awry.
To that end, regulation of cryptocurrency derivatives is a patchwork and many cryptocurrency exchanges have taken advantage of regulatory arbitrage to circumvent regulation.
In the U.S., the Commodity and Futures Trading Commission is taking a stab at regulating cryptocurrency derivatives and in Japan where cryptocurrency exchanges are regulated, leverage is limited to as low as four times.
While these jurisdictions may come with their restrictions, investors concede leverage for a more certain regulatory environment, which in the long run, may be a safer bet than just blind luck.