Digital Asset Futures Have Arrived
TL; DR: Digital asset futures trading is here and larger than most probably realize. Reported notional trading volume is significantly larger than spot trading today and futures influence on spot markets is something active managers and service providers should keep in the back of their heads.
The Growing Importance of Digital Asset Futures
On the afternoon of Tuesday, September 24th, the price of bitcoin, the digital asset industry’s most well-known and liquid asset, dropped precipitously and without warning. In the span of a little less than an hour, a drop of 13% took place, destroying nearly $20B in value. Contagion and correlations with other digital assets destroyed another $15B in value across the ecosystem.
In the 24-hour period including the price drop, $7.8B worth of bitcoin perpetual contracts traded on BitMEX, one of the world’s largest digital asset futures markets. As a point of comparison, the volume in that one BitMEX contract was nearly 40% greater than the spot trading of the sum of all digital assets traded on Coinbase, bitFlyer, Kraken, Gemini, Poloniex, Bitfinex, Bitstamp, Bittrex, itBit, and Liquid, combined. The next stage in the evolution of digital asset trading has arrived in the form of futures.
Digital Asset Derivatives Volumes Are Bigger Than You Think
Just to put a spotlight on the difference between digital asset spot and derivatives volumes in perspective, here are the self-reported 24-hour volumes on 9/26/19 as aggregated by FTX.
Our first observation is that $15.4B in notional is nearly 3x the size of spot markets in the selected exchanges. This doesn’t take into consideration leverage ratios, which can hit up to 100x, but we find it instructive for comparative purposes. Data disclosed by BitMEX showed that weighted average leverage for long positions was running at 22x as of April 2019 and shorts were running at 30x.
Not only is digital asset futures trading large today, it’s growing. According to data we’ve aggregated, average daily notional trading volume continues to grow, albeit with month to month volatility.
What are Futures?
Futures are a form of derivatives, financial contracts whose value is derived from another asset called the underlying, like Bitcoin. Futures are an agreement between two parties to deliver an asset at an agreed-upon price at a date in the future. These contracts are standardized and traded on an exchange. Digital asset markets have taken the concept further with the creation of the perpetual contract (swap or future, depending on the platform distinction), a contract without expiration that requires periodic funding (intraday typically), at the funding rate, to keep open long or short. These contracts are most like trading spot on margin (borrowed funds), but with leverage of up to 100x.
Most digital asset futures contracts are financially settled or cash settled, meaning there is no requirement to deliver the underlying at expiration. Instead, cash is sent. But platforms like Bakkt offer physically settled contracts, delivering Bitcoin instead of cash, as does CoinFLEX and Huobi. Seed CX, LedgerX, ErisX all plan to plan physically settled futures at some point in the future.
Why Trade Futures?
Futures offer traders a number of advantages compared to spot markets, some of which are less evident. Some of those benefits include:
- Leverage. First and foremost is trader access to leverage. Online digital asset markets, which began to spring up in 2010, have evolved from trading spot cash markets, to spot crypto markets (LTC/BTC for example), to spot cash markets on margin, to now derivatives. It’s no secret that trading is an important use case for digital assets today and leverage amplifies the ability to make (or lose) money.
- Counterparty Risk Reduction. It’s no secret that online digital asset markets have been subject to numerous hacks and thefts over the years. Industry estimates put the total amount of digital assets stolen from online markets at over $1.6B. Cash settled futures, like the CME’s Bitcoin futures, removes counterparty risk simply because the CME or its brokers don’t hold any Bitcoin. Online digital asset markets, like BitMEX, hold client digital asset deposits in cold wallets and have reduced reliance on hot wallets.
- Lower Commissions. The typical fees for trading futures on online digital asset markets can be significantly cheaper than trading on spot. Most exchanges, both futures and spot, employ a maker/taker pricing model whereby orders that provide liquidity (maker) are charged different fees than orders that take liquidity (taker). Futures markets typically provide maker rebates, a practice mostly done away with on spot markets, and taker fees are typically lower than spot market, except on the largest volume tiers.
Futures markets aren’t without their risks, however. Here are some of the highest level concerns:
- Loss of Principal. It should be no surprise to even the casual observer that trading digital assets involves significant risk. Bitcoin’s realized 1-month volatility has reached 155% in the past 3 years, nearly 5x the peak volatility of the S&P 500. Combine this volatility with leverage of up to 100x and you have the potential for significant capital impairments.
- Trading Hours Mismatch. Spot markets for digital assets trade 24 hours a day, 365 days a year. While online digital asset futures markets do the same, the same cannot be said for traditional futures exchanges, like the CME, which trade Bitcoin futures on the same schedule as its other products. Because these futures are priced off an index comprised of prices from spot markets, this can introduce price risk between regulated futures products and spot markets.
Regulations of Futures Products and Trading
Traditional derivatives, including futures and options, are investment contracts that trade on regulated exchanges. In most jurisdictions, these exchanges are overseen by a national regulator. While some digital asset futures trade on such exchanges, like the CME’s Bitcoin futures contracts, many do not. They trade on online markets, that while called “exchanges” in the vernacular, typically have not qualified for such distinctions for regulatory purposes. Complicating matters, digital assets and their associated derivatives transcend national boundaries bringing into question regulatory authority. Because of this, navigating regulations for digital assets and futures has been a challenge for secondary market trading venues, asset issuers, and other market participants. We summarize important regulatory bodies for futures trading and the current status of digital asset futures within those markets.
US — Commodity Futures Trading Commission (CFTC)
The CFTC is an independent agency of the US government entrusted to regulate futures, options, swaps, and other products subject to the Commodity Exchange Act (CEA). Its mission is to ensure market integrity, participant protection, financial integrity of the clearing process, and prevent manipulation, market abuse, and fraud. The definition of a commodity under the CEA is broad and in 2015, the CFTC determined that Bitcoin and other virtual currencies were properly defined as commodities. The CFTC has granted approval for Bitcoin futures on the CME, Cboe (not currently listed), and Bakkt.
UK — Financial Conduct Authority (FCA)
The FCA is a financial regulatory body that operates independently of the UK government but is charged with regulating the marketing of financial products. In July the FCA published a paper intended to pave the way for the ban of digital asset derivatives for retail clients, finding them difficult to value, volatile, and ill-suited for retail investors. Although the ban has not technically been put in place yet, most believe the outcome seems likely by year-end.
South Korea — Financial Supervisory Services (FSS)
South Korea’s FSS examines and supervises financial institutions under the oversight of the Financial Services Commission (FSC). In December 2017, just as Cboe and CME futures began trading, the FSC reportedly issued a directive banning Bitcoin futures contracts. The regulator does not recognize Bitcoin as an underlying asset for financial derivatives and therefore has restricted its use. The FSC has also banned margin trading of digital assets as well as Initial Coin Offerings (ICOs) and forced a real-name verification system on digital asset markets.
Hong Kong— Securities and Futures Commission (SFC)
The SFC is Hong Kong’s top regulator for securities, including futures and options. In November 2018, the organization created a voluntary regulatory sandbox for exchanges that wish to be licensed to trade in digital assets. As part of that sandbox, exchanges must only deal with institutional investors. After an exploratory period of undetermined length, the SFC could then decide to license and regulate exchanges. This regulatory sandbox is not available for platforms that operate in digital asset derivates markets, however. Traditional futures, like the ones that trade on the CME, are defined by the SFC as a Type 2 regulated activity and can be offered to Hong Kong investors through licensed intermediaries.
Japan — Financial Services Agency (FSA)
Japan’s top regulatory agency is the FSA, which oversees banking securities and exchanges, including futures exchanges. In early 2019, the FSA dropped plans to allow digital asset derivatives to be traded, including futures. This news came following a $530M hack of Coincheck, a popular online market in Japan that was unlicensed at the time of the hack. In Japan, digital asset markets are licensed and regulated by the FSA and Bitcoin is recognized as legal tender.
Conclusion
Digital asset derivatives have rapidly become an important fixture within the digital asset market landscape. While their forms differ by exchanges and markets, there is no denying their popularity. We think that active managers and service providers should be aware of their rapid rise and their potential impact on spot market and the regulatory landscape. We think that a complete picture of secondary trading activity is required to make informed investment and business decisions in this ever-changing space.
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