An Overview of the Evolution of Bitcoin Derivatives
Derivatives have become a dominant force in the cryptocurrency market, leading to reduced volatility and enhanced market efficiency. The emergence of these financial instruments shows how far bitcoin has evolved as an asset class. While starting off as digital collectable, the leading cryptocurrency has become one of the most actively traded assets worldwide.
What exactly is a bitcoin derivative?
Derivatives are contracts, such as futures, options, or perpetual swaps, that enable investors to place bets on a falling or rising price of bitcoin (BTC). The market for cryptocurrency derivatives has become diverse, with some products using BTC as collateral to avoid having to go through the banking system and others settle in US dollars. Unlike traditional derivatives, most bitcoin derivatives are open to individuals of any net worth.
In this article, we’ll summarise the beginnings of the derivatives market for bitcoin and how it has progressed. We’ll also look at what the future holds for this fast-moving, exciting market.
Early Development of Bitcoin Derivatives
Early bitcoin exchanges were focused on making it easy for people to buy bitcoin safely and securely. Once spot markets become developed enough, demand to trade cryptocurrency grew and exchanges gained the trust of users. Slowly but surely, bitcoin trading started to resemble traditional markets with the introduction of margin trading, which allowed traders to borrow USD to buy or sell the digital asset.
Most investors implemented a buy and hold strategy, which worked out well as bitcoin experienced a rapid appreciation in its early years. But as more players entered the scene, they sought the ability to trade bitcoin’s volatility in both directions.
Derivatives enabled them to do so.
The first derivatives that emerged for bitcoin was in the form of futures contracts. These contracts allow investors to lock-in a certain price for their coins and permits the use of sophisticated strategies.
As early as 2011, entrepreneurs were interested in building marketplaces (which were very basic websites run by a handful of individuals) to trade bitcoin derivatives such as ICBIT. Traders could engage in arbitrage to buy the digital currency at spot and sell futures contracts if a premium existed (receiving their profits in BTC). Futures also enabled traders to hedge price volatility and lock-in a price for their BTC.
The demand for such an instrument grew from the need to trade bitcoin without ever having to go through the traditional banking system, allowing investors to set up a trading account in minutes.
Investors were also trading in more sophisticated ways by writing options and negotiating futures contracts on IRC channels such as #bitcoin-pit and #bitcoin-otc for professional trading. More products emerged which connected bitcoin to traditional markets in 2012 with the launch of 1Broker, which allowed traders to trade equity derivatives using bitcoin.
Financial professionals, who were seeking a way out of the bores of banking, turned their sights to the new and exciting world of cryptocurrency, driving the slow but gradual growth of bitcoin derivatives. As the crypto market was underdeveloped (reminiscent of Wall Street decades ago) and experienced massive growth, it motivated a brain drain from traditional finance to crypto. As a result, many of the founders of derivatives exchanges that have emerged share a similar backstory (they have come from investment banking).
Traditional markets are now dull, in stark contrast to the days where forex and commodities traders could earn fortunes thanks to the volatility in the 1970s and 1980s. The early development of bitcoin derivatives laid the foundation for traders to relive the ‘heyday of finance’, replacing commodities and forex with cryptocurrency.
Early platforms like ICBIT were tiny in terms of volume, as the number of people aware of bitcoin was still relatively small as compared to today. After around two years in operation, ICBIT had grown to around 5,000 users according to ArsTechnica who spoke to Alex Stukalov, one of the people running the exchange. Towards the later end of 2013, ICBIT boasted a three-month trading volume of $1.4 million, illustrating the nascent stage that derivatives trading industry was at in the cryptocurrency market.
The ebbs and flows in the price of bitcoin won over investors who believed in the vision but also drew the attention of critics, who witnessed the massive price movements and wanted a way to short it — which is exactly what derivatives allow. The maturation of the bitcoin market led to the introduction of what is the most successful derivative in the cryptocurrency world; the bitcoin perpetual swap.
2018: The Year of the Bitcoin Perpetual
It wasn’t long until derivatives caught on. As bitcoin repeated its boom and bust cycle, defied countless critics that have denounced it “dead”, and continued to exhibit wild price gyrations, more and more traders started to use derivatives to profit from these fluctuations.
By 2014, the financial side of the Bitcoin economy was still relatively primitive and derivatives platforms like BitMEX and BitVC were on the cusp of launching in Hong Kong. Futures were the dominant form of bitcoin derivative in the early years, with OKCoin (now OKEx) establishing themselves as one of the main venues. But it was the bitcoin perpetual swap that enticed traders and sparked a rising trend in the trading volume of derivatives, beginning in 2016.
While futures are useful for hedging and arbitrage, the expiry dates mean that they are not as desirable to investors who want to profit from the market’s fluctuations (especially if they want to hold on to a position for past a futures expiry date). Also, the price of a futures contract can often deviate substantially from the price of the underlying asset.
The bitcoin perpetual swap provided a trading instrument that did not have an expiry date and strengthened the bond between spot markets and derivative markets (since arbitrage was made easier). Also, the innovative contract allowed traders to hedge BTC positions without having to touch the USD (if you owned 1 BTC, you could short 1 BTC using a perpetual swap) and provided a simpler way to take a position as compared to futures contracts.
The Rapid Growth of the Bitcoin Perpetual Swap
Comparing the volume for BTC-USD from top five spot exchanges and the BTC-USD perpetual swap from derivatives exchanges, we see that the perpetual swap volumes makes up around 80 percent of bitcoin’s trading volume.
The volume attributed to derivative exchanges has grown massively (up from around 40 percent at the end of 2017), capturing most of the price discovery and is the main driver of the bitcoin price today. As a result, metrics from derivatives exchanges, such as open interest and funding rates, have become more important for analysts trying to predict where the market would go next.
The top derivatives exchanges have accounted for approximately 80 percent of bitcoin trading since February 2018 and started to overtake the main spot markets for BTC-USD during the bull run of 2017.
The beginning of the bear market precipitated a strong increase in the trading volume of bitcoin derivatives, as investors sought ways they could profit from falling prices. Also, the exchanges operating during 2016–2017 had also improved on the user experience, evolving from early, basic platforms like ICBIT.
The most liquid bitcoin derivative is BitMEX’s XBT-USD perpetual swap, which was launched in May 2016. The early growth of the bitcoin perpetual swap occurred alongside the ICO boom, which took centre-stage with investors making unimaginable returns on these projects trading these altcoins and tokens.
But as the boom turned to bust and ‘Crypto Winter’ started in early 2018, derivatives started to take centre-stage. Trading started to take off and surpass the volume of spot markets. Regulated derivatives also arrived on the market to improve the credibility and reputation of bitcoin, with the CME introducing its bitcoin futures contract on December 17, 2017.
While offering a perceived safer alternative, the essence of Bitcoin and decentralised cryptocurrencies is self-regulation. The development of a derivatives market has also meant that exchanges operate in countries with no restrictive regulations. They are not bound to the rules and regulations of certain jurisdictions. As a result, market-based solutions have emerged to address settlement risk.
Most derivative exchanges use auto-liquidation, where any excess proceeds are added to an insurance fund. The insurance fund effectively replaces a central clearing house found in the traditional markets — to make sure any winners are paid or to cover the risk if there is a price movement that bankrupts one side of the trade.
The other main effect of the growing derivatives market on bitcoin has been a reduction in price volatility. The long-term volatility of bitcoin returns has remained below 0.05 ever since the derivatives market became more significant (except for the euphoria period in early 2018 after BTC-USD peaked near $20,000). The role of the derivatives market is to provide ways that businesses can reduce the volatility of their bitcoin holdings and therefore make bitcoin more suitable as a currency so it can be more widely used in commerce.
Institutions Get Their Foot in the Door
The number of derivative contracts aimed at institutional traders is ever increasing, laying the groundwork for a broadened investor base for bitcoin.
Products aimed at institutional investors have had a slow uptake, with regulated exchanges being ‘second-movers’ to unregulated incumbents that offer bitcoin derivatives. The CME’s bitcoin futures allowed institutions to short bitcoin without having to own any bitcoin, and lets businesses hedge their risk (however, there’s not much evidence of that happening on a large scale yet). On the other hand, Bakkt launched its physically settled futures in the September 2019 but also plans to launch a cash-settled instrument for December 2019.
The trading volume on regulated exchanges/products like the CME’s futures contract has started to pick up in recent months. The diagram below illustrates the inertia of investors regarding these regulated products, where the volume (in terms of BTC) for bitcoin perpetual swaps is much larger than the combined volume for the CME’s bitcoin futures contract and the Grayscale Bitcoin Trust synthetic derivative.
As more investors enter the cryptocurrency space, the trading activity on instruments similar to the traditional financial world will increase. For greater mainstream acceptance, institutional traders want to see more security and regulation of spot markets. Many standards are yet to emerge for regulated products to come to market (such as tick size) and manipulation remains omnipresent, which will take time to address.
Unregulated derivative exchanges, however, have kept the spirit of Bitcoin alive by allowing users to sign up in minutes, without a need to submit sensitive information and sidestepping the banking sector completely by offering contracts that require BTC (or other cryptocurrencies) as collateral.
Retail traders still drive the bitcoin markets and we are some way away from seeing institutions taking prominence. In many ways, the regulated derivatives exchanges have inherited some of the same limitations as traditional exchanges, such as the exclusion of retail traders, circuit breakers to limit volatility and limited trading hours.
The Future of Bitcoin Derivatives
New entrants who have joined the bitcoin derivatives market in 2019 are eager to make their mark and we expect derivatives trading to enjoy high growth over the next few years.
Despite the high rate of new entrants, the options side of the market has yet to see its full potential and represents just a tiny share of the bitcoin market. At present, three platforms offer bitcoin options but only one is sufficiently liquid. The CME also plans to offer bitcoin options in 2020.
As the futures and options market becomes more established, more miners should take part and become the primary source of flows, as we see in traditional markets like gold and oil. Nevertheless, the runaway success of the bitcoin perpetual swap and increasing interest in regulated products is a clear sign of maturity for cryptocurrency as an asset class.
What’s Next for the Bitcoin Derivatives Market?
With a number of new entrants this year, we expect the derivatives market to blossom. Keep an eye out for further advances in bitcoin perpetual contracts allowing traders to bet not just on the price of bitcoin, but also on traditional assets like commodities and equities.
The issue of funding and pricing of bitcoin perpetuals will continually be improved upon by exchanges. For instance, one of the innovative features of Interdax’s bitcoin perpetual swap is the continuous settlement; there are no eight-hour funding periods that contribute to market disruptions and manipulation, and profits are realised instantly.
Interdax has also utilised a unique methodology to price derivatives, further helping to combat manipulation and ensure that all traders are treated fairly.
Trillions are spent in the traditional derivatives market for the purposes of hedging, so there is still some way for cryptocurrency derivatives to go. But as a variety of products become available for those enticed by trading bitcoins, the growth of derivatives should play a part in increasing liquidity, broadening the investor base and setting the stage for the next bull run.
