Derivatives in Crypto
Futures and options and swaps, oh my!
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What do Thales of Miletus and hedge fund managers have in common?
They use derivatives to speculate on the future.
In pre-Socratic Greece, Thales believed a bountiful olive harvest was on its way. He went to the owners of the olive presses and paid them a fraction of the cost of the equipment for the right to use them in the following year. When the next harvest was as good as he predicted, people were clamoring for the presses, and Thales profited nicely by renting them out. This was the first recorded options contract.
Nowadays, bankers use options to speculate on anything from Apple stock to wheat to weather. Derivatives have become an integral part of the global financial system, for both speculation and risk management. In fact derivatives have burgeoned into a $500 trillion dollar market, exceeding global GDP by over 7 times.
After the ’08 crisis these financial instruments had their reputation tarnished — and rightfully so — as derivatives such as the CDO³, a three times repackaged collateralized debt obligation, masked enormous risk in the underlying mortgage market. This type of financial engineering added complexity to an already opaque market and created leverage that was difficult to identify in the system.
Still, certain derivatives are a necessary component for many businesses.
Whether you’re an airline, a tomato farmer, or any business with credit needs there are ways derivatives can be used to manage risk. In these situations an increase in the price of oil, a decrease in the price of tomatoes, or a rise in interest rates can significantly damage your bottom line. Derivatives allow you to lock in the price of a commodity or the interest rate on a loan in order to mitigate that risk. This type of hedging provides tangible benefits to these business owners. However, it wouldn’t be possible without the speculators. Someone always has to take the other side of the bet.
Just as gold miners have an inherent long position on gold, bitcoin miners have a similar position to bitcoin. In order to decrease the impacts of a precipitous drop in price, miners can use derivatives to offset some of that risk.
This has not been easy for most of bitcoin’s existence.
Creating these structured products requires regulatory approval, which as we know has been a hurdle for anything related to bitcoin. The first crypto derivative came about in 2014 after Tera Exchange received CFTC approval to list bitcoin swaps and forwards. Since then there have been a number of exchanges (including the largest derivatives exchange in the world — CME Group) looking to offer bitcoin derivatives.
A partial list of the largest crypto derivatives platforms today:
These products open the possibility for businesses with long exposure to bitcoin to hedge their risk, even if the biggest use case for crypto options to date has been leveraged bets on the underlying assets.
No one knows that better than Arthur Hayes, the CEO of BitMEX.
With the recent uptick in volatility, Bitmex saw daily volumes reach a staggering $10 billion in notional value recently. This coincided with volumes on the CME blowing by prior all time daily highs by 50% to over $1.25 billion in notional.
If the crypto markets are anything like the traditional markets, we should expect to see explosive growth in the number and type of derivatives traded. 2019 is already proving to be a major year for crypto derivatives.
We’ve already seen Kraken acquire a future’s trading firm for over $100 million, and Bakkt is planning to test their futures trading this July.
With the necessary infrastructure in place for institutions, we believe it is likely that derivative volume will soon surpass spot markets as it has in most asset classes. It’s likely that the majority of crypto price discovery already happens on platforms like BitMEX and Bitfinex today.
We’re looking to ingest more data on crypto derivatives markets soon in order to better highlight the state of those markets. Stay tuned.
