Getting High Off Cryptocurrency Derivatives

As the market for cryptocurrency derivatives swells, investors are getting high off leverage and getting burned off margin calls, which is inviting regulatory attention.

Patrick Tan
Oct 22, 2019 · 9 min read
Rural impressionist version of Beijing was not as menacing but twice as effective. (Image by Free-Photos from Pixabay)

Ma Yi reigned in his horse. The late 17th century Qing dynasty general sensed that something was amiss. Without a word, he signaled his two-point men, who rode ahead of the entourage to scout for danger.

Escorting a sizeable load of silver taels, General Si was wary when traveling through the southwestern region of 17th century China.

Though ostensibly a Qing dynasty general, General Si traced his lineage and his loyalty to the now defeated Ming dynasty, making him a prime target for brigands and highwaymen who worked under the indirect authority of the Chinese southwest’s “King.”

In late 17th century China, the Qing emperor may have reigned from Beijing, but the southwestern hemisphere of the Middle Kingdom took its cue from one of Chinese history’s most infamous traitors, Wu Sangui.

Appointed as “Pingxi Wang” — which translates to “King who Pacifies the Southwest,” after helping the then-nascent Qing dynasty defeat the incumbent Ming dynasty, Wu held court over much of the legal and illegal activity in China’s southwest.

Because treasure is critical to raising armies and buying loyalty, treasure escorts such as those of General Si were an irresistible target of Wu Sangui’s avarice.

While the Qing emperor ruled from Beijing with the mandate of heaven, in the Chinese southwest, it was Wu Sangui who ruled on the land, with the mandate from Beijing.

Beijing may dictate, but ultimately it was Wu Sangui who would interpret.

Because in the 17th century China, the truth was what the nodes of power made of it and no node was more powerful than Wu Sangui’s node in Hengzhou (now Hengyang).

Far from the imperial capital, Wu ruled his very own fiefdom, with its own set of laws, its own brand of loyalty and its own tenuous link to its source of power — Beijing.

Anybody that needs a palace this big may be compensating for something else. (Image by walter688 from Pixabay)

Which meant that for the millions of Chinese citizens living in southwest China, the Qing emperor may have laid claim to be the son of heaven in Beijing, but on the ground in the heart of China, it was Wu Sangui who ruled with fear, the hearts on earth.

As an old Chinese proverb goes,

天高皇帝远. ( tiān gāo, huángdì yuǎn)

Which translates to,

“Heaven is high and the emperor is far away.”

The proverb is intended to mean that central authorities have little control over local affairs.

Cryptocurrency Derivatives Are More Impressionist Than Representative

And nowhere is this proverb more apt than in describing the marketing, sale, and trading of cryptocurrency derivatives.

Because while most of the mainstream media’s attention may have been focused on New York’s Bakkt — a platform for the trading of physically-deliverable Bitcoin contracts — in a quiet corner of the cryptoverse, the real action in cryptocurrency derivatives has a far more compelling influence on cryptocurrency prices overall.

Take September 24 for instance, when Bitcoin plunged by US$1,000 in a mere half-hour — a move which hardly raised eyebrows simply because such moves happen with such a degree of regularity that neither explanation nor exclamation is offered — but one which precipitated a cascading downward spiral for cryptocurrency derivatives.

Bitcoin ballers be like…(Image by mohamed Hassan from Pixabay)

It’s no big secret that the bulk of Bitcoin and other cryptocurrency derivatives are traded on BitMEX, an unregulated trillion-dollar cryptocurrency exchange.

So when Bitcoin’s price started to plummet in the last week of September, traders who had gone “long” on Bitcoin were being asked by BitMEX to post more collateral for their contracts, which triggered a stampede.

By the end of the day, over US$643 million worth of Bitcoin contracts had been liquidated on BitMEX, dragging long contracts on other cryptocurrencies down with it.

Traders immediately noticed the plunge and Bitcoin and other cryptocurrency prices as a whole went down with the vortex that the BitMEX derivatives created with it.

But the reason for the initial drop was inexplicable.

If nothing else cryptocurrency markets have been relatively stable by most standards and with mainly positive news emanating from the sector — no major hacks of exchanges, no large-scale scams — in the cryptoverse, an absence of bad news can only be good news.

Yet the fall in prices coupled with a large number of outstanding “long” contracts and a simultaneous margin call can result in altogether unforeseeable results.

Yet despite their destructive capability, cryptocurrency derivative products, which include options, futures, and far more exotic flavors are hugely popular.

Everybody Else Is Doing It

According to Chainalysis, a research firm that searches the public blockchains of many cryptocurrencies, in 2019 alone, over 23 billion cryptocurrency derivatives have been traded — versus Bakkt, which only recently hit a trading record of 212 contracts, although that number is growing steadily.

Part of the reason why BitMEX’s derivatives, as well as the scores of other cryptocurrency exchanges that offer these products, are so popular is that there is no requirement to post the underlying asset to place a bet and traders (punters) can take on huge amounts of leverage.

But derivatives can be highly destructive.

Oopsy, did I do that?

Take the 2008 financial crisis for instance, which was blamed on mortgage-backed securities.

In that crisis, the masters of finance thought they had finally developed a way to eliminate risk.

In a nutshell, mortgage-backed securities are instruments created out of a pool of mortgages. Now instead of a single lender being on the hook, investors looking for a steady return could invest in these basket of mortgages.

By pairing a large pool of mortgages, the assumption was that even if a couple of mortgages went bad, surely not all mortgages could possibly go sour at once.

And because rating agencies drank from that Koolaid (or rather drank from the heady fees available) of risk-free securities, many of these mortgage-backed securities were rated “AAA” — the highest investment grade available and the level at which many pension funds were able to invest in them.

Markets simplified. (Image by ar130405 from Pixabay)

As an aside, because pension funds have a primary duty to preserve funds for their members’ pensions, they are typically only allowed to invest in the most high-quality investment-grade instruments.

Traditionally, when a bank gives you a mortgage on your house, the bank does plenty of due diligence on you to find out whether or not you’re able to pay off that mortgage.

But what derivatives did for the bank was that instead of the bank taking on the risk of you defaulting on your mortgage, the bank was able to re-package that risk and sell it off to investors.

And while it may be simple to value a single mortgage, because actuaries can assess the credit risk of the borrower, it’s far more difficult to value a basket of mortgages, each with its own maturity dates, risk-premium profile and borrower idiosyncrasies.

Against that backdrop, it was only a matter of time before the bank cared less about the people it was lending to than investors ought to have.

Which brings us to cryptocurrency derivatives.

Money For Nothing And Your Chicks For Free

Because the bulk of cryptocurrency derivatives are not actually backed by their underlying digital asset and because traders (punters) can leverage orders of magnitude more than they need to stake, there is substantial disconnect between cryptocurrency derivatives and the underlying cryptocurrencies they represent — a case of the tail wagging the dog — just as there was substantial disconnect between the underlying value of the pool of mortgages and the face value of a mortgage-backed security.

Because every time you separate the ownership of the underlying asset — for instance the Chicago Mercantile Exchange’s and the Chicago Board of Exchange’s cash-settled Bitcoin futures contracts — and the contract that derives its value from the underlying asset — you create an opportunity for price manipulation, especially when the transaction value of the derivatives far exceed the transaction value of the underlying assets.

In most financial markets, derivatives such as futures are used by stakeholders as a form of price guarantee for a future product — for instance, a farmer needs to know the minimum price he or she will get for their crop before deciding what crop to plant for that season.

But cryptocurrency derivatives of the non-physically-deliverable variety serve no such hedging purpose.

Everyone’s a winner. (Image by stokpic from Pixabay)

Cryptocurrencies themselves are also hard to track in terms of value, with price correlation between various cryptocurrencies strong.

Thin (genuine) trading volumes of cryptocurrencies also means that prices of the same cryptocurrency can differ widely between exchanges, making them poor reference points for cryptocurrency derivatives.

And cryptocurrency illiquidity means that price swings are amplified — Bitcoin on average is four times more volatile than any physical commodity.

Cryptocurrency derivatives are essentially a form of steroid-laden gambling instrument — with traders (punters) able to borrow anywhere from between 2 and 100 times the amount that is staked.

So while (for now at least) cryptocurrency derivatives are at no risk of jeopardizing planet finance, they do pose a danger to retail investors.

Big Brother Is Watching

This is why it should come as no surprise that regulators from London to Tokyo are concerned retail investors may be getting slaughtered by sharks while trading cryptocurrency derivatives.

Japan is mulling substantial registration requirements for cryptocurrency products and Hong Kong already bars retail investors from participating in cryptocurrency funds.

Europe has had stiff restrictions on any form of cryptocurrency derivative since last year and the United Kingdom’s Financial Conduct Authority is now considering imposing a blanket ban on selling cryptocurrency derivatives to retail investors altogether.

But trying to stymie cryptocurrency derivatives trading may not be as easy as regulators would hope.

In the same way that virtual private networks (VPNs) allowed millions from across the world to bypass national firewalls to bet on online casinos as well as to provide IP anonymity — determined cryptocurrency derivative market participants have a plethora of tools at their disposal to circumvent local restrictions and firewalls.

Pigeons protesting the police state. (Image by Stafford GREEN from Pixabay)

To be sure, the cryptocurrency industry as a whole needs to do some introspection to reflect if cryptocurrency derivatives which are unlinked to their underlying cryptocurrency asset, do the cryptoverse more harm than good.

But the same way that the statistical odds of success at the casino are against gamblers, that hasn’t stopped gamblers from showing up.

Game On

For now at least, cryptocurrency derivatives are like a supercharged betting instrument, like going into a casino and getting a line of credit valued at a hundred times the number of chips you are going in with — you either better be a heck of a gambler or a good negotiator when you end up owing the casino more than you have.

Similarly, with cryptocurrency derivatives, traders will need to understand that given the volatility of the underlying assets, imprecise and opaque price information sources as well as rampant manipulation, the odds of consistently making profits from cryptocurrency derivatives are few and far between.

On top of that, there is the suggestion that some exchanges, especially those with sufficient trading volume to alter the price of the underlying cryptocurrency asset that a derivative is based on, may be actively trading against their own clients.

For instance, if a cryptocurrency exchange notices that there are a lot of “long” Bitcoin futures contracts on its exchange, the exchange (through third parties or otherwise) can take up the opposite side of those contracts (short) and can push down the price of Bitcoin on its own exchange, forcing the “long” contracts to be out of the money and profiting off their client’s losses.

And for traders (punters) who have leveraged big, there is a serious temptation on the part of unregulated exchanges to do so.

Because many of these cryptocurrency exchanges are the marketplace for both the derivative as well as the underlying asset and because they are not regulated — the opportunity for abuse is a clear and present danger.

So traders (punters) thinking that cryptocurrency derivatives (especially those that are not for physical delivery) are a quick and easy way to use leverage to make a killing in the crypto markets might want to think again.

Until such time that reliable, transparent and readily verifiable price discovery mechanisms exist for cryptocurrencies, there will be crypto market participants who can and will actively game the platforms for profit and if you don’t know who’s the one left holding the bag, chances are it’s you.

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Patrick Tan

Written by

CEO of Novum Alpha, an all-weather digital asset trading firm that uses Deep Learning tools to deliver dollar-returns in all market conditions.

The Capital

A publishing platform for professionals in business, finance, and tech

Patrick Tan

Written by

CEO of Novum Alpha, an all-weather digital asset trading firm that uses Deep Learning tools to deliver dollar-returns in all market conditions.

The Capital

A publishing platform for professionals in business, finance, and tech

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