The state of crypto derivatives and what it tells us about the crypto space
The state of crypto derivatives and what it tells us about the crypto space
septembre 05 2022
Back

Weekly stories are first featured in our Newsletter. Subscribe here to receive it directly in your mailbox every Monday.

Financial markets play an important role of facilitating the flow of capital, creating asset liquidity and helping its price discovery, putting together buyers and sellers and recording the price they have agreed to upon every new transaction.

By nature, financial markets are also speculation tools, especially when it comes to derivatives, which allow betting on the market and hedging from its dangers in a number of different ways. It comes as no surprise then that derivatives trading volume is often higher than the spot one: for example, yearly paper gold trading volume is estimated to be 200 times higher than physical gold trading, and they both are at least three times higher than the actual volume of all the above ground gold.

Crypto is no exception. While the total crypto market cap (the amount of circulating cryptoassets multiplied by their price) is turning around $1 trillion, its spot trading volume now amounts to $1.38 trillion, and derivatives trading volume – $3.12 trillion (source: Cryptocompare’s July report). Crypto derivatives represented 69% of the total trading volume, increased from 66% in June.

Derivatives data can tell a lot about the whole space and the aspirations of its players, and it’s important to understand how they work.

This is a short guide to crypto derivatives and their state.

Crypto derivatives by type

In the crypto world the most common derivatives are:

➡️ Futures – an agreement between a buyer and a seller to sell an asset at a set price and a set date in the future,

➡️ Options – a possibility to either sell or buy an asset at a set price at a set date,

➡️ Perpetual contracts (swaps) – futures without an expiry date.

Currently most popular crypto derivatives are perpetual swaps, for they allow very easy speculation: a trader deposits their coins (native crypto or stablecoins) on a platform and then buys a position (long if they believe that the price of an asset will go up, and short if they believe it will go down). If the price goes in their direction, they will be able to cash out the difference, if it goes in the opposite direction, they will have to suffer the equivalent losses deducted from their deposit, all the way until its liquidation – also called the margin call, for liquidation can be avoided if the trader adds more coins to their deposit, or margin account.

Positions are measured in the number of contracts, which often equal $1. An important feature of many platforms is leveraged trading, allowing to bet (= buy a position) more than the deposited amount. However, this goes with an increased risk: the bigger the leverage, the closer is the liquidation threshold.

Perpetual swaps are very popular with day traders, and they can tell a lot about the market sentiment. For example, the end of August data by Glassnode and Decentral Park Capital showed Bitcoin and Ethereum perpetual futures open interest leverage ratios at their all-time highs, and this could be a sign of approaching turbulence.

Open interest is the total amount of open positions on main derivatives platforms. Open interest leverage ratio divides that amount by the market cap of an asset to estimate the degree of leverage. The higher the ratio, the higher are the speculations, which increases the risks of strong price movements known as “squeezes”: even a small price move can trigger liquidations of highly leveraged positions, which, when sold at market prices, can start a snowball reaction.

More weighted open interest on Ethereum than on Bitcoin is likely due to the upcoming Merge: traders betting that something will go wrong (it could) vs traders betting on a dramatic amelioration of the whole ecosystem (it could too) are putting Ethereum market in a very unstable situation.

Crypto derivatives by platform

Crypto finance exists on three planes: CeFi, DeFi and TradFi, and all three of them propose derivative products.

CeFi, or centralized finance, is responsible for the crashing majority of crypto derivatives trading volume – around 95%, with Binance as incontestable leader ensuring over 50%.

DeFi is represented mostly by dYdX, with just over 1% of the overall derivatives trading. DeFi is generally more complicated than the CeFi, as users must learn how to be responsible for their own wallets. DeFi operations can also be more complicated from the accounting and compliance point of view. This explains DeFi’s relative unattractiveness when it comes to derivatives trading, which brings up another problem: lack of liquidity, especially for big operations.

TradFi, or traditional finance, could not resist the appeal of the new asset class, and some of its most prominent actors have come up with their own crypto-based derivatives, which allowed even the tightly regulated and/or conservative investors to try themselves on the crypto market.

Most famous is Chicago Mercantile Exchange, world’s largest futures exchange. It launched cash-settled Bitcoin futures in December 2017, and their success pushed it to expand the offer to Ethereum futures, then options, then micro-futures and options for both coins.

Last week CME launched euro-denominated Bitcoin and Ethereum futures, and Ethereum options will complete the offer starting from September 12.

CME derivatives are an important metrics of market sentiment not only because they cater to investors outside the crypto world, but also because the CME, unlike 24/7 crypto-native platforms, does have weekends and holidays off. This can create gaps: areas on the price chart where price seems to be discontinued, most often due to a notable difference before and after the day(s) off. Many traders use these gaps to adjust their strategies, as a common belief says that more often than not the gaps are “filled in” later on.

Crypto derivatives are important not only for traders, but for the whole crypto space: they help optimize price discovery, measure the interest for an asset and make the market more liquid. They can, however, be dangerous: big amount of highly leveraged positions risk to amplify market movements, triggering liquidations cascade and making the underlying asset price crash (or skyrocket) in a matter of minutes.

Traditional stock markets also had this kind of problem, which, after the 1987 market crash, lead to the implementation of the so-called “circuit breakers” – temporarily trading halts that an exchange sets off following an unusual activity like panic-selling or manic-buying.

In the crypto space circuit breakers were much discussed after the “Covid” crash, but, as pointed out by Binance’s CZ, “the free market does not work this way”, and crypto exchanges chose not to interfere with traders’ orders. Arguably, this makes derivatives-watching even more important for all crypto market players.