Exploring the evolution of the Crypto derivatives market and institutional adoption
Whether institutional clients consider cryptocurrency investing as a hedge against increasing inflation, a safe haven alternative, an innovative technology play or upside potential, they are increasingly looking to add crypto exposure to diversify their portfolios and include non-correlated returns.
Firmly halfway into 2022, such clients have stopped asking “should I invest in crypto?” and now ask “how much should I allocate to cryptocurrencies?” It’s no longer a question of when institutional investors will come, but rather how quickly, and what that means for the nascent cryptocurrency industry.
This development coincides with the tremendous growth of the crypto derivatives market, with both traditional and crypto-native venues building institutional-grade infrastructure to capture the expected exponential growth. Crypto derivatives, financial tools that derive their value from a primary underlying asset, such as bitcoin, are playing a key role in institutional investment strategies. Trading such derivatives provides protection against adverse price movements in the underlying asset, allows for capital efficient exposure, enhances risk management and facilitates arbitrage strategies to exploit market inefficiencies.
Futures and options can provide institutional investors with several advantages such as potentially lower transaction costs, efficient risk transfer, capital efficiency, and ample liquidity. The increasing participation of institutional investors and the growth of the cryptocurrency derivatives market are mutually reinforcing and indicate a degree of maturation.
Derivatives Make Up A Greater Share Of The Cryptocurrency Market
Crypto derivatives activity has been heavily dominated by futures, including perpetual swaps, based on bitcoin and ether. In January 2022 trading activity in the derivatives market overtook the spot or cash market, for the first time, as the number of available crypto derivatives products continuously expands.
Notional volumes in crypto derivatives registered almost $3 trillion in April 2022, accounting for more than 60% of trading in the total crypto market, according to data provider CryptoCompare.
Historically, the bulk of product innovation within crypto derivatives happened among offshore, non-regulated pure-play crypto exchanges, with BitMEX's 2016 creation of the perpetual swap contract serving as the starting point. Still, most activity occurs on offshore venues such as Binance, OKEx, FTX, and HuobiGlobal, which are subject to little or no regulatory oversight or take place in the OTC markets. These unregulated crypto derivatives markets offer several unique characteristics including, accelerated account opening process, 24/7 trading access, enhanced leverage and the ability to accept cryptocurrencies as collateral.
These unregulated marketplaces also operate without clearing firms in the traditional sense, with the exchanges themselves providing that function by way of auto liquidations. As such, they present clear challenges for institutional investors that operate under strict regulatory oversight and have fiduciary responsibilities to their client's capital. For many of these investors, the elevated counterparty risks of trading on these opaque, offshore non-regulated crypto exchanges and their inability to offer extensive KYC/AML protections, are still too high.
Fortunately, several CFTC-regulated exchanges now offer crypto derivative products, bringing more traditional institutional flow into the space. One of the most liquid, regulated US marketplaces is CME Group, which through its bitcoin and ether futures and options products, accounted for 4% of global crypto derivatives trading last month, according to CryptoCompare data.
In fact, the highest volume traded in a day, so far in 2022, has been $5.1 billion, with open interest, or the total number of outstanding derivative contracts, reaching $3.1 billion, ranking amongst the top 3 crypto derivatives exchanges according to data from skew.com. CME Group traders are generally institutions, not individuals, which is why this open interest in the digital asset market is noteworthy. Institutions that are already onboarded and active at the CME Group — trading wheat and oil for example — are increasingly moving into crypto futures as an alternative asset class.
For highly regulated institutions like banks, regulated cash-settled futures are easier to manage from a credit, compliance and legal point of view because the synthetic exposure eliminates the complexities of managing the actual cryptocurrency. Such contracts do away with the need of having a crypto wallet and are not subject to hacking, spot exchange flash crashes and auto liquidations.
Regulated crypto derivatives products at CME Group provide reliable access in a trusted, familiar environment and lowers some of the barriers that are hindering access to the unregulated platforms or even the underlying spot markets. With a centrally cleared model, counterparty risk is mitigated and eliminates some of the strains on the network. Finally, and most importantly, the idea of settling to, and convergence with, an index is key. All CME crypto futures contracts settle to robust underlying indexes that are regulated benchmarks under European BMR.
Where Does Price Discovery Happen/Does Spot Lead The Futures Or Do Futures Lead Spot?
In the traditional finance space futures markets are usually more liquid than the corresponding spot markets and often lead price discovery.
For example, mature equity index derivatives contracts offered on the CME platform trade 1.5 to 2 times more than the underlying individual equities on the cash markets. In comparison to Equity ETFs, equity futures trading on CME is also 10-12 times greater per day.
Across other asset classes, the futures markets are available more broadly than the underlying market, but crypto is the anomaly, with the spot and derivatives markets being open 24/7, making it a little hard to tell which market is leading which. Deep liquidity is conducive to efficient price discovery so, when paired with recent trends in Open Interest, Volumes, and the personas active in the market, the CME bitcoin futures is certainly a leading centre of price discovery and oftentimes the leading place for price discovery particularly when auto liquidations are happening on unregulated platforms.
The recent launch of futures-based bitcoin ETFs was a major factor in validating the space. The ETFs together with other structured products, further continues to develop the interrelatedness between the spot market and the futures market, ultimately leading to a growth vs growth nature for the crypto ecosystem.
What we are witnessing today may be similar to the 70s – an era during which the (financial) futures markets were rapidly developing, far exceeding their agricultural and commodity origins, and later developed an enormous impact on other key markets such as the interest rate (swap) market. The difference this time is the order in which market participants have joined – retail first, followed by institutional adoption.
This increase in liquidity, is not least due to investors’ preference for capital efficiency through low transaction costs and leverage and the influx of institutional investors are two key recurring developments that are likely feeding off each other and are driving growth in the crypto derivative markets. If both developments persist in the future, they will drive crypto markets towards further maturation.
An additional sign of liquid mature markets can be expressed with the recent market volatility, where price swings have been much more muted in crypto futures than elsewhere, and dislocations between exchanges — which can give rise to arbitrage opportunities — have been fewer than in previous episodes of market turbulence.
Given the current climate across crypto markets, a flight to the safety of things like derivatives continue to attract institutional players. Adoption of cryptocurrencies could grow further in the wake of innovation and regulatory clarity. Once a certain critical mass is reached, the institutional rally could further intensify and become self-sustaining.