We have all heard stories of multi-billion dollar liquidations of futures contracts causing 25% intraday price drops in Bitcoin (BTC) and ether (ETH) but the truth is that since BitMEX’s perpetual futures contract was launched in May 2016, the industry has been plagued by 100x leverage.
The derivatives industry goes well beyond these retail-focused instruments as institutional clients, mutual funds, market makers and professional traders can benefit from the instrument’s hedging capabilities.
In April 2020, Renaissance Technologies, a $ 130 billion hedge fund, received the green light for invest in bitcoin futures markets with instruments that are listed with the CME. These trading mammoths are nothing like crypto retailers, but instead focus on arbitrage and undirected risk exposure.
The short-term correlation with traditional markets could increase
As an asset class, cryptocurrencies are becoming a proxy for global macroeconomic risk, regardless of whether crypto investors like it or not. This is not only true for Bitcoin, as most commodity instruments suffered from this correlation in 2021. Even if the Bitcoin price decouples monthly, this short-term risk-on and risk-off strategy has a strong impact on the price of Bitcoin.
Bitcoin / USD on FTX (blue, right) vs. 10-year US yield (orange, left). Source: TradingView
Notice how the price of Bitcoin is steadily correlated with the 10-year US Treasury bill. Whenever investors demand higher returns to hold these fixed income instruments, there are additional requirements for crypto exposure.
Derivatives are essential in this case as most mutual funds cannot invest in cryptocurrencies directly, so using a regulated futures contract like the CME Bitcoin futures allows them to enter the market.
Miners will use longer term contracts as a hedge
Cryptocurrency traders fail to realize that a short-term price fluctuation does not make sense for their investment from the miners’ point of view. As the miners become more professional, their need to constantly sell these coins is greatly reduced. It is precisely for this reason that derivative instruments were primarily created.
For example, a miner could sell a quarterly futures contract that expires in three months and effectively fix the price for the period. Then the miner knows his returns in advance, regardless of the price movements from this moment on.
A similar result can be achieved by trading Bitcoin options contracts. For example, a miner may sell a $ 40,000 call option in March 2022, which is enough to offset if the BTC price falls to $ 43,000, or 16% below the current $ 51,100. In turn, the miner’s profits above the $ 43,000 threshold are cut 42%, making the option instrument act as insurance.
The use of Bitcoin as collateral for traditional funding will increase
Fidelity Digital Assets and crypto lending and exchange platform Nexo recently announced a partnership that Institutional Investor Crypto Lending Services. The joint venture will enable Bitcoin-backed cash loans that cannot be used in traditional financial markets.
This move is likely to ease pressure from companies like Tesla and Block (formerly Square) to keep Bitcoin on their balance sheets. Using it as collateral for your day-to-day business significantly increases your risk limits for this asset class.
At the same time, even companies that don’t seek directional exposure to Bitcoin and other cryptocurrencies could benefit from the industry’s higher returns compared to traditional fixed income securities. Lending and borrowing are perfect use cases for institutional clients who are not directly exposed to the volatility of Bitcoin, but at the same time are aiming for higher returns on their wealth.
Investors will use option markets to produce “fixed income”
The Deribit derivatives exchange currently holds a market share of 80% in the options markets for Bitcoin and Ether. US-regulated options markets such as CME and FTX US Derivatives (formerly LedgerX) will, however, gain in importance at some point.
Institutional traders value these instruments because they offer the opportunity to develop semi-fixed income strategies such as: covert calls, Iron condors, Bull call spread and other. In addition, by combining call (buy) and put (sell) options, traders can set options trading with predefined maximum losses without the risk of liquidation.
It is likely that central banks around the world will keep interest rates near zero and below inflation around the world. This means that investors are forced to look for markets that offer higher returns, even if that involves some risk.
It is precisely for this reason that institutional investors will step into the crypto derivatives markets in 2022 and transform the industry as we know it right now.
Reduced volatility is coming
As mentioned earlier, crypto derivatives are currently known to add volatility when unexpected price fluctuations occur. These forced liquidation orders reflect the futures instruments used to gain access to excessive leverage, a situation typically caused by retail investors.
Institutional investors, however, will gain a wider presence in the Bitcoin and Ether derivatives markets and therefore increase the bid and ask sizes for these instruments. As a result, retailer liquidations of $ 1 billion will have a smaller impact on price.
In short, a growing number of professional players participating in crypto derivatives will reduce the effects of extreme price fluctuations by absorbing this flow of orders. Over time, this effect will be reflected in lower volatility or at least problems like that Crash in March 2020 if BitMEX servers are “down” for 15 minutes.
The views and opinions expressed here are solely those of author and do not necessarily reflect the views of Cointelegraph. Every investment and trading movement involves risk. You should do your own research when making a decision.
