Crypto Derivatives | Deep Dive
Review Date: February 5th, 2021
What Are Derivatives And Why Are They Useful?
A derivative is a financial instrument tied to the underlying asset it is derived from and is used as a means to gain leveraged exposure on the underlying asset or to hedge against a spot position. Essentially, derivatives provide traders optionality on how to manage the risk of their position whether it be risk-on leverage or de-risking via hedging.
These financial products are common in both legacy financial markets and the cryptocurrency asset class. There is a wide range of derivatives including futures contracts, options and the most commonly used derivative product in the cryptocurrency asset class the perpetual swap contract that has no date of expiration.
The Crypto Derivatives Market
In its infancy, the cryptocurrency asset class only offered spot exposure to underlying crypto-assets such as Bitcoin, Litecoin and Ethereum. However, as the asset class began to mature around 2016–2017 exchanges such as BitMex launched that offered derivatives on Bitcoin in the form of a perpetual swap and futures contracts in which traders could gain leveraged exposure to the volatile asset.
The cryptocurrency derivatives market began to see an uptick in derivatives trading volume in May 2020 with a total trading volume of $602 bn totaling 32% of the market with the remaining being spot trading volumes of $1.27 tn. After Bitcoin broke it’s all-time high derivatives trading volume has continued to surge with $600 bn of BTC futures being traded within the first week of 2021 across all exchanges.
Beyond Futures and Perpetual contracts, the cryptocurrency Options market has recently exploded with Deribit leading in total daily volume and open interest across BTC and ETH option markets. Deribit exchange processed $14.5 bn in BTC options within the first two weeks of January compared to the $57 bn total volume processed in 2020.
Investment Thesis For Decentralized Derivatives Protocols
DeFi Eating CeFi
The DeFi narrative of replacing centralised financial services with permissionless censorship-resistant smart contracts fully emerged in 2020 with the success of automated market makers (AMM’s) such as Uniswap against centralised exchanges and their traditional order book model. In September 2020, Uniswap became the 4th largest cryptocurrency exchange by volume. DEX’s like Uniswap are not subject to wash trading as the transaction fees on the Ethereum blockchain make the practice of faking transaction volume financially infeasible.
Given the rise of DEX’s that are eating into the centralised exchange spot market, it makes sense to extrapolate that in the cryptocurrency asset class financial instruments such as options, futures and perpetual contracts can also be decentralised and eat into the CEX derivatives market. The rapid growth of the cryptocurrency derivatives market fueled by speculators looking to profit off volatility means protocols set to disrupt CEX derivatives have the potential to capture huge transaction volume in the coming years.
Regulatory Oversight & KYC
The UK’s Financial Conduct Authority (FCA) recently banned the sale of cryptocurrency derivatives to retail investors which was enforced on January 6th, 2021 [4]. This decision was made as the financial authority deemed the products too risky due to volatility for retail investors to be consistently profitable. In many cases, UK cryptocurrency traders like US traders will search for exchanges that do not require KYC and use a VPN to re-route their internet activity from a UK/US IP address. If traders are willing to go to this length in order to trade these products then there is significant demand for a decentralised derivative solution.
In order to trade derivatives on centralised exchanges, many require information on your identity such as official ID documentation (passport, driver’s license) and sources of income used to fund the account. As stated by Nick Szabo the infamous developer of BitGold a precursor to the Bitcoin Protocol ‘trusted third parties are security holes. Private information stored by these exchanges is subject to being leaked as shown by the Binance KYC leaks in 2019. Decentralised derivative protocols require no KYC in order for a trader to begin interacting with the protocol’s smart contracts and are outside any regulatory framework.
Capturing Derivatives Trading Activity
Similar to how Uniswap allows liquidity providers to capture the transactions fees generated by token swaps in liquidity pools, decentralised derivatives protocols will allow users to capture trading fees generated by the trading of derivatives. Many models have emerged such as Perpetual Protocols governance token PERP which will allow token holders to stake their PERP tokens to participate in protocol governance, capture PERP inflation and 50% of the trading fees generated by the derivative trading distributed in USDC on a weekly basis.
This incentive structure aligns with the direct growth of the protocol by firstly allowing stakers to capture derivative trading fees which is a direct source of cash flow that increases the demand to stake the governance token. This creates an imbalance between supply and demand resulting in token appreciation which attracts more traders to the protocol and results in higher trading volume and derivative trading fee capture.
Many decentralised derivative protocols will adopt the derivative trading fee model, for example, Charm Finance a decentralised options protocol distributes all options trading fees to those who provide liquidity for their options markets.
Derivatives Optionality
Optionality in derivatives allows traders to specify the contracts they want to trade. For example, if a trader wanted to create an ETHUSD perpetual contract that uses WBTC as collateral and also settles in WBTC instead of a dollar-pegged stable coin. The composability of DeFi would facilitate a wide range of possible derivative products that traders could use to execute the trade of their choice.
An example of such an implementation would be MonteCarlo DEX V3 architecture in which perpetual contracts are permissionless markets in which anyone can issue a contract to be traded on any asset connected to a reliable price feed oracle. In relation to decentralised options protocols such as Hegic and Charm Finance, an option trader can specify a specific strike price and maturity for their call and put options unlike centralised exchanges such as Deribit which only offer predefined options.
Summary
The cryptocurrency derivatives market is growing at a rapid pace as speculators look to increase their exposure to volatile crypto assets. Uniswap’s constant-product AMM disrupted the centralised exchange spot market and the next step is to disrupt the centralised exchange derivatives market. The incentive model of distributing derivative trading fees to those who provide liquidity or further collateralise markets via staking is extremely powerful due to the potential volume attracted to a decentralised solution through harsh regulation and the prospect of no KYC.
These protocols are still in their infancy and have many problems to solve in regards to liquidity for low-slippage trading, transaction latency & gas fees for trading experience and limit order functionality which is absent from most AMM derivative protocols. The long-term vision is an exodus from centralised exchanges to decentralised derivative protocols not subject to regulation of nation-states and allowing anyone in any jurisdiction to trade derivative products in the emerging cryptocurrency asset class.
References
https://analytics.skew.com/dashboard/bitcoin-futures
https://www.coindesk.com/deribit-options-bitcoin-volume-2021-surge
https://duneanalytics.com/hagaetc/dex-metrics
https://www.fca.org.uk/news/press-releases/fca-bans-sale-crypto-derivatives-retail-consumers
https://docs.perp.fi/getting-started/perp-tokens
