The space of cryptocurrencies is evolving fast, yet many institutional market participants are still waiting on the sidelines. In this DerivSource commentary, Sascha Semroch, product development manager for volatility and crypto currency derivatives at Eurex explains some of the common obstacles firms face as they look to jump into the digital derivatives space and how Eurex aims to tackle these challenges using crypto futures and by leveraging existing infrastructure. Read on for insights into how eager firms can participate in crypto derivatives now.
Digital assets and cryptocurrencies trading has been a hot topic for the last two years. A 2021 Eurex survey of buy and sell-side firms found that 24% of respondents were already invested in digital assets, a further 30% were interested.
Trading opportunities were the biggest driver, followed by growing confidence in crypto as an asset class and portfolio diversification. The sell side was further along in implementing investment strategies, while institutional investors were in the early stages of adoption.
For the buy side, however, there are various factors causing these financial institutions to hesitate. Cryptocurrencies, particularly Bitcoin, are very volatile instruments and investors are wary of that. From the perspective of a traditional asset manager, there is a need for models that can assess the impact of crypto currency allocations to the overall risk profile of a portfolio. As such, asset managers have a healthy level of caution when considering digital assets as part of any investment strategy.
There are two more main factors causing buy-side financial institutions to pause. One is a lack of regulatory clarity. Firms want to know which regulatory frameworks this emerging asset class falls into, and this is not clear at present. The other element is custody. If an institutional investor is allowed to invest in Bitcoin, it is not clear where to store it once they have bought it. Getting established with a new custodian comes with a lot of due diligence work and likewise, setting up to do self-custody comes with many compliance implications, which means ironing out the custody element of digital asset investment is not necessarily straightforward.
In addition, most of the traditional asset managers track indexes—they follow a benchmark index that they use as a reference. These asset managers will have difficulties finding a benchmark that includes digital assets or crypto currencies next to all the other asset classes they cover in their portfolio. Digital assets are just simply not part of the asset allocation for the traditional asset managers at this point in time.
“Cryptocurrencies, especially Bitcoin, are very volatile instruments. Investors are wary of that. From the perspective of a traditional asset manager, there is a need for models that can assess the impact of crypto currency allocations to the overall risk profile of a portfolio.”
Today’s crypto derivatives landscape
In Europe, there is a very high level of curiosity about digital assets. Financial institutions want to learn more although the two obstacles around regulatory clarity and custody are holding them back and there is a high level of caution even with respect to regulated products.
Eurex has launched a derivatives product that offers Bitcoin exposure but remains in the fully regulated and traditional financial infrastructure. It uses an Exchange-traded Note (ETN) as an underlying, which is essentially a claim into a certain amount of Bitcoin. It is a bond, providing indirect exposure as it is a traditional security that is however backed 100% by Bitcoin. It provides regulatory clarity desired in that it is regulated under the Markets in Financial Instruments Directive (MiFID).
ETC Issuance, part of ETC Group, is the originator of the bond, and they were the first in Europe to come up with the concept of having a paper asset that is 100% collateralised with digital assets.
For every thousand ETNs, one Bitcoin is placed into custody with BitGo, an institutional grade custodian for digital assets. The ETN itself is in custody with Clearstream Banking, the custodian of Deutsche Börse for paper assets and this is where settlement takes place. Eurex Clearing, as the central counterparty, then provides the settlement instructions for every transaction that takes place on the cash market in that ETN. This is the set-up for the cash market.
Eurex now has listed a futures product that has physical delivery into 1000 of these ETNs. One future represents approximately one Bitcoin. Every third Friday of the month, Eurex takes the closing auction price of the cash market to determine the price at which the future is delivered by the ETN. This is all organised and guaranteed by Eurex Clearing.
“Utilising regulated futures is a much safer way to get exposure to digital assets than investing in Bitcoin directly.”
Benefits of listed crypto derivatives
The Eurex Bitcoin ETN futures offers firms a way to express their view on the Bitcoin market. Given the overall hesitance in the traditional finance industry, this product has the lowest barrier to entry. There is nothing unusual about the product; it is a classic futures instrument that settles into a classic cash market instrument. Additionally, there is nothing new from an infrastructure perspective. Firms do not need new lines, new APIs, or new interfaces—they only need to have a view and access to Eurex.
Utilising futures is a much safer way to get exposure to digital assets than investing in Bitcoin directly. There have been many stories of people digging through rubbish yards to find their old computer or USB stick where they once stored their Bitcoin, after accidentally throwing them away. Futures cannot get lost or stolen. They are managed by Eurex Clearing who acts as central counterparty to all transactions and resulting claims.
The Bitcoins that back the underlying ETN are also in professional custody with BitGo, who is one of the most diligent digital asset custodians and uses an array of safeguards to make sure the Bitcoins that back the ETN are safely stored. The Bitcoins sit in cold storage and they are not lent away. The issuer has restricted themselves from being able to lend the token in return for money or for different assets.
Looking ahead to wider adoption
As mentioned previously, firms are understandably hesitant about rushing into allocating their clients’ money into projects they may not fully understand. There must be a better understanding of what an allocation to digital assets does to the portfolio and the portfolio risk. Many asset managers are currently working to find the right technique to add this new asset class to the mix.
Every customer starts with their view on Bitcoin. Then they need to find a clearing broker that has access to Eurex and clears Eurex products to get started.
As this space evolves, I’m hopeful that in a year from now the traditional financial industry will have found its approach to digital assets and cryptocurrencies will be part of their everyday offering.
