Lynn Strongin Dodds look at the fortunes of crypto derivatives and why the asset class will continue to capture the imagination.
Although crypto derivatives have become part of the financial fold, they are still tied to the vicissitudes of bitcoin and other crypto currencies. After starting off the year with a bang, demand faltered as inflation remained stickier than expected in the US and enthusiasm for bitcoin exchange traded funds (ETFs) faded.
Crypto derivatives are financial instruments that derive their value from underlying crypto assets. Traders place their bet based on speculation of the price movements of crypto tokens and can choose to either sell or buy the asset. The transaction can either happen through physical delivery of crypto tokens, or directly via cash settlement into the trader’s account without owning the asset. They come in three different versions – futures, options, and perpetual swaps, although the first two seem to be the most popular.
April saw a surprise drop in trading volume on major crypto exchanges after seven months of steady increases as market bellwether bitcoin retreated from a record high. This was due to inflation in the US coming in at a higher than anticipated 3.5% in March, dashing hopes of an imminent interest rate cut by the Federal Reserve. The situation was further compounded by the escalation in the geopolitical tension in the Middle East and ongoing conflict in Ukraine.
This scenario dovetailed with investors losing their appetite for spot bitcoin ETFs, which drove the price of major crypto assets to their range lows. Overall, spot trading volume on so-called centralised exchanges such as Coinbase Global, Binance and Kraken tumbled 32.6% to $2 trn last month, according to research firm CCData. Crypto derivatives saw a 26.1% drop to $4.57 trn while the spot market slid 32.6% to $2.01 trn during the same time frame.
The picture brightened in early May with inflation dipping back to 3.4% but the jury is out as to whether crypto spot and derivative volumes will climb back up to March’s all-time record of $9.12 trn recorded in CCData’s March Exchange review report.
It is also too early to determine whether market share will ever recover. Despite the buoyancy in March, crypto derivatives saw their cut of total activity slipping to 67.8%, the sixth consecutive monthly decline. Some market participants attribute this to the maturity of the asset class and a shift to tangible ownership of assets. Derivatives also have a reputation for creating artificial demand and supply in the market and are often an outlet for speculative activity, especially during major market tops.
While predicting the future is always difficult, many industry experts believe that in the short-term investors and traders should brace themselves for prolonged volatility given the same themes are playing out in Q2 plus the impending elections in the US and UK are looming ever closer. In addition, markets may also be impacted by the old adage – ‘sell in May and go away, come back on St. Leger’s Day, (September 12).” Historically, in the period between May and October, traditional financial assets tend to stagnate, and their crypto counterparts are following suit.
This is evidenced by recent analysis from eToro (https://www.etoro.com/news-and-analysis/press-releases/selling-in-may-and-going-away-analysis-reveals-global-markets-return-1-less-per-month-from-may-to-october) which found that the monthly average return of shares on the world’s 15 largest indexes was 1.2% from November to April over 50 years through 2022 while it fell to just 0.09% from May to October.
The long term prognosis though for crypto derivatives is more positive with a recent report by EY expecting that they will continue to evolve and be used for both hedging purposes as well as investment opportunities. It also noted an influx of new products outside the well-established options, futures and perpetual swaps realm. They differ in that they have no counterpart in traditional assets and although the valuation is still in the early stages of development, market participants are looking for innovative solutions to meet their requirements.
Notable examples cited in the report include Crypto.com’s UpDown options and FalconX’s staking yield swap as notable examples. The former is a Commodity Futures Trading Commission (CFTC)-regulated product listed on Crypto.com Derivatives North America, a US-regulated exchange. The option automatically expires only when the underlying asset price reaches a predetermined target stop price. The benefits comprise limited losses, full exposure to asset price fluctuations at a reduced cost and tailored hedging strategies. There is of course also a downside in that there is a capped profit potential and a heightened risk of premature termination in turbulent market condition.
The latter, on the other hand is a variation on the interest swap theme. They are exchange fixed payments for floating payments based on variable fees earned from staking ether (ETH). They not only offer synthetic access to staking yields, but also more intricate trading strategies for hedging and investing as well as facilitating the development of structured product advances.
Related Reading:
Great Expectations – an Update on Blockchain and Derivatives
