And How These Derivatives Lead to More Efficient Markets
Disclaimer: This information is meant for educational purposes only, and should not be taken as investment advice.
Lately, I’ve been hearing a lot of confusion surrounding the role of market participants in this near 6-month downturn in crypto. Many traders are afraid to buy at these prices, as maybe the bottom isn’t in. Many others think it would be insane to sell so low. Around this time last year, anyone could throw their life’s savings into any asset on CMC and find themselves in unbelievable profit. Some people continued to do this up until the very top in December 2017, and faced terrible drawdowns. As prices linger down near this year’s lows, most traders are on edge. The ones that aren’t feeling the burn quite so badly are likely to be the ones managing their risk more carefully with derivatives.
So why is this?
Well, there are the obvious upsides to trading crypto derivatives such as futures contracts: hodlers can keep hodling while hedging the fiat value of their portfolio with leveraged short positions, and megabulls can get extra long using their crypto as collateral.
As the crypto market drops, a trader that is hedged with a short position in crypto derivatives earns more crypto, increasing the size of their portfolio in crypto terms while keeping it stable in fiat terms. So even if ETH drops from $600 to $300, if your ETH stack goes from 100 to 200, you are in good shape relative to the market.
But what about the rest of us?
You might be asking, though, isn’t shorting bad for the price?
To ask this is to miss the point. The market is just a collision of animal spirits reflecting the herd’s view on the price of an asset at any given time.
As such, the market needs efficient price discovery mechanisms. Any stakeholder who has a remote interest in being either long or short in an asset should be able to express their directional view with minimal frictions. If there are bears in the market who want to sell and overpower the bulls who want the price to go up, then down is where the market will go. The market is just one big maturity transmission mechanism that allows those with varying liquidity preferences to find prices to exchange the asset in real time.
Market impact: Cash Settled vs Deliverable
Counterparty derivatives contracts are really just bilateral bets that traders take with one another over price direction. For every long in the market there is a short, shorts pay the PnL of longs, and longs pay the PnL of shorts.
Let’s use ETH/USD as an example. This is the USD quoted value of ETH.
In the cash-settled markets this does not require any movement of ETH or even USD. You could cash settle the changes in price of ETH/USD in any currency: JPY, CHF, LTC or BTC. Since traders cash settle the gains/losses between each other in the relevant collateral, they can take massive long and short positions against each other without any action in the underlying market.
In the deliverable markets, these contracts would require, at expiration, that shorts deliver ETH and longs deliver USD. This means that the market requires BOTH assets to be held on the exchange to facilitate the PnL and delivery.
CME, Cboe, and Leverj all trade cash-settled crypto derivatives. CME and Cboe cash settle in fiat, whereas Leverj cash settles in ETH. This means that there is not necessarily a need for any activity in the spot market to facilitate this market. Participants still use the underlying market to balance risk as they provide liquidity, but it is not required in the mechanics of the contracts.
By contrast, the deliverable contracts which require the underlying assets have a more direct mechanism involving the spot markets which link the two. Traders need to have ETH or USD to make delivery, which creates a direct channel of effect on the spot market.
Either way, futures contracts are not harmful to the price of crypto per se. They are merely financial tools which are essentially price agnostic, since they only provide a way for both bulls and bears to manage risk. In fact, derivatives markets may actually create price stability — something we sorely need in the crypto space.
Do derivatives markets create stability?
The main stability mechanism derivatives provide is an easier way to build long or short positions. This allows market makers, speculators, and merchants to more easily balance their net exposure when they are providing liquidity in the underlying markets.
For example, a professional market maker is able to better provide liquidity to a spot orderbook for ETH vs USD if they can more easily go short on ETH to adjust their risk. This means that a derivatives market can help liquidity providers better provide reliable orders in the underlying market.
Trading volume in the derivatives market can directly and indirectly lead to price moves in the spot market, and vice versa. Imagine you are a market maker and you are quoting large sizes in the Ethereum futures market. Now, someone in the Futures market starts buying lots of contracts and this leads you to be net short on ETH/USD. As a market maker you would need to balance this risk by offsetting the short with a long. This long could be taken either in the futures market itself, or in the spot market buying ETH. But either way, these markets are inextricably linked.
More Efficient Markets
It is an ongoing debate amongst traders and industry players whether these tools contribute more to stability or volatility, but one thing is sure: these are natural steps in the maturation of any financial asset. As crypto gets more popular and merchants/investors alike begin needing to manage their risk, these tools will become more and more necessary.
Futures markets like Leverj’s allow the market to develop an anchor for the time value of money in crypto terms, which is needed to help foster other types of crypto-based financial transactions.
Derivatives provide an additional tool to traders to take clear directional positions to manage exposure to crypto assets. This leads to more efficient price discovery mechanisms and market expectations in the futures curve and basis markets.