We‘ve all heard stories of billion-dollar future contracts liquidations being the cause of 25% intraday price crashes in Bitcoin (BTC) and Ether (ETH) but the truth is, the industry has been plagued by 100x leverage instruments since BitMEX launched its perpetual futures contract in May 2016.
The derivatives industry goes far beyond these retail-driven instruments, as institutional clients, mutual funds, market makers and professional traders can benefit from using the instrument‘s hedging capabilities.
In April 2020, Renaissance Technologies, a $130 billion hedge fund, received the green light to invest in Bitcoin futures markets using instruments listed at the CME. These trading mammoths are nothing like retail crypto traders, instead they focus on arbitrage and non-directional risk exposure.
The short-term correlation to traditional markets could rise
As an asset class, cryptocurrencies are becoming a proxy for global macroeconomic risks, regardless of whether crypto investors like it or not. That is not exclusive to Bitcoin because most commodities instruments suffered from this correlation in 2021. Even if Bitcoin price decouples on a monthly basis, this short-term risk-on and risk-off strategy heavily impacts Bitcoin‘s price.
Bitcoin/USD on FTX (blue, right) vs. U.S. 10-year yield (orange, left). Source: TradingView
Notice how Bitcoin‘s price has been steadily correlated with the United States 10 year Treasury Bill. Whenever investors are demanding higher returns to hold these fixed income instruments, there are additional demands for crypto exposure.
Derivatives are essential in this case because most mutual funds cannot invest directly in cryptocurrencies, so using a regulated futures contract, such as the CME Bitcoin futures, provides them with access to the market.
Miners will use longer-term contracts as a hedge
Cryptocurrency traders fail to realize that a short-term price fluctuation is not meaningful to their investment, from a miners‘ perspective. As miners become more professional, their need to constantly sell those coins is significantly reduced. This is precisely why derivatives instruments were created in the first place.
For instance, a miner could sell a quarterly futures contract expiring in three months, effectively locking in the price for the period. Then, regardless of the price movements, the miner knows their returns beforehand from this moment on.
A similar outcome can be achieved by trading Bitcoin options contracts. For example, a miner can sell a $40,000 March 2022 call option, which will be enough to compensate if the BTC price drops to $43,000, or 16% below the current $51,100. In exchange, the miner‘s profits above the $43,000 threshold are cut by 42%, so the options instrument acts as insurance.
Bitcoin‘s use as collateral for traditional finance will expand
Fidelity Digital Assets and crypto borrowing and exchange platform Nexo recently announced a partnership that offers crypto lending services for institutional investors. The joint venture will allow Bitcoin-backed cash loans that can t be used in traditional finance markets.
That movement will likely ease the pressure of companies like Tesla and Block (previously Square) to keep adding Bitcoin to their balance sheets. Using it as collateral for their day-to-day operations vastly increases their exposure limits for this asset class.
At the same time, even companies that are not seeking directional exposure to Bitcoin and other cryptocurrencies might benefit from the industry‘s higher yields when compared to the traditional fixed income. Borrowing and lending are perfect use cases for institutional clients unwilling to have direct exposure to Bitcoin‘s volatility but, at the same time, seek higher returns on their assets.
Investors will use options markets to produce “fixed income”
Deribit derivatives exchange currently holds an 80% market share of the Bitcoin and Ether options markets. However, U.S. regulated options markets like the CME and FTX US Derivatives (previously LedgerX) will eventually gain traction.
Institutional traders dig these instruments because they offer the possibility to create semi “fixed income” strategies like covered calls, iron condors, bull call spread and others. In addition, by combining call (buy) and put (sell) options, traders can set an options trade with predefined max losses without the risk of being liquidated.
It‘s likely that central banks across the globe will worldwide keep interest rates near zero and below inflation levels. This means investors are forced to seek markets that offer higher returns, even if that means carrying some risk.
This is precisely why institutional investors will be entering crypto derivatives markets in 2022 and changing the industry as we currently know.
Reduced volatility is coming
As previously discussed, crypto derivatives are presently known for adding volatility whenever unexpected price swings happen. These forced liquidation orders reflect the futures instruments used for accessing excessive leverage, a situation typically caused by retail investors.
Yet, institutional investors will gain a broader representation in Bitcoin and Ether derivatives markets and, therefore, increase the bid and ask size for these instruments. Consequently, retail traders‘ $1 billion liquidations will have a smaller impact on the price.
In short, a growing number of professional players taking part in crypto derivatives will reduce the impact of extreme price fluctuations by absorbing that order flow. In time, this effect will be reflected in reduced volatility or, at least, avoid problems such as the March 2020 crash when BitMEX servers “went down” for 15 minutes.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.