What’s driving the popularity of crypto derivatives in 2022?

By Kapil Rathi, Chief Executive Officer & Co-Founder of CrossTower

 

As the cryptocurrency market reached new heights in the past year, digital assets came to represent the next big investment and we saw more widespread acceptance of Bitcoin as a macro asset. The next wave of transformation will see growing appetite for derivatives, which had a breakthrough year as they surpassed spot trading for the first time.

Kapil Rathi

CryptoCompare data shows that crypto derivatives reached record-breaking trading volumes of nearly $3 trillion for the month of January. This highlights their rising appeal and signals the entrance of a more sophisticated investor base as crypto evolves similarly to traditional finance.

 

Compelling benefits for a growing investor base

The crypto derivatives market is still in its infancy, having emerged over the past couple of years. This growth stems in part from macro economic headwinds including the pandemic and low interest rates. In established financial markets, derivatives have long been seen as a way to hedge against inflation, access new market segments and asset classes, and speculate on the price movements of assets. While swaps tend to dominate the crypto derivatives market, crypto futures can also offer similar benefits to traditional derivatives.

The advantages of futures contracts are truly compelling, allowing investors to make riskier and more calculated bets by making directional moves on the price of cryptocurrencies. This means traders can benefit from the volatility inherent in crypto and short positions on Bitcoin and other coins. Futures also effectively hedge the price movement of an underlying asset, which can help prevent losses resulting from unfavourable price changes. They offer better liquidity than spot markets and, uniquely, allow investors to earn funding depending on the coin and its market performance at any given time, generating a yield.

Perpetual futures, meanwhile, are also gaining popularity due to the amount of leverage they carry, allowing traders to gain much more exposure for a certain amount of collateral than possible with many traditional exchanges. Similarly, Bitcoin options experienced a surge in popularity amongst institutions, who could undertake faster transactions via OTC exchanges to benefit from better liquidity and ability to diversify investments.

 

Evolution into a regulated market

This demand for derivatives trading will be a catalyst to more widespread crypto adoption. In the US, for instance, as more retail and institutional investors are looking for ways to make stronger bets on digital assets, a number of big players – BlackRock among them – have moved to facilitate Bitcoin futures investment within a tightly regulated derivatives market.

In Europe, the market is small but growing, led by rising demand from institutional, rather than individual, investors. In the UK, too, there is more institutional investor interest in multifaceted investment strategies, something that is offered by crypto derivatives. For retail investors, there has been heavy regulatory scrutiny focused on consumer protection, as the Financial Conduct Authority banned exchanges from offering crypto derivatives and ETNs to consumers, saying that these products are “ill-suited for retail consumers due to the harm they pose.”

However, as crypto ventures deeper into regulated markets it will expand the user base and make derivatives more accessible to all types of investors, not least from a more thorough understanding of the products among consumers. Institutional investors, too, require a regulated environment to be able to participate fully in the market. Jon Cunliffe, the Deputy Governor for Financial Stability at the Bank of England, noted in a speech: “the possibility exists today for retail investors and institutions to take leveraged positions, through unregulated as well as regulated derivatives infrastructure, including leverage of up to 100 times.” To fully validate the market in the mainstream, it is clear that regulation needs to evolve accordingly to afford better transparency. This requires collaboration at policy and industry level to establish a set of global best practice standards.

For Europe, this may mean mirroring the US model to drive European competitiveness on the world stage – meeting investor demand for greater liquidity and enabling crypto derivatives to be an established segment of a diverse financial ecosystem.

 

Derivatives as a hedge against volatility

In the current landscape of intense market uncertainty due to the war in Ukraine, open interest in Bitcoin futures – seen as a barometer of demand for crypto derivatives – almost halved from the $26.4 billion high of November, according to Skew. However, while Bitcoin and trading volumes climb back up and offer a much-needed financial lifeline in the context of the Ukrainian crisis, derivatives can help safeguard investment portfolios elsewhere.

For instance, while market volatility can add more risk to directional bets, investors can turn to crypto options to bypass this. As the derivatives market evolves, options – which have seen slower growth up to now – will see more interest, as they offer the possibility of speculating on market volatility instead of directional trades on individual price movements. Additionally, futures contracts can also offer greater assurance by enabling investments backed by physical assets – such as gold – that offer higher levels of stability in a volatile climate.

The crypto derivatives market is only just starting to come into its own. As it grows and evolves, it will include many other coins and assets as investors look to capitalise on a fast-growing global market while mitigating volatility.

 

 

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