Crypto derivatives might be a new concept for many people. But these financial instruments actually have already seen major traction on cryptocurrency exchanges in the last year, primarily on those that are unregulated. Going forward, the derivatives market will no doubt carve out an important role within regulated exchanges as well. Let’s take a look at how this is playing out. First, let’s cover the basics:
Definition of Derivative
A derivative is a contract between to buy or sell an underlying asset or group of assets. The price of a derivative is based on the price fluctuations of the underlying asset. This could be an index, bonds, commodities, and interest rate, or specific security. Some of the most common derivatives in traditional finance include options, swaps, and futures.
By using derivatives, investors are able to potentially earn large returns from small fluctuations in the price of the underlying asset. They also run the risk of substantial losses when the underlying price moves against them in a significant way.
The use of traditional derivatives is much more pervasive than you might think. Marketwatch, in fact, reported that the derivatives market vastly outweighs all other asset types – put together.
“The positives are derivatives can be used to help allocate and take price risk out of everything from corn to cattle to stock. There are good derivatives that are self-regulation, such as interest rate swaps and currency forwards. I’ve been working for exchanges for 41 years. I do not think regulation is incompatible with an efficient market. I think derivatives promote efficiencies”.
Derivative Markets in Crypto
Having a thriving derivatives market may be one of the most important keys to ‘gentrifying’ cryptocurrencies. In that scenario, retail and institutional investors alike are able to actively participate in a healthy blockchain system. Many consider it a strong sign that Bitcoin futures have gone over so well and experienced so much growth already. It points to a strengthening crypto derivatives market, where demand for such products is increasing significantly.
Unregulated vs. Regulated Crypto Exchanges
When we talk about exchanges that host crypto derivatives products, there are two different kinds: regulated and unregulated. Some of the most popular crypto exchanges are unregulated, which means the exchange has no governmental financial authority regulating its operations and that it’s a decentralized entity. For instance, BitMex and Binance are examples of unregulated exchanges offering crypto derivatives, and examples of regulated exchanges include Bakkt and LedgeX.
During the past few years, we’ve seen the unregulated crypto exchanges grow profusely without regulators intervening. It’s where innovations are happening at breakneck speed. Both Binance and BitMEX have experienced massive growth and both have already introduced crypto derivatives.
“Since its debut, Binance Futures has attracted billions of dollars of trading volume and has grown into one of the largest exchanges for Bitcoin futures, by volume. On average, Binance Futures processes over 300,000 BTC daily today.’ – Binance Blog
The above quote is impressive alone. But when you realize that Binance just rolled out futures in September of 2019, it’s hard to believe that in just four short months, they have achieved such numbers. Their growth in the number of users and trading volume suggests that the Binance Futures program is setting itself up as a price discovery leader for hedging risk in the derivatives market.
The second unregulated exchange we’re covering today is BitMEX. This derivatives platform was the first to introduce Bitcoin perpetual swaps. These futures contracts are also known as “inverse Bitcoin futures”. They settle in BTC, even though fiat currencies may be part of the underlying asset in the futures contract. What this does is eliminate regulatory obstacles that come into play when settling in USD or other fiat currencies.
Perpetual swaps help traders hedge positions in USD by opening short positions. Another key feature is that they don’t expire. Instead, BitMEX charges a funding rate that is determined according to the difference between the swap contract price and the spot price of BTC.
Currently, BitMEX holds .18% of all Bitcoins in circulation and is the world’s largest crypto derivatives platform. Even despite the recent negative press. We’ve seen a massive data breach involving users’ emails, the hacking of their Twitter account, and a lawsuit involving a seed investor. Still, BitMEX has forged on to continue its reign as the go-to derivatives trading venue.
Regulated Crypto Derivatives Exchanges
Bakkt and LedgerX have entered the market, but are still trying to carve out their edge. Both have worked with regulators every step of the way. So it is natural that innovation is taking longer with regulated derivatives exchanges. But innovation is certainly happening. Many leaders in the space believe that there is room for them in a booming crypto derivatives market.
From their homepage, shown below, it’s clear that Bakkt is catering to traditional finance:
The main goal of Bakkt is to create a secure ecosystem for institutional, merchant, and consumer level investors. As they are working directly with US regulators for compliance as they create crypto derivatives, their focus is on creating a safe place – especially one that is trusted by institutional investors.
Many cryptocurrency enthusiasts and traders are very familiar with Bakkt. With promises of Bitcoin settled futures, the crypto community saw this development as a huge step in giving crypto trading product legitimacy. But when the futures were rolled out, the product was designed to settle in fiat, instead of BTC.
However, Bakkt has plans for taking crypto derivatives mainstream through its upcoming consumer app. They’ve partnered with the Intercontinental Exchange (ICE) which already operates 12 traditional exchanges. ICE already has the infrastructure of a successful future that services international market participants. So Bakkt, like ICE, is regulated by the CFTC and is going after regulated markets that want inclusion in crypto derivatives, but with more of a safety than what is perceived with unregulated exchanges.
LedgerX specializes in Bitcoin derivatives in a fully CFTC-regulated exchange and clearing facility. They offer physically-settled Bitcoin call and put options, with other derivative products in the works. Available to US residents, LedgerX provides the platform for fully-collateralized, physically settled Bitcoin options and swaps for institutional clients.
The CFTC has been overseeing LedgerX’s registration as a Swap Execution Facility (SEF) and Derivatives Clearing Organization (DCO). But in late 2019, major controversies involving LedgerX management and regulators circulated the news cycle, culminating in the sudden removal of LedgerX’s Co-Founders, Paul and Juthica Chou.
According to their website, a team comprising leaders from Goldman Sachs, MIT, and the CFTC is leading the company. LedgerX boasts 24/7, next day Bitcoin buys in addition to options. Futures and exotics will be coming soon as well for this institutional derivatives exchange.
“Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.” – Warren Buffet
As leaders in the regulated crypto derivatives market, both Bakkt and LedgerX put a strong focus on security. Institutional investors have shown trepidation in crypto markets so these regulated exchanges are banking on drawing them in on the promise of “military-grade” storage of crypto assets. It’s important to remember, that while these platforms offer opportunities to speculate on prices of crypto assets, traders do not have custody of their crypto, eliminating that stronghold of security (the seed phrase).
How do unregulated vs regulated exchanges compare?
The differences between these types of exchanges are clear and point directly to a non-stop year of massive growth on the unregulated end. As it is, regulated exchanges Bakkt and LedgerX are playing catch-up. For instance, Bitcoin-settled futures were approved this year for Bakkt, after several years of regulatory push and pull. But they have yet to offer that feature. With their name literally coming from the “backing” of Bitcoin derivatives in BTC, their community was not quick to embrace cash-settled futures.
Meanwhile, BitMEX margins can be denominated in Bitcoin. Additionally, traders are free to speculate on the future value of BitMEX products using only Bitcoin if they so choose. Binance, on the other hand, continues to increase leverage and announce new products, much like a steamroller, unhindered by the constrictive regulations imposed on US-based Bakkt and LedgerX.
Unregulated derivatives exchanges have massive global reach and considerably more traffic than regulated exchanges (for instance, BitMEX is ranked 25,000 by Alexa globally, while Bakkt ranks 124,000). Moreover, unregulated exchanges enjoy a fervent community of traders. These derivatives market participants enjoy continuous upgrades, increased leverage, more coins, etc., all within the unregulated, volatile market that they love.
What the future holds for crypto derivatives exchanges
Peter Danihel is Lead Developer and Co-Founder here at HedgeTrade. He’s also an experienced derivatives trader. It’s his view that unregulated exchanges will continue to have an advantage over-regulated venues:
“Crypto was originally designed to thrive in unregulated markets. Therefore, many of its users will likely oppose regulation, causing liquidity to be an issue in the short term. Although security is a concern in an unregulated environment, BitMEX, and other exchanges are still massive and it will be a tough sell to lure existing users to switch over to regulated counterparts in the short term.”
While regulated exchanges are building out their custody services, unregulated exchanges like Shapeshift are beginning to offer non-custodial options that may provide better security than centralized cold storage. On top of that, BitMEX, Huobi, and several others already have alleged trading volumes that exceed those on CME by 3x or more.
The main drawbacks to unregulated exchanges
While it’s easy to see that regulated exchanges have disadvantages, it should also be noted that unregulated exchanges are, by and far, unavailable legally to US citizens. So Bakkt, LedgerX, and others do cater to this market. However, the use of VPNs and privacy measures may further entice Americans who want to participate in the world of unregulated crypto derivatives. Moreover, Singapore-based Huobi and Malta-based Binance have both commenced operations in the US, working with regulators to get in on that market.
Additionally, these exchanges do not offer the same investor protections as those with regulatory oversight.
Unregulated exchanges offering derivatives products are essentially lighter on their feet, without the regulatory authorities hampering them. On the other hand, regulated exchanges that promise stronger security will need to adapt quickly. They may even need to move out of their current jurisdiction. Just recently, Amsterdam-based Deribit did just that by moving to Panama to avoid overly strict AML regulations.
Regulation is slow-moving, stifling the crypto industry in some ways as a result. Once the architecture and frameworks are established, regulated derivatives exchanges will likely see massive adoption. There will be plenty of room for regulated and unregulated platforms to coexist. For the end-user that may be the best bet: A derivatives market that gives them the choice of where they’d like to trade.