The Cryptocurrency Sector in 2022
The derivatives industry extends far beyond these retail-driven instruments, with institutional clients, mutual funds, market makers, and professional traders benefiting from the instrument’s hedging capabilities.
In April 2020, Renaissance Technologies, a $130 billion hedge fund, approved to invest in Bitcoin futures markets through CME-listed instruments. These trading behemoths are not like retail cryptocurrency traders; instead, they concentrate on arbitrage and non-directional risk exposure. Whether crypto investors like it or not, cryptocurrencies are becoming a proxy for global macroeconomic risks as an asset class. It is not unique to Bitcoin; most commodities instruments experienced this correlation in 2021. Suppose Bitcoin’s price decouples every month. In that case, this short-term risk-on and risk-off strategy have a significant impact on the cost of Bitcoin. Take note of how Bitcoin’s price steadily correlated with the US 10-year Treasury Bill. When investors demand higher returns for holding these fixed income instruments, there is an increase in demand for crypto exposure.
Because most mutual funds cannot invest directly in cryptocurrencies, using a regulated futures contract, such as the CME Bitcoin futures, provides them with access to the market.
Longer-Term Contracts as A Hedge
Cryptocurrency traders fail to recognize that a short-term price fluctuation has no bearing on their investment from the perspective of miners. The need for miners to constantly sell coins decreases as they become more professional.
For example, a miner could sell a quarterly futures contract with a three-month expiration date, effectively locking the period’s price. The miner will then know their returns ahead of time, regardless of price movements.
Trading Bitcoin options contracts yields a similar result. A miner, for example, can sell a $40,000 March 2022 call option to compensate if the BTC price falls to $43,000, or 16% below the current $51,100. In exchange, the miner’s profits above $43,000 are reduced by 42%, so the options instrument functions like insurance.
Bitcoin’s Use as Collateral
Fidelity Digital Assets and the crypto borrowing and exchange platform Nexo recently announced a partnership to provide institutional investors with crypto lending services. The collaboration will allow Bitcoin-backed cash loans not currently available in traditional finance markets.
This movement will most likely relieve pressure on companies like Tesla and Block to continue adding Bitcoin to their balance sheets. Using it as collateral for day-to-day operations significantly expands their exposure limits for this asset class.
At the same time, companies that do not want directional exposure to Bitcoin and other cryptocurrencies may benefit from the industry’s higher yields when compared to traditional fixed income. Borrowing and lending are ideal use cases for institutional clients who do not want direct exposure to Bitcoin’s volatility while also seeking higher returns on their assets. Deribit derivatives exchange currently controls 80% of the Bitcoin and Ether options markets. However, regulated options markets in the United States, such as the CME and FTX US Derivatives, will eventually gain traction.
These instruments are popular among institutional traders because they create semi-fixed income strategies such as covered calls, iron condors, bull call spreads, and others. Furthermore, by combining call (buy) and put (sell) options, traders can set a trade with predefined maximum losses without the risk of being liquidated.
Central banks worldwide are likely to keep interest rates near zero and below inflation levels. As a result, investors are compelled to seek out markets with higher returns, even if doing so entails some risk.
Reduced Volatility Is Coming
Cryptocurrency derivatives are currently known for increasing volatility whenever unexpected price swings occur. These forced liquidation orders reflect the future instruments used to obtain excessive leverage, which retail investors typically cause.
However, institutional investors will gain a more significant presence in the Bitcoin and Ether derivatives markets. This will increase the bid and ask sizes for these instruments. As a result, retail traders’ $1 billion liquidations will negatively impact the price.
In short, an increasing number of professional players involved in crypto derivatives will absorb that order flow. Therefore, they will mitigate the impact of extreme price fluctuations. This effect will result in lower volatility. At the very least it could result in the avoidance of problems such as the March 2020 crash, in which BitMEX servers went down for 15 minutes.