Over the past several months, cryptocurrency derivatives markets have been heating up.
Indeed, much like the spot markets on which they sit, the crypto derivatives scene seems to be beginning a sort of ‘renaissance’ period: the stagnancy that hit the price of Bitcoin for months earlier this year pushed traders into altcoin markets, which has, in turn, created a new crop of interest–and capital–in altcoin derivatives markets.
For a comprehensive analysis on the current and future trends in the crypto derivatives market, Finance Magnates spoke to Pankaj Balani, chief executive of Delta Exchange, a cryptocurrency derivatives exchange incorporated in St. Vincent. Delta Exchange offers futures and derivatives trading across bitcoin and altcoins with up to 100x leverage.
Pankaj was able to share unique insight into the ways that cryptocurrency derivatives markets are currently developing. Before co-founding Delta, Pankaj acted as the head of derivatives strategy and sales for Elara Capital, a sales trader at UBS, and many other things.[youtube https://www.youtube.com/watch?v=jwRIw7d5wNs]
Derivatives markets are “somewhere between five to seven times the size of the underlying spot markets”
“If you look at crypto derivatives markets, we are amid an explosion that’s currently happening,” Pankaj explained. “The rate at which we’ve grown over the last two years on the derivatives side is phenomenal, and it is only going to continue from here on.”
Pankaj explained that “the reason I say this quite confidently is that I’ve taken examples from other markets, seeing the growth that’s happened there.”
“If you look at equity markets, there is about $65 trillion to $70 trillion of market cap outstanding across the globe (all companies put together); and if you see the derivatives on top of it, there is close to $800 trillion worth of derivatives outstanding. (This varies between 8 to 10 times.)”
“If you look at FX markets, you have roughly $1 trillion to $2 trillion of FX trading on a daily basis,” Pankaj continued, “and you have FX generators, which trade about $4 billion on a daily basis.”
“So, the ‘rule of thumb’ is that derivatives are markets that are somewhere between five to seven times the size of the underlying spot markets,” he explained. However, “this is not true for cryptos as of yet.”
Crypto derivatives still have much potential for growth
In other words, crypto derivatives markets still have a lot of room to grow.
Still, there has already been significant progress: between January and March of 2018, when the cryptocurrency derivatives markets were first starting to take off, “volumes across all derivatives exchanges back then were less than a billion on a daily basis, while spot volumes were much higher.”
“From there on, we have come to a point where there is parity between volumes of cryptocurrency spot markets and cryptocurrency derivatives markets; but still, there is a long way to go…I think in the next five years, it is the derivatives market is going to be five times the size of the spot market.”
“Another important feature of the derivatives market, if you look at it globally, is that most of the Bitcoin derivatives volumes are currently dominated by Bitcoin futures, and now (to some extent) Bitcoin options–that has happened only in the last two months,” Pankaj said.
“This has happened because for the first time, we have seen Bitcoin volatility getting crushed on a sustained basis,” he said. Indeed, for much of May, June, and July the price of Bitcoin stayed roughly between $8800 and $9800.
At the same time, “more and more sophisticated traders are coming in” to the market, and “shorting volatility, trying to capture the upside.”
Following growth in altcoin spot markets, altcoin derivatives markets could be poised for significant expansion
Growth in altcoin spot markets also shows huge potential for the eventual growth of altcoin-based derivatives markets, Pankaj explained.
At the moment, most of the trading volume in the cryptocurrency derivatives space is comprised of Bitcoin perpetual swap contracts.
“Even Bitcoin futures have much lower volume as compared to spot markets,” he siad. “When you go deeper into the space–when you look at Ethereum, when you look at coins like BNB, LINK, and other coins–the volumes of futures and perpetual swaps is much lower as compared to spot volumes.”
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Therefore, there is massive potential for growth in altcoin derivatives markets: “these are ‘pockets’ that will explode,” he said. “These are pockets that will show huge growth over the next three to four years.”
How exactly will this happen? Pankaj explained that the growth of the derivatives markets so far has positioned more traders to use derivatives tools to their advantage n the future.
“The big shift happened in 2018, when people found a way to short Bitcoin,” he said. “That was the use case that allowed derivatives and futures to become commonplace: after the bull run of 2017, everyone was looking for the ‘next trade’. The ‘next trade’ was to short Bitcoin, because it was going lower.”
Therefore, Pankaj believes that traders have learned how to use derivatives markets effectively: “now that people shorted Bitcoin, they learned how to trade on leverage: that education part is complete.”
“So now, when markets are going up, there’ll be participation on the upside as well, using leveraged trading–this is something that we did not see in the 2017 rally. Most of the 2017 ‘move up’ was spot-dominated.”
Bitcoin options could also see increased volumes
“Another area that we expect to grow heavily for Bitcoin is options, which has already happened for Bitcoin in the last one to two months–but there is much more possible from here on,” Pankaj said.
“This trade of selling options and looking to capture the premium that is offered by market volatility and other options is a staple trade for lots of traders in traditional markets,” he continued. “We are seeing more of that happening in the cryptocurrency space as well.”
Therefore, Pankaj believes that “options on Bitcoin and Ethereum will be quite popular.”
“This is a space where we will probably see the top ten coins participate–not so much of the ‘longer tail’”, he explained. “There will be huge growth in this area as well.”
Derivatives exchanges are gearing up for the future
Pankaj said that for Delta, his own exchange, this crypto derivatives “renaissance” period has caused focus on building a wider range trading features and products.
“We already have futures on Bitcoin, we already have futures on thirty other altcoins,” he said. “We have built technology to be able to offer futures on a hundred altcoins–and, mind you, technology is going to be a big differentiator here.”
This is because “it is not that easy to offer futures or derivatives on too many assets in a very highly volatile asset class because your systems are under huge pressure,” he said. “This is not something that you can go and buy from CME or any other traditional market with a number of derivative contracts, because they work very differently.”
For example, “their margining is quite different; they don’t margin in real-time. They have a market open and a market close. They have circuit-breakers, which allow these exchanges to not margin customers during certain price movements, which is not the flexibility that crypto exchanges have.”
The unique requirements of the altcoin derivatives market
Indeed, “crypto exchanges are trading 24/7 across the whole world, and unlike traditional asset classes that have fixed trading times and a fixed price band in which they can trade during the day–these are constraints that don’t apply to Bitcoin and other cryptocurrencies.”
Therefore, “margining and the way you build your technology is also going to be quite different” for cryptocurrency derivatives exchanges as opposed to traditional derivatives exchanges, Pankaj said.
He added that his exchange was built specifically to accommodate the needs of the cryptocurrency derivatives markets, with altcoin derivatives as a central focus.
“We were the first ones to go after the altcoin segment,” he said. “We saw the problems in that space and we have solved for them specifically, and right now we are pretty confident that we could open up 100 altcoins for trading today.”
However, “the bottleneck there is how much liquidity there is in spot markets: if things move too much…there are very heavy liquidations, and you cannot offer that high leverage.” In other words, the liquidity presents more of a challenge than the technological trading infrastructure.
Institutional money is “entering the market in a sizeable way.”
“Another theme that we see is that there are a lot of sophisticated traders entering the market now,” Pankaj said. “For the first time, we are seeing that institutional money is entering the market in a sizeable way.”
“That money is going to create a lot of opportunities which are available in traditional markets: so, for example, trading straight between two different maturity levels of Bitcoin futures–i.e., trading between a September and a December expiry, or trading the interest rate differential between perpetual swaps and futures.”
Delta is hoping to take advantage of this opportunity: “we are building products that will help us capture all this volume,” Pankaj said.
“So, for example, we are launching spread calendars and spread contracts that will be live on Delta in about three weeks’ time; we already have an interest rate swap for traders to capture the interest rate differential between the perpetual swap rate on Bitcoin and the fixed futures rate on Bitcoin.”
What are your thoughts on the growth of the cryptocurrency derivatives markets? Let us know in the comments below.