Crypto derivatives continue to play a vital role in the larger crypto market, as institutional investors increasingly use them to gain entry to cryptocurrency markets while managing risk and complexity. As these larger market players become more comfortable with the asset class, they have begun to expand their reach from the familiarity of the CME to trade on centralized crypto-native exchanges, attracted by features such as deeper liquidity and 24/7 trading accessibility.
This broader institutional involvement is maturing the crypto derivatives market, impacting volatility and boosting the popularity of products such as crypto options. It’s also raising the bar for crypto exchanges, as institutional traders demand more robust capabilities than crypto-native trading tools typically have offered.
While US firms still have significant restrictions in jumping into this market, crypto-native exchanges are providing launch pads via venues that pass US regulatory muster. And professional-grade trading platforms such as Exegy’s Metro are making them accessible to institutional traders. Metro currently offers access to CME, with crypto-native expansions for Metro planned soon.
Derivatives outperform spot prices during ‘crypto winter’
2022 has been a bumpy year for cryptocurrency, after a breath-taking rise in 2021. The two largest currencies, Bitcoin (BTC) and ether (ETH), lost more than half their value from January through October. Digital assets under management for all cryptocurrencies, which had peaked at about USD 63 billion in December 2021, stood at about USD 27 billion 11 months later.
However, the picture has been more positive for derivatives, suggesting that institutional investment in this asset class hasn’t been permanently depressed by 2022’s “crypto winter.”
Derivatives have grown to 69 percent of the total crypto market, up from 60 percent in January. Open interest for both BTC and ETH derivatives on Binance, the largest crypto derivatives exchange, and on CME, the traditional US derivatives giant, reached all-time highs in October.
A June 2022 survey of traditional hedge funds showed that more than a third are currently investing in digital assets (up from 21 percent in 2021), with derivatives listed as the most prevalent vehicle.
Among the factors heightening activity in institutional crypto derivatives:
- Institutions began looking for ways to enter the crypto market, as it outperformed other asset classes. In addition, crypto performance was largely uncorrelated to other asset classes, providing an attractive means of diversification.
- As in other asset classes, sophisticated traders have incorporated crypto derivatives into their strategies to hedge, provide liquidity, leverage positions, and optimize price discovery.
Proprietary traders were among the early adopters of crypto derivatives products, drawn by the market’s liquidity and leverage opportunities. A 2021 survey of prop firms trading crypto derivatives found that about half were traditional firms that were moving into this sector, while half were launched specifically to take advantage of the crypto market.
Unlike traditional derivatives, crypto derivative liquidity is spread among many exchanges, providing ample opportunities for arbitrage. Prop trading firms surveyed reported trading on an average 5 markets for futures and 2.3 markets for options, with traditional firms tending to trade more markets than specialist firms. Prop traders are also drawn to the higher volatility of the crypto market, although experts note that volatility in this market will likely drop as more institutional firms join it.
Overall, crypto futures are more than twice as popular as options. At the end of October 2022, open interest in Bitcoin futures stood at about 661,000 contracts, totaling USD 13.5 billion. Binance had the largest share of that activity with 27% of volume, followed by Okex (16%), and Bybit (13%).
At the same time, open interest in Bitcoin options totaled about 301,000 contracts, and USD 6.1 billion. The Deribit exchange dominates this market, with 87% of volume (CME was second with 9.5%, and Okex was third with 2.5%).
However, options volume has been growing, and many market watchers believe that increased participation of institutional investors will continue to move the options/futures ratio to a level closer to that of traditional markets, where options are more prevalent.
One obstacle to institutional crypto options trading is that Deribit currently cannot be accessed by US traders, due to disagreements with US regulatory authorities. In fact, US regulations have put a number of crypto-native exchanges out of reach of American investors. But as this market matures, exchanges are looking for opportunities to cater to this market—and are drawing the attention of larger firms.
Bringing enhanced trading to crypto-native exchanges
For several years, the principal way that institutional investors accessed crypto derivatives was via traditional (TradFi) exchange CME, which began offering Bitcoin futures in 2017. CME’s offerings allowed firms a way to gain exposure to cryptocurrency without owning the physical coins and as part of a diversified portfolio of various asset classes.
In March 2022, CME added micro futures and options for both BTC and ETH in an effort to broaden its crypto clientele and provide traders with more flexibility.
As the markets became more comfortable with crypto derivatives, firms have started to migrate to centralized crypto-native exchanges. These exchanges are responding to institutional interest by providing venues that meet US regulatory requirements, such as adhering to KYC and AML laws.
But access is only half the challenge for proprietary traders and other professionals who need to trade crypto derivatives. These groups employ complex strategies requiring capabilities that the crypto exchanges’ native platforms lack—estimating volatility, for example, and analyzing risk.
To meet those needs, Exegy’s Metro platform is leveraging the same performance and functionality utilized for years by sophisticated traders in the TradFi space.
Metro traders are equipped with an advanced tool set to navigate the fragmented crypto landscape—tools that include dynamic volatility surface modeling, algo execution, and robust risk analysis capable of aggregating “like” products across exchanges.
TradFi and crypto-native exchanges
For traders used to operating on traditional exchanges, there are important distinctions they must understand about crypto-native exchanges that can impact their trading:
CME uses dollar settlement of crypto derivatives, whereas crypto-native derivative transactions are all crypto-settled, meaning that upon settlement, there is a transfer of the underlying asset (Bitcoins or ether). Therefore, the buyer would need to have a digital wallet with the exchange where these assets could be deposited. If a firm is trading with two different exchanges that use crypto settlement, it would have to maintain wallets with both.
One practical issue raised by crypto settlement deals with the expiration of futures and options. As with other crypto-settled assets, traders must be prepared to deliver or take possession of the coins upon expiration. Firms trading with crypto settlement must keep a margin of coins in their wallet for this purpose—on each exchange on which they trade. Many crypto futures and options traders routinely close out positions in advance of expiration (and take new contracts with a later expiration) to avoid having to deliver or take possession of coins.
CME’s Globex market is open Sunday through Friday, 6 p.m. to 5 p.m. ET, with a one-hour break each day beginning at 5 p.m. It is closed for three international holidays: Good Friday, Christmas, and New Year’s Day. Most crypto-native exchanges are open 24/7, year-round.
While CME’s closures are minimal, crypto-native exchanges’ expanded hours give participants the opportunity to react to news or market-changing events immediately, regardless of the day or time.
Many institutional derivatives traders seeking to enter the crypto market already trade on the CME and could easily expand into that asset class. Crypto-native exchanges typically don’t require physical connectivity, because their entire infrastructure is in the cloud. This makes it more accessible to up-and-coming firms, who may lack the resources to co-locate in a data center. However, cloud connectivity does affect latency—which may be a crucial consideration, depending on a firm’s strategies.
As noted previously, some firms choose to connect to multiple crypto derivatives venues to seek liquidity or execute arbitrage strategies. Ideally, a firm should have the infrastructure to access both types of markets.
Spanning the crypto derivatives market with Metro
Exegy has committed to overcoming barriers to institutional adoption of crypto-native exchanges. Crypto-native connectivity is planned for Metro early in 2023.
To be at the forefront of this expansion, set up an appointment to speak with our Metro team.