Interest in crypto derivatives is surging as investors show an appetite to bet on the movement of Bitcoin prices without actually having to hold the cryptocurrency itself. The number of Bitcoin futures exchange-traded funds filed with the Securities and Exchange Commission is a prime example. With Federal regulatory scrutiny intensifying, exchange-traded crypto derivatives such as BTC and ETH futures and options are in hot demand, especially for institutional investors.
There is a historical analog to how crypto derivatives may evolve as an industry: the Dutch tulip bulb. Tulips are often presented as a cautionary tale due to the spectacular 17th century crash of the bulb market. But there is an additional side to the story, that from tulip bulb market the derivatives market was born and flourished.
In 1637, at the height of tulip mania, the Dutch created the first financial forward contract on tulip bulbs. Buyers agreed to pay a fixed price for tulip bulbs at some point in the future. By late 1637, a sudden glut of bulb supply caused by a war between Germany and Sweden put the Dutch tulip investors in a bind because forward contract prices were fixed above the prevailing market price. Investors agreed to convert the forward contracts into options, turning the obligation to buy into a choice to buy. A thriving tulip bulb options market followed.
Bitcoin futures’ volume and open interest have exploded since the launch of the ProShares Bitcoin Strategy ETF, or BITO. The volume for Bitcoin options have increased as well, with open interest standing at a notional value of US$12 billion on crypto exchanges, according to Skew data. A relatively new crypto derivative is the perpetual swap contract, which are derivatives that are tied to the movements of an index price that represents the price of Bitcoin as measured on cryptocurrency exchanges.
Bitcoin futures exchange-traded products, including exchange trade notes as launched by Eurex, the European derivatives exchange, are a gateway for crypto derivatives to flourish. The original boom in interest rate, equity and commodity derivatives during the 1980s and early ’90s was driven by fast growth of notional principal — multiplying five-fold in five years — to nearly $10 trillion worldwide. The expansion was driven by growth of financial derivatives in the over-the-counter (OTC) markets of 40 percent annually, soaring above $6 trillion by 1991. The crypto derivatives market is mainly exchange traded. As of 2021, the market cap of crypto OTC — decentralized finance (Defi) — reached over US$140 billion. The exchange-traded crypto market, however, is over US$400 billion.
These amounts pale beside the derivatives market that is estimated to be over US$1 quadrillion in size. The OTC derivatives market alone was US$15 trillion in the first half of 2020, according to the Bank of International Settlements. Crypto derivatives markets are driven by a different kind of boom, the increased need for clear regulation for institutional and banking customers.
The International Swaps and Derivatives Association developed standards to settle and clear digital derivatives. The standards are specifically designed to address the hard fork (an upgrade of blockchain technology) and the soft fork (established blockchain under new rules) that may lead to crypto assets that are valued inconsistently. ISDA is focused on specific legal standards for crypto derivatives, the same way as for interest rate, FX, commodity and equity derivatives.
This is music to the ears of the investment banks who have become very interested in launching crypto derivatives trading desks as their hedge fund and other buy-side clients become interested in digital assets as an alternative investment. Goldman Sachs was one of the first investment bank to establish a crypto desk, and now others are likely to follow. The fees for derivatives trading consist mainly of central clearing, margin and bank capital charges. The bank revenues of derivatives have been on a steady decline: in 2008 they were 60% to 80% of consolidated trading revenues and this year they are 30% to 50%.
Crypto derivatives revenues are still small, but trading volumes of crypto derivatives are surpassing US$15 to US$20 billion annually. The financial engineering principles pioneered by the Dutch tulip traders have been applied to modern-day commoditized derivatives. The successful launches of Bitcoin futures ETFs are fertile ground for a major boom in crypto derivatives. Given the infant state of the crypto market and its minuscule share to the size of global derivatives outstanding, crypto derivatives have the potential to balloon.
