Disclaimer: This is an original article from Kraken. We are taking credit for it, but understand the importance of it and want to share...
INTRODUCTION
The crypto derivatives landscape has evolved tremendously over the last several years.
Beginning with pioneers like Crypto Facilities, BitMEX, Deribit, BitVC (now HuobiDM),
and OKCoin (now OKEx), derivatives trading in crypto markets really took hold in 2017,
dovetailing the entrance of traditional incumbents like the CME and CBOE. Over the
course of 2018 and 2019, derivatives notional volumes exploded, outpacing spot markets
and ushering in the likes of Bitfinex, Bybit, FTX, Binance, and Bakkt – which is owned
by the Intercontinental Exchange (ICE).
As the market has grown increasingly crowded, we took a look at how market structure
has evolved over time. In particular, we cover the relevance of derivative notional volume
now growing to more than 4.6x spot volume reported by a select group of top, global
crypto exchanges. We examine the implications of this top-heavy dynamic, including
market fragility and the culmination of Black Thursday. In this note, we posit that these
risks may increase instability in the short run and require structural changes to margining
in the crypto industry.
THE RISE OF CRYPTO DERIVATIVES
Derivatives play an integral role in traditional markets as a tool for transferring risk
between one counterparty and another. Counterparties are participants in a derivatives
contract and describe a diverse set of constituents, from individual speculators to entire
brokerage firms.
One important distinction between the derivatives market and the spot market is
the derivatives market is a zero-sum game. This means that every $1 gain (or loss)
recognized by one counterparty to a contract implies the other counterparty lost (or
gained) $1 of value. No value is created or destroyed in a derivatives market; however, it
shouldn’t be misconstrued that derivatives don’t provide any value to the broader market.
The spot market, in contrast, is a non-zero-sum game, which implies that the value
of a market can outgrow the amount of value invested. To describe this, imagine that
the current price of bitcoin is $10,000. An individual who wishes to buy bitcoin may
find that the best available offer to buy bitcoin is $10,100. If they purchase 1 bitcoin
for $10,100, then the last recorded price for bitcoin’s value will be marked at $10,100
(+1%), which impacts the measurement of the value of the entire network. That $10,100
transaction would increase the valuation of the entire network by roughly $1.8 billion, or
$100 for every bitcoin in circulation (roughly 18.5 million). Another example of a nonzero-
sum market is the equities market, where the marginal purchase or sale of a stock
changes the valuation of the entire company.
Despite their differences, derivatives markets are fundamentally tied to spot markets;
after all, derivatives contracts “derive” their value from an index on underlying spot
markets. More recently, derivatives markets have grown so significantly that they
too have the capacity to impact the spot markets that they derive value from. This
relationship will be examined further on in the discussion of market structure and
liquidations.
Trading activity, measured as notional volume, in the crypto derivatives market gained
traction during the notorious 2017 bull run that took crypto prices to all-time highs.
Perhaps unexpectedly, activity in the derivatives space didn’t really take off until
2018 when the value of cryptocurrencies took a dive. In the two months between mid-December 2017 and early-February 2018, bitcoin fell -65% from an annual high of nearly
$20,000 to a low of $7,000.
Measuring this growth in derivatives trading activity, we looked at the aggregated
crypto derivatives notional average daily volume (ADV) across Kraken’s peer group of
reputable exchanges. Our estimates show that notional average daily volume has grown
nearly 200x since 2Q2017 ($95.4M to $18.9B). The largest percentage rise unsurprisingly
took place throughout 2H2017 with a 15x increase ($95.4M to $1.44B), followed by a
consecutive three quarter rise (1Q2018 - 3Q2018) to a high of $3.2B. Notional ADV
subsequently retraced to a low of $1.1B over the next two quarters (4Q2018 - 1Q2019)
before bouncing and skyrocketing to highs just shy of $19B by 3Q2020.
CONCLUSION
Assuming the derivatives market continues to trump the spot market, there are several
potential outcomes to be considered:
1. Although unlikely, the recent move has raised the question about whether
the derivatives market should seek to implement traditional safety measures
to fortify against spot market fragility, including circuit breakers, tighter
order/position limits, modified index methodologies, among others.
Some analysts argue that circuit breakers trigger artificial market volatility by
decreasing liquidity and by causing limit orders to accumulate. The philosophy here
is that free markets without halts are more likely to settle into a more consistent
equilibrium than a heavily regulated market. However, because fairness in the market is
critical when trading on highly leveraged derivatives contracts, it can be expected that
exchanges will look to deploy price band limits and circuit breakers in an effort to curb
panic-selling and to avoid sudden spikes in the basis.
Additionally, many venues already set both order and position limits to reduce
manipulation. Because large orders in the order book can meaningfully impact price,
controlling the size and frequency of orders in a given amount of time is an effective
way to maintain market integrity. As for position limits, most require larger positions to
pledge more collateral and set a maximum to deter any players from manipulating the
OI to indirectly affect price action.
Spot indices must be accurately calculated in order to determine a fair mark price.
This is crucial for derivatives platforms because this price is what triggers liquidations.
Therefore, exchanges may begin to explore more creative methodologies in order to
ensure a stable and fair risk management system.
Huobi DM is one exchange which has already taken steps in this direction, having
implemented a "liquidation circuit breaker" following the Black Thursday crash in an
effort to minimize user exposure during times of severe market volatility. It's important
to note that Huobi's liquidation mechanism doesn't halt all trading as do traditional
circuit breakers, but only halts the liquidations on the platform.
2. The spot market will continue to grow in correspondence with traders seeking to trade derivatives more aggressively.
The spot and derivatives market have a demand-pull relationship with each other; as
derivatives traders begin to play more aggressive positions (i.e., larger and more frequent
in a smaller time frame), some would expect this relationship to lead to a subsequent
growth in the spot market due to the overflow of demand.
3. Volatility in spot markets will remain susceptible to sharp fluctuations,
causing derivative OI to chop around sustainable levels (as seen in figure 9).
The fragile relationship between the two markets can also cause the spot market to
become increasingly vulnerable to price spikes, growing in similar proportion to the rate
that derivatives outpace spot. As seen in the Black Thursday example on Figure 9, price
shocks like these can also lead to a slow, wave-like recovery.
In spite of these top-heavy vulnerabilities, market players are constantly iterating
towards a better solution to improve stability and protect market participants. An
example of this move towards a more stable market is the growing relevance of
cryptocurrency indices that assist with benchmarking, effectively reducing price
discrepancies between exchanges. The crypto pricing framework by Kraken-owned
CF Benchmarks, which is used by major platforms such as the CME Group for its
cash-settled BTC contract, includes key parameters to deal with inaccurate prices,
problematic exchange book issues, calculation failures and more, to achieve robust,
verifiably time-accurate pricing. These paramaters include prices that are calculated
from orderbook data instead of trade data, a strictly regulated divergence between mid-prices
and the mid-price volume curve, as well as weight-related and other probabilistic
calculations that ensure prices remain aligned with those of its select index constituents.
Unlike traditional markets, today’s derivatives leaders are largely unregulated and
have large retail trader bases. These venues address the needs of users by lowering the
barriers of entry for a more extensive customer base than traditional exchanges. Though
a regulated platform, such as Crypto Facilities or the CME, will provide streamlined
access to the most important financial centers worldwide, including the US, the EU,
Singapore, and Hong Kong, among others, it seems like it has hitherto been a long-tailed
fight to extract value from that strategy.
While there is no way to know for sure, this ongoing trend towards unregulated, exotic,
and aggressive derivatives offerings eclipsing the spot market will likely persist into the
foreseeable future. If this is the case, our team believes that a combination of scenario
(2) and (3) will play out because there is a strong theoretical connection between traders
getting exposure to a contract settling to an index and the underlying spot constituents
of the index seeing increased volume from traders replicating the index construction. As
the market continues to mature in this top-heavy fashion it's not unlikely that we will see
derivatives increasingly outpace spot and create more fragility between the two markets,
especially with the recent introduction and rapid success of new financial instruments
such as crypto options contracts. While it is also possible we may see (1) partially play
out, one can expect free market participants to push back against the introduction of
traditional circuit breakers by opting to trade on venues without the feature. However,
because crypto derivatives venues are constantly iterating towards stronger equity
protection programs for clients, exchanges may continue to implement modified versions
of traditional equity protections (e.g., Huobi's "liquidation circuit breaker") that are more
in line with the interests of crypto market players.