Cryptocurrency Derivatives Return to be the Tail that Wags the Dog

  • Healthy cryptocurrency derivatives trading suggests institutional activity is taking on a bigger influence again 
  • Sideways markets for cryptocurrencies such as the present favor the use of derivatives to generate returns in rangebound scenarios
While nobody knows for sure how big the size of the global derivatives market is, with estimates on the high end putting it at US$1 quadrillion (yes, that’s a real number), they can at least agree on one thing, it’s many times the size of the underlying assets that they derive (hence the term “derivative”) their prices from.
 
Derivatives are quite simply, a product, such as a future, option or warrant, whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency or security.
 
Investors, traders and stakeholders use derivatives for a variety of reasons, including hedging risk, guaranteeing price, arbitrage and of course, profit.
 
Contrary to popular belief, derivatives do not only serve a speculative role but are important as a hedge, especially for raw material producers.
 
The earliest known derivative was created in Osaka, where the Dōjima Rice Exchange provided for  the first rice futures contract that guaranteed rice farmers a price for their rice so that they could hedge their cost of production.
 
Since then, derivatives have been created on any number of underlying assets, from stock indices to cryptocurrencies and have often been seen both as a measure of the level of speculation, as well as the maturity of the market.
 
Which is why there are signs that the cryptocurrency markets may be growing up.
 
Last month, more cryptocurrency derivatives were traded than their underlying assets, according to data from CryptoCompare, an information service provider, in a sign of both increasing institutional participation in the space and sophistication.
 
Derivative activity in the digital asset markets has also been picking up, rising from 49.4% of market volume in May, to 53.8% of all trading volume in June, with derivatives volume hitting US$3.2 trillion, or just over double of the market cap for all cryptocurrencies at the time.
 
To be sure, cryptocurrency derivative trading has for the most part exceeded spot market volumes, but lowered volatility and prices have seen traders move into the derivative markets to deploy derivative strategies that tend to do better in sideways markets.
 
According to a CryptoCompare report released yesterday,
 
“As a result of both lower prices and volatility, spot volumes decreased by an immense 42.7%, while total derivative volumes decreased 40.7%.”
 
Lower volumes are generally to be expected when cryptocurrency prices fall as a whole and when the market starts to enter a relatively flat phase as it is in currently.
 
Traders are well advised to pay attention to the derivatives market for cryptocurrencies as they could also provide signs of where the market is headed to next, with a move in either direction, suggestive of future prices.
 
For now, the odds are slightly in favor of a medium-term bull case.
 
Given that the risk-reward ratio for bullish options and futures for cryptocurrencies with a relatively capped downside appear to be a favorable trade that isn’t particularly crowded at this point, some major macro event could be all that is needed to shift prices northwards.
 
Concern over a resurgent coronavirus, the catalyst for cryptocurrencies in 2020, as well as central banks hitting the limit on effective stimulus, or a U.S. Bitcoin ETF all provide “justification” for a bull case that could see the cheaper bullish options at this point in time turn profitable.
 
 

Novum Digital Asset Alpha is a digital asset quantitative trading firm.

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