We’ve all heard stories of billion dollar future contract closeouts being the cause of 25% intraday price drops in Bitcoin (BTC) and Ether (ETH), but the truth is, the industry is in the throes of the storm. to 100x leverage instruments since BitMEX launched its perpetual futures contract in May 2016.
The derivatives industry goes far beyond these retail instruments, as institutional clients, mutual funds, market makers and professional traders can take advantage of the instrument’s hedging capabilities.
In April 2020, Renaissance Technologies, a $ 130 billion hedge fund, was given the green light to invest in Bitcoin futures markets using instruments listed on the CME. These trading mammoths are nothing like retail crypto traders, rather they focus on arbitrage and non-directional risk exposure.
Short-term correlation with traditional markets may increase
As an asset class, cryptocurrencies are becoming an indicator of global macroeconomic risks, whether crypto investors like it or not. This is not exclusive to Bitcoin as most commodity instruments suffered from this correlation in 2021. Even though the price of Bitcoin is decoupled on a monthly basis, this short-term risk-free strategy has a huge impact on the price of Bitcoin.
Notice how the price of Bitcoin has been steadily correlated with the 10-year US Treasury bill. Whenever investors demand higher returns for holding these fixed income instruments, there are additional demands for crypto exposure.
Derivatives are essential in this case because most mutual funds cannot invest directly in cryptocurrencies, so the use of a regulated futures contract, such as CME Bitcoin futures, gives them access. at the market.
Miners will use long-term contracts as cover
Cryptocurrency traders fail to realize that a short-term price fluctuation is not meaningful to their investment, from the perspective of miners. As miners become more professional, their need to constantly sell these parts is drastically reduced. This is precisely the reason why derivatives were created in the first place.
For example, a miner could sell a quarterly futures contract expiring in three months, thereby locking in the price for the period. Then, regardless of the price movements, the miner knows their returns in advance from that point on.
A similar result can be achieved by trading Bitcoin options contracts. For example, a miner might sell a call option for $ 40,000 in March 2022, which will be enough to compensate if the price of BTC drops to $ 43,000, or 16% below the current $ 51,100. In return, the miner’s profits above the $ 43,000 threshold are reduced by 42%, so the options instrument acts as insurance.
The use of Bitcoin as collateral for traditional finance will expand
Fidelity Digital Assets and crypto borrowing and exchange platform Nexo recently announced a partnership that provides crypto lending services to institutional investors. The joint venture will allow bitcoin-backed cash loans that cannot be used in traditional financial markets.
This move will likely ease pressure from companies like Tesla and Block (formerly Square) to continue adding Bitcoin to their balance sheets. Using it as collateral for their daily operations significantly increases their exposure limits for this asset class.
At the same time, even companies that are not looking for directional exposure to Bitcoin and other cryptocurrencies could benefit from the sector’s higher returns compared to traditional fixed income securities. Borrowing and lending are perfect use cases for institutional clients who do not wish to be directly exposed to Bitcoin’s volatility but, at the same time, are looking for higher returns on their assets.
Investors will use options markets to generate ‘fixed income’
The Deribit derivatives exchange currently holds an 80% market share of the Bitcoin and Ether options markets. However, regulated options markets in the United States like CME and FTX US Derivatives (formerly LedgerX) will eventually gain ground.
Institutional traders like these instruments because they offer the possibility of creating semi-fixed strategies such as covered calls, iron condors, bullish call spread and others. Additionally, by combining the call (buy) and put (put) options, traders can set an options trade with preset maximum losses without the risk of being liquidated.
It is likely that central banks around the world will keep their interest rates near zero and below inflation levels. This means that investors are forced to look for markets that offer higher returns, even if it involves some risk.
This is precisely the reason why institutional investors will enter the crypto derivatives markets in 2022 and change the industry as we know it today.
Reduced volatility is coming
As previously stated, crypto derivatives are currently known to add volatility whenever unexpected price swings occur. These forced liquidation orders reflect the futures instruments used to access excessive leverage, a situation typically caused by retail investors.
Still, institutional investors will gain broader representation in the Bitcoin and Ether derivatives markets and, as a result, increase the size of the supply and demand for these instruments. Therefore, the billion dollar liquidations of retail traders will have less of an impact on the price.
In short, an increasing number of professional players participating in crypto derivatives will reduce the impact of extreme price swings by absorbing this order flow. Over time, this effect will result in reduced volatility or, at least, avoid issues such as the March 2020 crash when BitMEX servers “shut down” for 15 minutes.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trade move involves risk. You should do your own research before making a decision.