5 ways derivatives could change the cryptocurrency sector in 2022
We’ve all heard stories of billion-dollar futures contract liquidations causing 25 percent intraday price drops in Bitcoin (BTC) and Ether (ETH), but the fact is that since BitMEX released its perpetual futures contract in May 2016, the market has been plagued with 100x leverage instruments.
Institutional clients, mutual funds, market makers, and professional traders can profit from the derivatives industry’s hedging capabilities, which extend far beyond these retail-driven instruments.
Renaissance Technologies, a $130 billion hedge fund, was given permission to engage in Bitcoin futures markets using CME-listed securities in April 2020. Instead of focusing on retail crypto traders, these trading behemoths focus on arbitrage and non-directional risk exposure.
The short-term correlation to traditional markets could rise
Whether crypto investors like it or not, cryptocurrencies are becoming a proxy for global macroeconomic risks as an asset class. Similar isn’t exclusive to Bitcoin; in 2021, most commodity instruments had this connection. Even though the price of Bitcoin decouples on a monthly basis, this short-term risk-on and risk-off approach have a significant influence on the price of Bitcoin.
Take note of how Bitcoin’s price has remained consistently associated with the US 10-year Treasury Bill. There are additional demands for crypto exposure whenever investors demand higher returns for holding these fixed-income instruments.
Because most mutual funds are unable to invest directly in cryptocurrencies, they must rely on regulated futures contracts, such as the CME Bitcoin futures, to gain access to the market.
Miners will use longer-term contracts as a hedge
From the perspective of miners, cryptocurrency traders fail to recognize that a short-term price fluctuation has no bearing on their investment. The need for miners to constantly sell those coins decreases as they become more professional. This is precisely why derivatives were developed in the first place.
A miner, for example, may sell a three-month quarterly futures contract to effectively lock in the price for the duration. The miner then knows his or her returns ahead of time, independent of price fluctuations.
Trading Bitcoin options contracts can produce a similar result. A miner, for example, can sell a $40,000 March 2022 call option, which will cover the loss of the BTC price falls to $43,000, or 16 percent below the current $51,100. The miner’s profits above $43,000 are reduced by 42 percent in exchange, so the options instrument serves as insurance.
Bitcoin‘s use as collateral for traditional finance will expand
Fidelity Digital Assets and Nexo, a crypto borrowing and exchange platform, have announced a collaboration that would provide institutional investors with crypto loan services. The partnership will enable Bitcoin-backed cash loans that are not available on regular financial markets.
Companies like Tesla and Block (formerly Square) will likely feel less pressure to keep adding Bitcoin to their balance sheets as a result of this movement. Using it as collateral for day-to-day activities further expands their exposure to this asset type.
Even corporations who aren’t looking for directional exposure to Bitcoin and other cryptocurrencies might profit from the industry’s higher yields when compared to traditional fixed income. Borrowing and lending are ideal use cases for institutional clients who don’t want to be directly exposed to Bitcoin’s volatility but still want to get a better return on their assets.
Investors will use options markets to produce “fixed income”
The Bitcoin and Ether options markets are currently dominated by the Deribit derivatives exchange, which has an 80% market share. However, regulated options markets in the United States, such as the CME and FTX US Derivatives (formerly LedgerX), will gain traction over time.
These products are popular among institutional traders because they allow them to develop semi-fixed income strategies such as covered calls, iron condors, bull call spreads, and others. Furthermore, traders can establish an options transaction with specified maximum losses without the danger of being liquidated by mixing call (buy) and put (sell) options.
Central banks all around the world are expected to keep interest rates at zero and below inflation levels. As a result, investors are compelled to seek out markets with larger returns, even if this means taking on some risk.
This is why, in 2022, institutional investors will enter the crypto derivatives markets, transforming the industry as we know it.
Reduced volatility is coming
Crypto derivatives, as previously said, are now recognised for boosting volatility anytime unexpected price fluctuations occur. These forced liquidation orders indicate futures products that were utilized to get access to excessive leverage, a condition that is frequently generated by individual investors.
Institutional investors, on the other hand, will have a larger presence in the Bitcoin and Ether futures markets, increasing the bid and ask sizes for these products. As a result, the $1 billion in liquidations by retail traders will have a lower influence on the price.
In short, by absorbing order flow, a growing number of professional players participating in crypto derivatives will reduce the impact of extreme price fluctuations. This effect will eventually result in lower volatility or, at the very least, avoid issues like the March 2020 crash, when BitMEX servers “went down” for 15 minutes.