I’ve heard stories of the clearing of billions of dollar futures contracts that are causing a 25% daytime price plunge in Bitcoin (BTC) and Ethereum (ETH), but in reality BitMEX Permanent futures contract in May 2016.
The derivatives industry goes far beyond these retail-led financial products, as institutional investors, investment trusts, market makers and professional traders can benefit from leveraging the hedging capabilities of financial products.
In April 2020, Renaissance Technologies, a $ 130 billion hedge fund, received a green light to invest in the Bitcoin futures market using products listed on the CME. These trading mammoths aren’t like retail crypto traders, they focus on arbitrage and omnidirectional risk exposure.
May increase short-term correlation with traditional markets
As an asset class, cryptocurrencies are becoming a proxy for global macroeconomic risk, whether crypto investors like it or not. This is not limited to Bitcoin, as most commodities commodities suffered from this correlation in 2021. Even if Bitcoin prices are separated on a monthly basis, this short-term risk-on and risk-off strategy will have a significant impact on Bitcoin prices.
Notice that Bitcoin prices are steadily correlating with the US 10-year Treasury bill. Whenever an investor demands higher returns to hold these fixed income products, there is an additional demand for cryptocurrency exposure.
Derivatives are essential in this case, as most trusts cannot invest directly in cryptocurrencies. Therefore, using regulated futures contracts such as CME Bitcoin futures provides access to the market.
Miners use long-term contracts as hedges
Cryptocurrency traders are unaware that short-term price fluctuations are meaningless to their investment from the perspective of miners. As miners become more specialized, the need to constantly sell those coins is greatly reduced. This is exactly why derivative products were created in the first place.
For example, a miner can sell a quarterly futures contract that expires in three months and effectively fix the price for that period. That way, miners know their returns in advance from this moment, regardless of price movements.
Similar results can be achieved by trading Bitcoin options contracts. For example, miners could sell a $ 40,000 call option in March 2022. This is enough to cover if the BTC price is $ 43,000, or 16% below the current $ 51,100. Instead, the option product acts as insurance, as miners’ profits above the $ 43,000 threshold are reduced by 42%.
The use of Bitcoin as traditional financial collateral will expand
Fidelity Digital Assets and Cryptocurrency Borrowing and Exchange Platform Nexo recently announced a partnership to provide cryptocurrency lending services to institutional investors. The joint venture will allow Bitcoin-backed cash loans that are not available in traditional financial markets.
The move will ease the pressure on companies like Tesla and Brock (formerly Square) to continue adding Bitcoin to their balance sheets. When used as collateral for day-to-day operations, it significantly increases the exposure limit for this asset class.
At the same time, even companies that are not looking for directional exposure to Bitcoin and other cryptocurrencies can benefit from the high yields of the industry when compared to traditional fixed income. Borrowing and lending are perfect use cases for institutional investors who do not want to be directly exposed to Bitcoin volatility, but at the same time seek higher returns on their assets.
Investors use the options market to create “bonds”
Derivatives exchanges currently hold an 80% market share in the Bitcoin and Ether Options markets. However, the US regulatory options market, such as CME and FTX US Derivatives (formerly LedgerX), will eventually gain momentum.
Institutional investors dig up these products to offer the possibility to create semi- “bond” strategies such as covered calls, iron condors and bullcall spreads. In addition, the combination of call (buy) and put (sell) options allows traders to set up options trading with a predefined maximum loss without the risk of being liquidated.
Central banks around the world can keep interest rates close to zero around the world and fall below inflation levels. This means that investors are forced to look for markets that offer higher returns, even if that means there is some risk involved.
This is exactly why institutional investors entered the crypto derivatives market in 2022 and are changing the industry as we now know.
Volatility is declining
As mentioned earlier, crypto derivatives are now known to add volatility whenever unexpected price fluctuations occur. These compulsory clearing orders reflect futures products that are used to access excessive leverage, a situation normally caused by individual investors.
Nevertheless, institutional investors will increase the size of bids and asks for these products in order to gain a wider representation in the Bitcoin and Ether derivatives markets. As a result, the $ 1 billion liquidation of retailers has less impact on prices.
In short, as the number of professional players participating in crypto derivatives increases, it will reduce the impact of extreme price fluctuations by absorbing its order flow. Over time, this effect will be reflected in lower volatility, or at least avoid issues such as the March 2020 crash where the BitMEX server was “down” for 15 minutes.
The views and opinions expressed here are: author It does not necessarily reflect the views of Cointelegraph. All investment and transaction movements carry risks. When making a decision, you need to do your own research.