Are Crypto Derivatives the Next Step for Digital Assets?

For a long time, derivatives were used to track the price of stocks, commodities, and fiat currency. However, as cryptocurrencies started to gain more prominence in the financial world, crypto derivatives have also begun to interest a number of investors.

Seeing how the cryptocurrency industry has been susceptive to recent regulatory changes, could crypto derivates be the next step in building a digital asset industry?

Crypto Derivatives: Impact on Digital Asset Industry

A report published in June 2022 by Ernest & Young noted that “crypto derivatives are becoming a major digital asset class”.

According to the report, the number of digital asset derivatives listed in a number of US-registered trading and clearing venues had continued to grow (PDF), especially since the trading of bitcoin (BTC) futures was first supported by CME and Cboe Futures Exchange.

“The introduction of regulated bitcoin futures was a critical step forward to attracting institutional investment in digital assets as these products allow for synthetic exposure that does not require robust digital asset custody capabilities, as well as an effective route for hedging,” the report noted.

But where does the industry stand almost 1.5 years later?

“We watch general trading volume and general open interest in crypto derivatives globally. And we also obviously look at what we are seeing in the US and globally within US hours… to see what would be US-based institutional interest in derivatives.

 

And for the most part, we are seeing some of those data points grow, specifically volumes and open interest in already listed US products at, what I would call some of our competitors…So, [the crypto derivatives market] continues to grow,” John Palmer, Cboe Digital’s president, told Techopedia.

In June 2023, Cboe received regulatory approval from the US Commodity Futures Trading Commission (CFTC) to offer crypto derivatives on its digital trading platform, including physically and financially settled BTC and ether (ETH) margined futures contracts.

The head of tokenization at Polymesh, Graeme Moore, added that the crypto derivatives industry had greatly matured in recent years from being offered on offshore crypto exchanges with minimal licensing to moving into some more reputable institutions on the most liquid venues on the market.

“Crypto derivatives are incredibly positive and speak to the maturation of the asset class. The same way futures help a corn farmer lock in a future price and provide stability for their profits, futures do the same thing for bitcoin miners and other large market actors that need stability.”

In addition, crypto derivatives allow traders to short sell, leverage, and hedge their assets, increasing market efficiency and liquidity, Igor Telyatnikov, the CEO of AlphaPoint, told Techopedia, thus attracting more institutional participation and helping smooth out some of the volatility crypto prices often face.

“Derivatives are also critical for the growth of lending, staking, and other services that expand the digital asset ecosystem.”

Volatility, Development, Regulation

Like with any other aspect of the cryptocurrency industry, regulatory compliance may be the biggest challenge crypto derivatives face in today’s evolving economy, however, it is not the only challenge the industry faces.

“There is a lot of volatility in the space, and so I think there are institutions that may have concerns over that.

 

“I think the underlying coins are not regulated maybe the same way they are used to seeing other underlying assets traded, and so they may look at that and have some concern,” Palmer noted.

He added that a lot of entities prefer to look at how an asset class develops within the market before fully committing themselves to it.

The CEO and co-founder of Bracket Labs, Michael Wasy, added that liquidity is another major challenge. Due to regulatory uncertainty and “draconian enforcements” in a number of Western markets, institutional players are not as active, making liquidity in the market scarce.

“In general, one of the major benefits of using derivatives is for capital-efficient hedging. If you are a spot holder, it makes sense to protect the downside of your investment using options strategies.

 

With the evolution of [decentralized finance] DeFi, we are excited to see how tokenization can help traders. For example: using a liquid staked token, which represents the rewards from staking, as collateral for another trade.”

Moreover, meanwhile, derivatives tend to provide many useful risk management tools, but they also introduce risks like excessive leverage if not properly monitored, AlphaPoint’s Telyatnikov noted.

“Exchanges must ensure adequate collateralization and liquidation procedures. From a regulatory perspective, clear guidelines around crypto derivatives are still developing.

 

As the crypto market matures, there will be greater demand for standardization of procedures across liquidity venues. Overall, mature derivatives markets tend to promote price discovery and stability.”

Crypto Derivatives and Regulations

With crypto derivatives being a very novel industry, Cboe’s Palmer believes that it will take regulators time to figure out how the industry will continue to move forward, however, working in close cooperation with regulatory bodies has helped propel the

“We operate 26 markets globally, all of the highly regulated in the US. We operate eight SROs under the SCC. Cboe already has a DCM under the CFTC as well prior to its acquisition of Cboe Digital… So, we have a very deep experience of working with our regulators, educating them and innovating them for the benefit of our customers. And we approach the crypto derivative space very similarly.”

Polymesh’s Moore added that because derivatives live in highly regulated sandboxes that already have pre-existing rules and regulations, countries have managed to approach the regulation of crypto derivatives in an organized and timely manner, with Coinbase gaining approval to offer derivatives to its retail investors.

In adopting markets, crypto exchanges wishing to provide users with crypto derivatives have to follow FATF guidelines and gain virtual asset service provider (VASP) licenses. Such regulations allow derivatives under strict oversight, ensuring transparency that prevents the repetition of incidents such as FTX’s debacle happen all over again, CEO and co-founder of Bracket Labs, Michael Wasy, added.

“However, while VASP-compliant CeFi is here, DeFi has not fully implemented these changes yet. We think this DeFi compliance wave will come in the next 6-12 months.”

Are Regulated Crypto Derivatives the Next Step?

Palmer explained that a number of market participants are used to the structure that has been in place under the CFTC for a number of years, with derivatives being offered in a fully regulated and transparent industry. So, when newer industry players enter the financial markets, offering market participants a similar experience is the best way forward.

“This lowers the barriers to entry and what you want to call the friction of getting them into the ecosystem. And that is also our angle, trying to bridge the gap of the crypto native, the innovating technology and everything that’s behind it, but offer it to institutions and liquidity providers and folks that are already in the industry in similar ways as possible to what they are already used to trading today.”

Polymesh’s Moore added that the industry is quite focused right now on when a spot BTC ETF will be approved.

He noted:

“Derivatives are important for sophisticated, institutional investors, but in my experience unsophisticated investors playing with derivatives and short time frames and high volatility with features they may not understand are a good way to lose money quickly.”

US regulation of crypto derivatives will certainly provide greater clarity and protection compared to unregulated offshore platforms, AlphaPoint’s Telyatnikov added, however, if regulations are too restrictive, the industry could risk stifling innovation in such a rapidly evolving space.

“Regulated crypto derivatives represent an important pillar, as derivatives volume already exceeds spot trading. Overall, regulators face the delicate balancing act of protecting investors while still providing space for continued growth and maturation of crypto markets.”

The Bottom Line

The rise of crypto derivatives marks a significant evolution in the digital asset industry. Palmer concluded that by taking “the stigma away from all the underlying difference in the technology”, crypto derivatives are just another asset class that could offer institutional investors so much more.

Regulated crypto derivatives provide clarity and protection to market participants, however, overly restrictive regulations could stifle innovation. Striking the right balance is crucial as these derivatives become a vital pillar, exceeding spot trading volume and shaping the future of crypto markets.