By Ilgar Alekperov,  CEO of ZUBR
By Ilgar Alekperov, CEO of ZUBR

Crypto-Derivatives Market Evolution: Where we are, and where we need to be

The cryptocurrency derivatives market has as many specific attributes as the cryptocurrency spot market. Namely, they feature developed decentralisation, largely unregulated platforms and diverse instrument specifications

The cryptocurrency derivatives market has as many specific attributes as the cryptocurrency spot market. Namely, they feature developed decentralisation, largely unregulated platforms and diverse instrument specifications. However, some features of this market are exclusive to cryptocurrency derivatives. 

Inverse and quanto contracts, being the popular instruments on cryptocurrency derivatives markets, are practically unknown to classical exchanges. In an industry where the main speculative asset is also the main settlement asset - Bitcoin - and the operations required for settlement in fiat money are complicated, these instruments turned out to work the best.

If you look for analogues of the crypto derivatives in the classical markets, the closest one will be found at a foreign exchange. The market is highly decentralised and it embodies many Over-the-Counter (OTC) platforms, poorly regulated players and an exhaustive list of the instruments. 

In this market, as well as in the cryptocurrency derivatives markets, one asset, Dollar, globally takes place as the primary-asset. Comparing these two markets, you will see that the crypto derivatives market stands behind the classical foreign exchange market by about ten years, but the gap is rapidly closing. Following the evolution of the foreign exchange market, we may expect the following changes in the crypto derivatives market: 

  • Increase in transactional activity of robots on crypto derivatives platforms
  • Emergence of new restrictions to control hyperactive bots
  • Increase in the conversion of orders into transactions
  • Increase in the number of regional platforms
  • Growth of the OTC market

The evolution of cryptocurrency and crypto-derivatives platforms has now taken a very healthy path. Some platforms are beginning to introduce Know-Your-Client (KYC) procedures, trade processing speed is growing and, there is now  little to no noise about the hacking of exchanges and the theft of client funds. Reliability and performance will improve as time goes by. 

While the first exchanges were entirely cloud-based, many of the new launchings are using a hybrid or proprietary infrastructure. Critical processes at exchanges are increasingly transferred to hardware, and many exchanges now provide their customers with colocation and accompanying services.

For example, half a dozen of crypto/derivative platforms are already located in the LD4 Equinix data center in Slough. They all provide clients with the opportunity to collocate their equipment close to the exchange core and get an order execution speed comparable to the speed of execution on large, traditional exchanges.

The demand for manufacturability of exchanges will grow exponentially along with the growth of software speed for algorithmic traders. The demand for the bandwidth of communication channels between the sites will grow. The volume of the data exchange that robots have to process is constantly growing as well. Platforms that are the most technologically advanced will deservedly attract the most active market participants - 
algorithmic traders and relevant funds.

Importantly, industry is trying to increase its transparency. Platforms guilty of showing unrealistic trading volume are better to abandon this practice in the future, as a lot of research on this issue has already damaged the reputation of some exchanges. Also, services that monitor the platform’s turnover with fake turnover filtering and rank them by the honesty level became popular.

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Platforms that are the most technologically advanced will deservedly attract the most active market participants

One evident trend is that commissions on the crypto-derivative platforms are decreasing. Current commission levels on many sites hinder the development of active trading. The arbitrage at such platforms becomes challenging, and traders have to minimise the number of their transactions, most often aggressive ones since platforms take a much lower commission or pay extra for transactions on passive orders. Perhaps the practice of rebates for passive liquidity will go away since the commissions for makers and takers with different signs make the taker commission so large?

Another step towards a developed market may be the use of standard indices to unify specifications of the instruments traded on different platforms. At the moment, a problem exists on the cryptocurrency futures markets: cryptocurrency as an asset is traded on dozens of platforms. Further, avoiding the use of fiat currencies still widely exists, and the stable coin Tether is often used instead of the dollar. In addition, each site is free to choose its own set of platforms and principles of weight distribution between them to calculate the indices.

This does not always help in cases when a non-market movement or technical failure occurs on one of the exchanges used to build the index. Non-market movement of the index leads to liquidations on the derivatives market based on this index. To continue, different indices for futures contracts on the same asset hinder effective arbitrage. The classical arbitrage is impossible between the instruments based on various indices for the same asset. In fact, they are different instruments and only statistical arbitrage is possible between them. Trends in the unification of the instrument specifications are already observed; e.g., the calendar contracts traded on different platforms practically always have the same due dates.

Development of third-party custody/clearing services and prime brokers is quite evident. It is very likely that in the future, much of the turnover of institutional players, and maybe retail turnover, will take place on crypto-derivative platforms through intermediaries. At first glance, it seems strange since crypto exchanges combine the roles of exchanges and brokers providing all necessary services in a “one window” mode and directly controlling the risk of each client.

It is very convenient, and this is why it helped the industry to develop so quickly. The third-party services help to remove the counterparty risk, which is essential for new platforms. They allow balancing the trading result between different exchanges, which provides incredible opportunities for hedging and leveraging strategies. They also reduce the risk of lack of collateral liquidity on a single leg of the complex trade. Also, due to the aggregation of large trading volume of client pools, they can receive massive discounts on the trading commission at the platforms, which, in turn, attracts traders with high turnovers that are also traders for whom the commission size is very critical.

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It is crucial that the cryptocurrency options are professionally designed

Critical path bottlenecks

KYC and KYT (Know-Your-Transaction) procedures will be implemented by absolutely all operating platforms. In this regard, platforms are currently monitoring clients to exclude suspicion of money laundering and criminal capital camouflaging, but in the future, they may well exchange data with the authorities of the jurisdictions where clients are located. It is quite apparent that the future holds a uniform KYC procedure needed to be completed at each platform through a third-party service only once. The results of such information can be quickly and easily used by any other party. 

This could lead to exchanges combining their customer identification databases, and the KYC passed on one platform could be taken into account on others - in true decentralised fashion. The level of customer data security will naturally increase with the introduction of such practices. Specifically, any exchange will have to procure the safety of personal data of its customers; this will boost the enhancement of client data storage.

Equally, KYT procedures would also have to develop fast. Today, the systems monitoring recipient and sender addresses underlying the reliability scoring services already function well and may quickly react to cryptocurrency theft and help platforms identify assets and funds with a dark past.

Both the functionality and intellect of these systems will be increasing. Crypto derivatives exchanges would not allow using illicit assets for money laundering. At the very least, doing so would become difficult.

It may be that the institutions aimed at counteracting unlawful activity with cryptocurrencies become internationally recognised due to decentralised nature of cryptocurrencies. The industry will still benefit from all such initiatives, although they add some complexity to its operations.

Cryptocurrency legalisation would not be possible without solving these problems since they open opportunities and provide usability for illegal activity. The sooner these problems are eliminated, the faster the healthy market materialises.

Options growing, but professional outlook needed

The rapid development of cryptocurrency options has shown that the crypto derivatives market is quite mature and may digest these complex tools needed by professionals. Apart from using them in speculative strategies, options are created primarily to hedge risks by market participants. Since cryptocurrencies are one of the most volatile asset classes in the world, hedging risks related thereto is important, and tools achieving this will evolve.

But it is crucial that the cryptocurrency options are professionally designed. Options with a short lifespan, no selling possibility, a small set of strikes or binary ones are not professional tools and can only be used for speculation or even outright gambling. If a platform wants to develop its options market at the high-quality level, it should launch a line of options with a large set of strikes and expirations, ability to sell and, very desirable, portfolio margin. The large options desks should provide liquidity into this market. But to build such a liquid and well-functioning market from scratch is a rather tricky task which has not yet been dealt with by the platforms that decided to develop such trading products.
 
One should also not forget that options, especially on their expiration days, carry additional risks for the entire crypto market and platforms specifically. For example, the process of selling an option may result in a potentially endless loss for the trader. Certainly, after the trader’s bankruptcy, the total loss will end up with the exchange, and it is not at all certain that the liquidation fund of a particular options market will be enough to cover the loss.

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Derivatives platforms should come together to create special committees and associations

DeFi playground

The hype of Decentralized Finance (DeFi) is a hot topic being carefully observed in recent months. This, directly or indirectly, points at the possible interest of traders in the money market instruments. Several major services provide a landing service. This direction will be provided and supported by the appropriate tools in the form of forward contracts for funding rates, indices and swaps.

The development of this industry segment will attract large participants who frankly dislike the volatility of cryptocurrencies, but enjoy the profitability of the money market and the liquidity they could obtain. Although it is still quite a long way before formation and recognition of this segment, separate attempts to create it are regularly visible.

Coming together

Derivatives platforms should come together to create special committees and associations lobbying their interests, developing regulatory practices and recommendations that help standardise trading instruments and interact more closely with each other.

Performance of the platforms must grow to allow them to cope with the loads at any market volatility inherent in such a decentralised environment. For cryptocurrencies, this is especially important. Access to liquidity in the fast market must be guaranteed, and technical problems on the exchanges must be minimised.

Derivatives market regulations must become international and adopted by the largest exchanges and regulators. The industry should aim to become transparent; this is beneficial to all its legitimate participants. KYC procedure should become universal, understandable and straightforward. Ideally, it should imply one-time access to all the markets.

Such regulations should include the assessment of fair market commissions and practices. All market participants must have a level playing field. Any special trading conditions create non-competitive markets that negatively affect the liquidity of the entire market. The ability to compete on an equal footing with large players is critical to the healthy development of markets. The commissions themselves should be able to provide an opportunity for traders to work more actively when supplying the market.

We cannot stress enough that cryptocurrency exchanges that remain teetering on the edges of regulation are doing themselves and the industry a disservice. Institutions will enter when the market players provide the best possible opportunity in the long-run.

“We’re not playing together, but then again, we’re not playing against each other either.”
– Mike McDermott - Rounders (1998)