The Rapid Growth of Crypto Options and Structured Products
Over the past year, the nature and the quality of the participants in the crypto market have changed. Once dominated by retail participants and smaller crypto-native firms, today these smaller firms have exponentially expanded their assets under management (AUM).
The industry is also seeing the entry of institutional investors who have started to trade crypto as another asset class within their portfolio allocation. These larger investors are now using more sophisticated methods of executing their trading strategies, turning to options and structured products as they continue to improve their yields.
On Tuesday, our Chief Operating Officer, Daniel Yan participated in a webinar alongside Joshua Lim, Head of Derivatives at Genesis Global Trading, Anand Gomes, Co-Founder of Paradigm, and Shiliang Tang, Chief Investment Officer at LedgerPrime. Entitled “The Rapid Growth of Crypto Options and Structured Products”, the discussion explored the growth and maturity of the crypto derivatives market, its impact on market structure, and how they are increasingly being used by institutions.
As a recap, let us take a look at the key themes that emerged during the panel discussion.
Changes in funding
The rise of basis trading — buying a commodity at spot and simultaneously establishing a short position through derivatives such as options or futures contracts — has seen many participants collateralise BTC to borrow the dollar as a means of raising funds for the trade.
However, with basis trading now in contango, we are now seeing the reverse take place. Market participants are instead collateralising USDT to borrow BTC and paying interest in order to use BTC for other related trades such as GBTC trades. The continuous reduction in funding costs for USDT has made this approach even more attractive for participants to pledge as collateral.
Given this growing trend, there is an increasing opportunity for capital providers to fulfill the demand for funds and facilitate such trades.
Ease of execution driving the growth of crypto derivatives markets
The participants then discussed the major drivers of growth within crypto derivatives markets. As firms are increasingly able to manage more sophisticated packages of trades with options and various futures legs, the crypto derivatives space will only continue to see further growth. The increasing ease of execution will also be a contributing factor for growth as more market participants enter the space.
Anticipated demand for altcoins in the options market
99 percent of current product offerings in the options market comprises BTC or ETH options. As the options market continues to grow, there will be a greater appetite for more altcoin options. Exchanges will need to identify the point of growth and liquidity of other altcoins where an options instrument becomes feasible to cater to demand.
One interesting consideration is how the options markets for the most popular DeFi coins will evolve. For instance, in a situation with high liquidity, when an investor uses automated market makers (AMM) to trade ETH or Sushi, having an options market to hedge that will open up multiple other trades that can be conducted.
The need for cross-margining and issues with standardisation and risk
Cross-margining is a critical aspect of the crypto derivatives space. However, there are internal and external challenges exchanges face in facilitating this. For instance, ssues of standardisation across exchanges and geographical or jurisdictional restrictions can make cross-margining a highly complex process.
While there may be institutional demand for cross-margining, exchanges need to understand the customer profile and fit this demand into the broader system as well, factoring in risk management and scalability as well. If not introduced with the right measures, cross-margining could jeopardise the risk profile of a customer. Ultimately, this should be a long journey, starting from customer demand and assessing how that fits your product strategy from a risk, tech, and pipeline perspective.
Systematic hedging in bear markets
In the most recent sell-off, not many funds were positioned defensively. After the first drawdown, it has become far more expensive to continue rolling down the hedges. From the surge back in December 2020 to the Coinbase listing, many funds were conditioned to feel that every dip in price was meant to be bought, which means that a lot of investors haven’t yet derisked and were not expecting this dip to last as long as it did.
What the growth of DeFi means for market structure
Trading rails are needed to introduce DeFi derivatives. Given the lack of cross-platform collateralisation, trading options requires a robust delta one product on DeFi — and perpetual swaps and futures are needed to hedge that. With projects looking to introduce margining on their options, there’s been plenty of cross-pollination from the decentralised world to DeFi.
There is a lot of optimism on the DeFi front, but the optimism in options is more conservative. The reason spot trading worked was a result of a combination of factors — for example, the AMM system or in the case of a bull market, the token reward for investors to trade serves as an incentive and to arbitrage the differences between different venues on a spot trade.
When it comes to DeFi futures, some progress has been made, but the space is still nascent compared to spot trading.
Ultimately, there is a lot more work to be done for DeFi options to grow. The right market conditions and the market being in sync are needed, and it will be challenging for DeFi to evolve as fast as it has in the last year in a bear market.