Bitcoin trading volume has spiked since last December. Did you know? Most of these transactions are happening in the derivatives market. Currently, derivatives trading leads bitcoin trading.
The largest crypto derivatives exchanges are Binance, Huobi, OKEx, and BitMEX, which together hold 71% of the market in terms of open positions and volume. BTCUSD Perpetual Swap is currently the most popular bitcoin derivatives contract, with a leverage factor of up to 125x.
A notable feature of derivatives trading is high leverage, and most bitcoin futures are traded using high leverage, which amplifies price volatility.
The recent decline in the price of bitcoin can be analyzed by understanding how derivatives trading controls the bitcoin market. From January 10th to the 11th, Bitcoin fell 24% in just a few hours. One can’t help but wonder why the bitcoin price fell so abruptly.
One reason, according to analyst Myret Zaki, is that Bitcoin and other cryptocurrencies are being targeted by regulators due to its recent frenzy. on Jan. 11, the U.K. financial regulator warned that consumers who invest in cryptocurrencies should “be prepared to lose money.” In addition, the U.S. Treasury Department has instituted a new rule requiring custodians and exchanges to collect anti-money laundering information.
With retail investors who keep chasing the rally on one side and official bodies who keep warning about the risks of the bitcoin market and doling out regulation on the other, the two forces are fighting it out and it’s no wonder that bitcoin volatility has shown so much volatility recently.
How is the derivatives market fueling bitcoin prices?
Of course, many people are still very puzzled by this surge in bitcoin over the last month.
Analyst Myret Zaki says the most important driver behind the bitcoin price is the derivatives market and its highly leveraged positions, which have also created tremendous instability in the bitcoin price. Trading volume in bitcoin futures contracts has been soaring. As of Jan. 10, there were about $13 billion in open bitcoin futures contracts, a record high.
According to the Chicago Mercantile Exchange (CME), its bitcoin futures have exceeded $100 billion in notional trading volume since its launch in December 2017. Since 2017, the CME and other derivatives exchanges (BitMEX, OKEx, Huobi) have become major platforms for large institutional investors to trade bitcoin.
These large institutional investors generally hold bitcoin when they trade, but many of the institutions and retail investors who are driving up the price of bitcoin prefer to trade bitcoin futures contracts rather than buy and hold bitcoin directly, preferring to bet on the price of bitcoin with cash-settled futures contracts.
The impact of the derivatives market on the spot market has been significant. 2017 saw unprecedented volatility in the bitcoin price when bitcoin derivatives were officially launched on the CME, as the volatility of the bitcoin price was exacerbated by a significant spike in the value of undelivered derivatives contracts.
A study by the MIT Blockchain Lab shows that the derivatives market leads to bitcoin price movements more frequently than the spot market. The spot market is more likely to influence the direction of bitcoin price movements, while the derivatives market is more likely to lead the magnitude of bitcoin price movements, according to the report.
According to Myret Zaki, there are many different strategies for trading derivatives. The most basic one is to increase investments through leverage and then periodically short them to earn short-term profits. This was a common occurrence during the bubble from last December to January of this year.
Sophisticated investors on bitcoin trading platform Coindesk have set new records for the number of short positions almost every week in the last quarter of 2020 by investing in CME bitcoin futures and taking advantage of their highly leveraged trades.
There is a famous saying in the Bitcoin and other cryptocurrency communities, “Protect your private key to control your cryptocurrency”, meaning that if you lose your private key, your Bitcoin account is like a “freezer” because your Bitcoins will be frozen forever, however, derivatives trading does not have this risk.
Myret Zaki said the relationship between derivatives trading and bitcoin is a speculative one, which large institutional investors generally don’t speculate on, while speculators are interested in bitcoin’s price volatility and profit margins, and they like to take advantage of bitcoin’s volatility to earn spreads. This type of trading is more of a gamma trade than a blockchain and private key technology.
Myret Zaki argues that the bitcoin derivatives boom is due to high leverage ratios, such as the two to three times leverage available to traders on the Chicago Mercantile Exchange and more than 100 times leverage available on local crypto derivatives exchanges. Last March, when the epidemic broke out, Lennix Lai, director of financial markets at bitcoin trading platform OKEx, said the derivatives market would eventually be bigger than the spot market:
“I wouldn’t be surprised if in less than two or three years the derivatives market grows to 5 to 10 times the size of the spot market.”
Little did I know that what happened in the stock market was now playing out in the bitcoin market.
Over the past 17 years, the global equity futures market has grown almost twice as fast as the equity spot market. The same is true for bitcoin. A report from bitcoin trading platform Kraken in October showed that the ratio of bitcoin futures to spot trading volume has increased from 2.3:1 to 4.6:1, indicating that bitcoin futures trading volume is outpacing spot trading volume. in the report, Kraken stated:
“Since 2018, the derivatives market has completely replaced the spot market as the dominant market.”
The report also said that the growth in derivatives trading volume is in stark contrast to the growth in spot trading volume. Spot trading in cryptocurrencies has declined since the last bull market, but derivatives trading remains hot, according to Kraken:
“From the second quarter of 2017 to the first quarter of 2018, spot trading volumes spiked from a low of about $58 billion to a high of $570 billion, then plummeted to a low of $104 billion in the last two years.”
Meanwhile, notional trading volume in derivatives surged from less than $6 billion in the second quarter of 2017 to more than $1.7 trillion in the third quarter of 2020. Since then, the derivatives market has completely replaced the spot market as the dominant market, while the spot trading market has not been able to fully recover.
Regulated exchanges vs. unregulated exchanges
According to Kraken, most bitcoin trading is done on unregulated crypto exchanges that operate overseas and that offer aggressive contracts with high leverage: they have initial margin requirements of just 1%, compared to 40% on regulated platforms such as the Chicago Mercantile Exchange.
Moreover, while anti-money laundering regulations are being considered in both the UK and the US, these unregulated platforms are largely unregulated and do not have strict “customer protection” measures in place. As a result of these lax rules, the derivatives market can be said to be largely unregulated, with at least 40 times the notional trading volume of the regulated derivatives market.
In addition, Myret Zak believes that low-interest loans have fueled this speculative boom. Thanks to the Fed’s easy money policy, the market was pumped with unprecedented liquidity. It is hard to believe that the Fed created 30% of the entire dollar issuance history in the period from March to December 2020.
Myret Zak, therefore, believes that the direct cause of the doubling of the price of bitcoin in two weeks is the boom in credit in the derivatives market. In the derivatives market, traders can borrow money at very low prices and then, through high leverage, buy assets with money they don’t actually own.
Kraken’s report warns of a situation in which the derivatives market takes over from the spot market and dominates:
“This could create a vicious cycle where a sell-off in the derivatives market would lead to lower spot market prices, which in turn would create further sell-off risk for derivatives that rely on spot index pricing.”
Be Aware of a Series of Sell-Off Risks in Derivatives Markets
Derivatives markets are most vulnerable during price corrections, as they are prone to trigger a series of sell-offs. On March 12, 2020, the cryptocurrency market suffered a “Black Thursday” when the price of bitcoin dived to the $3,000 range.
On that day, billions of dollars worth of open derivative contracts had to be marked-to-market in real time and quickly closed out as the spot price plummeted, eventually leaving them worth tens of millions of dollars. This happened because the spot exchanges for cryptocurrencies are far less liquid than the derivatives market for open positions, so the spot market is far from covering the risk in the derivatives market.
This is exactly the same as the subprime crisis that occurred in 2008, when collateral failed in the spot market and the real estate derivatives market triggered systemic risk.
Bitcoin is supposed to be a safe-haven asset in today’s macro-environment where fiat currencies have been devalued, but derivatives trading has turned it into a highly volatile speculative asset.
Article from Jin10
Translated by Yang(Mengyan Finance)