5 ways derivatives could change the cryptocurrency sector in 2022

We‘ve
all
heard
stories
of
billion-dollar
future
contracts
liquidations
being
the
cause
of
25%
intraday
price
crashes
in
Bitcoin
(BTC)
and
Ether
(ETH)
but
the
truth
is,
the
industry
has
been
plagued
by
100x
leverage
instruments
since
BitMEX
launched
its
perpetual
futures
contract
in
May
2016.

The
derivatives
industry
goes
far
beyond
these
retail-driven
instruments,
as
institutional
clients,
mutual
funds,
market
makers
and
professional
traders
can
benefit
from
using
the
instrument‘s
hedging
capabilities.

In
April
2020,
Renaissance
Technologies,
a
$130
billion
hedge
fund,
received
the
green
light
to

invest
in
Bitcoin
futures
markets

using
instruments
listed
at
the
CME.
These
trading
mammoths
are
nothing
like
retail
crypto
traders,
instead
they
focus
on
arbitrage
and
non-directional
risk
exposure.

The
short-term
correlation
to
traditional
markets
could
rise

As
an
asset
class,
cryptocurrencies
are
becoming
a
proxy
for
global
macroeconomic
risks,
regardless
of
whether
crypto
investors
like
it
or
not.
That
is
not
exclusive
to
Bitcoin
because
most
commodities
instruments
suffered
from
this
correlation
in
2021.
Even
if
Bitcoin
price
decouples
on
a
monthly
basis,
this
short-term
risk-on
and
risk-off
strategy
heavily
impacts
Bitcoin‘s
price.


Bitcoin/USD
on
FTX
(blue,
right)
vs.
U.S.
10-year
yield
(orange,
left).
Source:
TradingView

Notice
how
Bitcoin‘s
price
has
been
steadily
correlated
with
the
United
States
10
year
Treasury
Bill.
Whenever
investors
are
demanding
higher
returns
to
hold
these
fixed
income
instruments,
there
are
additional
demands
for
crypto
exposure.

Derivatives
are
essential
in
this
case
because
most
mutual
funds
cannot
invest
directly
in
cryptocurrencies,
so
using
a
regulated
futures
contract,
such
as
the
CME
Bitcoin
futures,
provides
them
with
access
to
the
market.

Miners
will
use
longer-term
contracts
as
a
hedge

Cryptocurrency
traders
fail
to
realize
that
a
short-term
price
fluctuation
is
not
meaningful
to
their
investment,
from
a
miners‘
perspective.
As
miners
become
more
professional,
their
need
to
constantly
sell
those
coins
is
significantly
reduced.
This
is
precisely
why
derivatives
instruments
were
created
in
the
first
place.

For
instance,
a
miner
could
sell
a
quarterly
futures
contract
expiring
in
three
months,
effectively
locking
in
the
price
for
the
period.
Then,
regardless
of
the
price
movements,
the
miner
knows
their
returns
beforehand
from
this
moment
on.

A
similar
outcome
can
be
achieved
by
trading
Bitcoin
options
contracts.
For
example,
a
miner
can
sell
a
$40,000
March
2022
call
option,
which
will
be
enough
to
compensate
if
the
BTC
price
drops
to
$43,000,
or
16%
below
the
current
$51,100.
In
exchange,
the
miner‘s
profits
above
the
$43,000
threshold
are
cut
by
42%,
so
the
options
instrument
acts
as
insurance.

Bitcoin‘s
use
as
collateral
for
traditional
finance
will
expand

Fidelity
Digital
Assets
and
crypto
borrowing
and
exchange
platform
Nexo
recently
announced
a
partnership
that
offers

crypto
lending
services
for
institutional
investors
.
The
joint
venture
will
allow
Bitcoin-backed
cash
loans
that
can
t
be
used
in
traditional
finance
markets.

That
movement
will
likely
ease
the
pressure
of
companies
like
Tesla
and
Block
(previously
Square)
to
keep
adding
Bitcoin
to
their
balance
sheets.
Using
it
as
collateral
for
their
day-to-day
operations
vastly
increases
their
exposure
limits
for
this
asset
class.

At
the
same
time,
even
companies
that
are
not
seeking
directional
exposure
to
Bitcoin
and
other
cryptocurrencies
might
benefit
from
the
industry‘s
higher
yields
when
compared
to
the
traditional
fixed
income.
Borrowing
and
lending
are
perfect
use
cases
for
institutional
clients
unwilling
to
have
direct
exposure
to
Bitcoin‘s
volatility
but,
at
the
same
time,
seek
higher
returns
on
their
assets.

Investors
will
use
options
markets
to
produce
“fixed
income”

Deribit
derivatives
exchange
currently
holds
an
80%
market
share
of
the
Bitcoin
and
Ether
options
markets.
However,
U.S.
regulated
options
markets
like
the
CME
and
FTX
US
Derivatives
(previously
LedgerX)
will
eventually
gain
traction.

Institutional
traders
dig
these
instruments
because
they
offer
the
possibility
to
create
semi
“fixed
income”
strategies
like

covered
calls
,

iron
condors
,

bull
call
spread

and
others.
In
addition,
by
combining
call
(buy)
and
put
(sell)
options,
traders
can
set
an
options
trade
with
predefined
max
losses
without
the
risk
of
being
liquidated.

It‘s
likely
that
central
banks
across
the
globe
will
worldwide
keep
interest
rates
near
zero
and
below
inflation
levels.
This
means
investors
are
forced
to
seek
markets
that
offer
higher
returns,
even
if
that
means
carrying
some
risk.

This
is
precisely
why
institutional
investors
will
be
entering
crypto
derivatives
markets
in
2022
and
changing
the
industry
as
we
currently
know.

Reduced
volatility
is
coming

As
previously
discussed,
crypto
derivatives
are
presently
known
for
adding
volatility
whenever
unexpected
price
swings
happen.
These
forced
liquidation
orders
reflect
the
futures
instruments
used
for
accessing
excessive
leverage,
a
situation
typically
caused
by
retail
investors.

Yet,
institutional
investors
will
gain
a
broader
representation
in
Bitcoin
and
Ether
derivatives
markets
and,
therefore,
increase
the
bid
and
ask
size
for
these
instruments.
Consequently,
retail
traders‘
$1
billion
liquidations
will
have
a
smaller
impact
on
the
price.

In
short,
a
growing
number
of
professional
players
taking
part
in
crypto
derivatives
will
reduce
the
impact
of
extreme
price
fluctuations
by
absorbing
that
order
flow.
In
time,
this
effect
will
be
reflected
in
reduced
volatility
or,
at
least,
avoid
problems
such
as
the

March
2020
crash

when
BitMEX
servers
“went
down”
for
15
minutes.


The
views
and
opinions
expressed
here
are
solely
those
of
the



author


and
do
not
necessarily
reflect
the
views
of
Cointelegraph.
Every
investment
and
trading
move
involves
risk.
You
should
conduct
your
own
research
when
making
a
decision.

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