In one of the first major interventions in the bitcoin market, the Financial Conduct Agency (FCA) laid down the law this week, publishing its final rules on the sale of crypto derivatives and exchange-traded notes (ETN). Per the UK watchdog, these instruments are “ill-suited” for retail consumers due to the apparent harm they pose.
The ban comes into effect on January 6th, 2021, and promises to save retail investors $68 million. (n.b., the watchdog didn’t speculate on how much investors could have gained if the ban hadn’t been in place).
But how dangerous and ill-suited are these instruments in reality? And do they really influence the underlying market as many seem to think?
A Brief History of Derivatives
Derivatives stretch as far back as the 19th century to the grain futures markets. They allowed farmers, who were forced to halt trade during harsh winters, a means of setting a pre-determined price for their produce, reducing the risk of future price dips. The same theory still applies today.
In their modern form, derivatives are a contract between two or more individuals that derives value from the price of an underlying financial asset. In the case of crypto futures, this underlying asset is invariably bitcoin. These instruments enable capital-efficient exposure to the underlying asset while mitigating unwanted risk—that’s the theory, at least.
Derivatives are well worn by traditional investors. In fact, derivatives—collateralized debt obligations, or CDOs, in particular—were one of the leading factors for the 2008 banking collapse, which, in turn, triggered an entire global financial meltdown.
To put it fairly seductively, the bankers got greedy, relentlessly repackaging subprime mortgages as top-rated CDOs to gain hefty bonuses. When the underlying mortgages inevitably defaulted, investors were left holding the bag and the financial system nearly came to a complete standstill. It’s not difficult to see how these instruments earned their stigma.
However, while the subprime mortgage crisis and subsequent recession ironically acted as the impetus for bitcoin‘s creation, that hasn’t stopped derivatives from becoming a staple within the crypto markets.
The Impact of Bitcoin Futures
It all began with the launch of bitcoin futures from the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) in 2017, followed by Bakkt, the brainchild of the intercontinental exchange, a little later in 2019. The entrance of these financial giants has sparked significant interest from institutional and retail investors alike. In fact, combined with a litany of offerings from various crypto exchanges, bitcoin futures volumes reached an unbelievable zenith of $187 billion in July 2020.
The only issue is, many of these offerings are cash-settled, with no actual bitcoin swapping hands. As such, they don’t influence the underlying price of bitcoin in the same way as billions of dollars of volumes typically would. And while Bakkt claims to be settled in bitcoin, there’s little evidence to suggest that many investors actually opt for physical delivery.
Some analysts have gone as far as to suggest that futures trading in its entirety is bad news for bitcoin—simply because investors can gain exposure without actually buying any BTC. Others suggest that futures provide an easy mode of betting against bitcoin. Up until 2017, crypto cynics could only short the market by selling bitcoin. Nowadays, however, shorting bitcoin is as easy as it is in any other futures market.
In fact, according to researchers from the San Francisco Federal Reserve, this is precisely what occurred in 2018. Within an economic letter, the Fed’s researchers opine that the CME was to blame for bitcoin‘s rapid decline from its all-time high of $20,000.
“The rapid run-up and subsequent fall in the price after the introduction of futures does not appear to be a coincidence,” reads the letter. “It is consistent with trading behavior that typically accompanies the introduction of futures markets for an asset.”
The researchers submit that the launch of bitcoin futures allowed pessimists to enter the market, which contributed to the reversal of the bitcoin price dynamics.
But that’s not the only issue with bitcoin derivatives; overleveraging poses a different concern.
Popular platforms like Binance, BitMEX, and ByBit offer leverage of up to 125x.
Leverage at these margins can be extremely attractive to an investor—particularly retail investors—as it reduces capital requirements while increasing exposure and potential payoff.
But, as traders become more and more leveraged, they also expose themselves to a higher liquidation threat. Enough of a downward price swing, and these over-leveraged investors can cause an avalanche of liquidations that reshapes the entire market.
This was said to be one of the contributing factors of the March 12 meltdown, in which nearly half of bitcoin‘s value was wiped in the space of a few days. Derivatives platform BitMEX experienced over $1.4 billion in liquidations alone—with its high margins compressing bitcoin‘s price further.
So while the FCA’s crypto derivatives ban could inform a negative outlook on the industry as a whole, ditching derivatives could temper market volatility and downward pressure during sell-offs, ultimately aiding the market and its investors.