A Maturing Market: Crypto Derivatives and Standardisation
The price of Bitcoin is still going through a phase of adolescent mood swings and, until relatively recently, cryptocurrency trading has been approached cautiously by most financial institutions. However, this volatility means profit. Like cautious schoolkids, many market participants have avoided being the first to dive in. There’s always a risk of ridicule when advocating something not yet accepted by the wider group, but boldness can pay off. At present, more of the top dogs of the financial playground are dipping their toes in the water, and as trading ramps up, the infrastructure is becoming more sophisticated. There’s still a way to go but progress is being made.
The CME’s launch of crypto futures contracts in 2017 was a turning point. It marked a strategic decision from a major institution that trading cryptocurrency derivatives represented long-term potential. Shortly after the launch of these futures, trading activity spiked, and the price of bitcoin shot up to $20,000 before crashing back down to $2,000.
Since this infamous tantrum, the crypto market has taken encouraging steps. Just a few weeks ago, the CME launched its much-anticipated Bitcoin options, marking another leap forward. How these options will affect volatility of the underlying asset has yet to be seen, but it’s certain to present opportunities. Even the day after this announcement, crypto derivatives trading spiked, indicating there is high demand for the new contracts.
Additionally, banks and asset managers’ attention will be drawn to crypto trading following a recent research from Eurekahedge showing that cryptocurrency funds generated returns of more than 16 per cent in 2019, compared to just 10.4 per cent for traditional hedge funds.
With more players entering the market, having robust trading systems in place is becoming essential, and, as a result, the architecture used by the industry is becoming more standardised. So much so that now, beneath the surface, the crypto markets are beginning to look more like other asset classes – a quiet yet significant transition into maturity.
From a technological perspective, crypto trading increasingly resembles traditional markets. Firstly, the APIs which are being used are now more straightforward with user-friendly interfaces. Looking at how orders are passed between buyers and sellers, the systems involved for the other asset classes are being transferred. Namely, some exchanges now offer FIX connectivity – a way in which counterparties communicate. It’s seen as the universal language of capital markets. This was not the case several years ago and it’s a move which allows for easy integration with the trading systems of the more established firms. It’s all part of a process where the end-to-end lifecycle of a trade is underpinned by more efficient technology which will make trading easier and more reliable.
As it stands, the main actors of crypto today are mainly unregulated. Traditional asset managers want to trade digital assets, just in a regulated way. It looks like there is a bridge between the two sides soon. Regulators in the US, including the SEC and CFTC, are working on a Cryptocurrency Act for 2020 which will split crypto assets into three categories and it will force all crypto traders to play from the same rulebook. Therefore, with the introduction of a universally regulated environment in the US, this trend of standardisation looks set to get a further boost this year. Fundamentally, if the US provides more of a framework for crypto trading, not only may other countries follow suit, but clarity will draw in institutional investors and trading volumes will increase.
One area which need addressing is pricing. When it comes to options, pricing methodologies are not always the same depending if the interpretation is from equities or commodities. For cryptocurrencies, there has long been a debate around how to define the asset – they are not quite like currencies and not quite like commodities. They are their own asset, which raises a few questions around how options should be priced. For example, in the case of Bitcoin, it’s traded on many exchanges where the price is not always the same, so what price would you use for those option? It’s a problem which needs addressing because, in order to reach a true tipping point for broader institutional involvement, pricing techniques will have to be made uniform.
People have been talking about crypto options for a while and now it’s happening on all the major exchanges. Despite being the underdog of the trading for some time, the introduction of more sophisticated securities such as these act as a prerequisite for a more standardised market structure. However, for cryptocurrencies to become the mature asset the strive to be, the trading systems have got to be in place first. There are valuable lessons to be learnt from the established markets when it comes to the standard of infrastructure and a core element of this is ensuring the trading is underpinned by seamless technology. Either way, the landscape will only become more user-friendly from here so it seems inevitable that cryptos will become integrated into the portfolios of institutional investors.