A Crypto Derivatives Primer

Learn about crypto derivatives, risk management and the solutions they offer.

From the CMC editorial desk: With increasing interest in crypto derivatives and the function they serve in managing risk, what must you know about them? We asked LXDX, and they’re sharing their knowledge about the role that derivatives play, and its challenges and opportunities!

Derivatives are an essential part of any well-functioning financial system.

You want to express an opinion on oil futures, but you probably don’t want to take delivery of a few million barrels at your doorstep. Probably.

Similarly, you might want to express an opinion on a crypto asset but have no desire to fumble around with private keys and custodianship costs, which can total 1% or more of your investment principle each year (not to mention exchange fees both coming and going.)

Derivatives play an important role in price discovery. With derivatives, a trader can participate on both the long and short side of a market, and thus, derivatives often act to suppress reckless exuberance. In a world without derivatives, the only way you can engage with a market is by buying an asset.

Derivatives, therefore, help temper out-of-control speculation on assets. And due to their leverage, they create condensed sources of liquidity. The available liquidity on levered assets in notional dollar terms is almost always multiples of what’s there in a cash market.

In short, derivatives conveniently unlock more liquidity at more accurate prices.

Risk Management

Derivatives also play a critical role in risk management. Let’s say you’re invested in a hedge fund. Maybe it’s a crypto hedge fund. The fund manager’s job is to return to you alpha, excess returns (implying that it’s indeed a “hedged fund”). He may selectively invest strategically in a few assets while hedging overall market exposure by selling Bitcoin (BTC) and Ethereum (ETH). Once again, enter derivatives.

Or, say you have an event-specific insight. If one thing is revealed onstage at Devcon, you think Ethereum (ETH) will go up. If another thing is announced, ETH will go down. In this case you don’t actually want to take a position on ETH. The talk you are tracking at Devcon isn’t about ETH. It’s about volatility.

Options (a derivative with which you have the right but not obligation to buy or sell an asset) offer direct exposure to volatility. A hedged options position, in the world where you’re correct that the talk is an important driver for movement in ETH, is the optimal investment.

Or perhaps, you are long 0x or EOS, you might want to be short ETH. You may see being short ETH as a hedge for the overall Ethereum ecosystem risk. You might specifically use put options to position for a prediction that, conditioned on 0x or EOS underperformance, those companies will likely liquidate their ETH holdings thus further driving down the value of ETH.

Options facilitate not only the ability to take short positions in cryptoassets, but to express nuanced opinions on the shape of things to come.

Options

Often, the opinion you want to express is simple. “I think there’s a higher probability than usual that ETH will go down in the next few days.”

One could participate by being short futures or swaps, but that opens the trader up to unlimited downside risk. If ETH skyrockets higher, the trader could face an enormous loss. And such a position was not expressing the trader’s thesis — the thesis was that the probability of dropping was elevated, not that it was a sure thing.

Options buying (in this case puts) provide exactly this type of exposure. And, the most you can ever lose on a trade, is the price you paid for the option. You can participate in the upside or downside of a price move but for a much smaller price than via any other type of asset.

Trading only in cash products, even when you can borrow to short, is blunt risk taking. Options offer the chance for outsized returns but with finite, low and fixed cost.

Risks

There are many common criticisms of derivatives. Often, there is the fear that derivatives lead to gambling, or speculation for sport, not prudent investment.

Traders of derivatives are frequently focused on short-term price action. While this isn’t a necessity (there are many physically settled derivatives where the buyer does take custody of barrels of oil upon expiry), most of the derivatives traded around the world are cash settled, and derivatives are undoubtedly used frequently to express short term opinions.

With respect to options, while the risk to a buyer is fixed and limited, an unavoidable fact is that the value of an option goes down every day as expiration nears. Options decay.

Therefore, as an investor you are managing the relationship between the volatility theta (time decay) and expected future volatility. Being successful means managing this relationship well. Chiefly, this means being on top of when things are happening. Time and timeliness take center stage, and paying attention to what’s happening and when is essential.

Why Socialized Losses Suck

These derivatives function quite differently in the crypto world as compared to traditional financial markets. Socialized losses, while commonplace in the crypto world are never part of trading in the traditional world.

As per Investopedia:

“Privatizing profits and socializing losses refers to the practice of treating firms’ earnings as the rightful property of their shareholders, while treating losses as a responsibility that society as a whole must shoulder, for example through taxpayer-funded subsidies or bailouts.”

The gist of socialized losses is that, when one trader loses a lot of money, everyone suffers. A reckless trader may bankrupt you even if you never trade the risky assets he’s trading, and in fact, may bankrupt you even if you never trade on that exchange at all.

In traditional markets, there is a whole ecosystem built to make sure this never happens. Brokers and clearinghouses are responsible for making sure you have enough money to safely trade and to minimize possible risk contagion.

Furthermore, in the traditional world, there is generally no notion of auto-liquidation. Individuals are not members of exchange; the broker is responsible for ensuring you have adequate margin, not the exchange. Excess risk taking impacts the individual broker, not the entire market.

Not a Theoretical Problem

OKEx is one of the most prominent exchange for trading crypto derivatives today. OKEx allowed a user to accumulate a position of 460MM USD worth of Bitcoin futures, and shortly thereafter, force liquidated the user socializing his losses to all traders on the exchange with opposing positions.

A trader who was using OKEx to hedge his risk by selling Bitcoin futures suddenly held a pretty worthless hedge.

Other platforms use other socialized loss variants such as “auto-deleveraging” which unwind the positions of the biggest winners first, in an attempt to find an “appropriate” offset for large losses. The idea of the algorithm is to attempt to make socialized losses more “fair” than simple pro rata socialization. There’s nothing fair about it.

Socialized losses, regardless of their flavor, ruin the efficacy of hedging and targeted speculation for both retail and institutional investors. How is being short futures to hedge your other positions a viable hedge if the gains from the hedge can be socialized at any time?

Most retail investors don’t know about or understand what’s really going on. Thus far, catastrophes have been rare and because most retail investors haven’t personally experienced socialized losses yet, they’re not worried . . . yet.

Why have socialized losses at all then?

Exchanges want to facilitate volume, and to facilitate that volume, they are offering unnecessarily high leverage. You, like it or not, are effectively the lender of assets to risk takers on these platforms. All the while, the exchange collects massive fees off of your loans, but shoulders none of the risk.

If the customers themselves are the primary backers of the risk taking on the platforms, where’s their share of the trading fee revenues being generated off of their loans?

Solutions

There are a myriad of solutions that minimize or entirely absolve the risk of loss socialization.

Imagine a warrant where you cap the upside on calls so the total amount that can be won or lost is fixed on any given contract. While the total upside is now constrained for our call buyer, there’s no longer any unconstrained losses.

Because losses are constrained, one can calculate and collect the necessary amount of collateral. The balance sheet is 100% available and solvent.

But doesn’t this ruin all the fun and destroy all the upside?

No. Imagine you cap movement at 50% per week. Such a cap would almost never come into play, but still solves the unbounded losses problem. Furthermore, consider that, when the cap is relevant, it’s exactly at the times when socialized losses would be most destructive.

To the end user, the cap, beyond its risk mitigation benefits, also means that the options are cheaper. Because there is a cap, the option will trade at a cheaper price. You’re not losing any fair value to the option because the person on the selling side no longer has to worry about that unbounded upside risk.

Products of this nature, which most closely represent options call or put spreads, provide leverage, the ability to hedge from either the long or short side, and zero risk of default. Furthermore, both the buyer and the seller know the maximum amount they stand to make or lose — the auto liquidation engine is never coming for them.

There are other financial instruments that share many of the qualities of a highly leveraged swap or future and many of these similarly address the dangers of products with unbounded and socialized losses. Additionally, there’s nothing that stops a broker from providing additional leverage on top and outside of the exchange. If the aforementioned products are synthetically 5-10x leveraged exposure, a broker can step in to provide an additional 5-10 above that through directly lending to the trader. In this model, the broker holds the default risk, not the exchange and not customers trading outside that one broker.

Traditional financial markets have iterated on leverage and risk best practices for the last three decades. We’ve occasionally learned some tough lessons, but rewinding our practices back to our most degenerate and high risk days, is not the solution.

The Opportunity for Crypto

It was recently announced that NASDAQ is “plowing ahead to launch Bitcoin futures despite cryptocurrencies’ bear market.” This move was just officially confirmed by Nasdaq Vice President of Communications Joseph Christinat.

Analysts correctly called this move a “game changer.” The only thing standing between the exchange giant and a H1 2019 launch is the official go-ahead from the U.S. Commodity Futures Trading Association (CFTC), which is expected.

Nasdaq’s move — particularly right now — is a strong indicator of confidence in the crypo asset market’s intrinsic strength and long-term potential. But why make this move now, when prices are so bad? Is Nasdaq’s move as simple as a belief we’ve hit a floor, and that things will only go up from here?

I read Nasdaq’s action as an indicator of a more subtle belief, one that I agree with wholeheartedly — namely, the belief that crypto derivatives are an essential component of a well functioning market of any kind, and the biggest and most exciting opportunity in crypto, period.

About the author

Joshua is co-founder and CEO of LXDX, the crypto derivatives exchange. Follow him on Twitter here.