Crypto derivatives are becoming a major digital asset class

Crypto derivatives are on the rise, with fast-paced growth that exceeds the underlying cryptocurrency spot market.

In brief

• Product innovation will increase as firms seek exposure to digital assets.
• Much remains to be resolved for full adoption, particularly in regulatory clarity, the bilateral derivative market and innovation in decentralized finance.

Blockchain technologies have created new ways of conducting business and the digital asset industry is consistently innovating in ways that could disrupt traditional finance or provide it with paradigm changing technologies. Spot digital asset products, such as cryptocurrencies and stablecoins, are digital representations of value that can be stored and transmitted electronically. While these spot assets have led the market innovation so far, the digital asset-based derivatives market has experienced rapid growth in recent years.  

This corner of the industry can be expected to continue to gain traction as institutional investors seek to hedge positions, gain synthetic exposure to price movements or create structured/leveraged exposures in a capital efficient manner.

That said, the digital asset-based derivative market faces many challenges over the next few years. The regulatory environment around these derivatives is still nascent, which leaves certain industry participants questioning when and how to engage in this space.

Traditional finance derivatives

Market participants use derivatives for a variety of use cases such as risk management, hedging, leveraged exposure and market access: 

• Risk management/hedging: Counterparties may enter into a derivatives contract to mitigate exposure to price movements of a related investment.
• Leveraged exposure: Counterparties may seek amplified exposure to a trade without significant capital investment.
• Market access: Counterparties may also seek to gain exposure to a spot market without directly holding the asset.

Derivatives are generally based on five groups of underliers: rates, credit, foreign exchange, commodities and equities.

Digital asset derivative products today most closely resemble commodity or equity derivatives.

The current state of digital asset derivatives

To date, digital asset-based derivative trading has been dominated by listed futures and options on centralized exchanges. Although there are thousands of digital asset tokens in circulation, existing derivatives reference only a subset of the population. Further, crypto derivative volume as a percentage of spot is just a fraction in comparison to traditional markets. A rise in volume in existing products and the introduction of new, more bespoke products, is inevitable as this market matures:

• US markets: Today, we see a growing number of US-registered trading and clearing venues for listed digital asset derivatives, with new products entering the market. Bitcoin futures trading was first supported by US-regulated exchanges in December 2017. The introduction of regulated futures was a critical step forward to attracting institutional investment in digital assets, as these products allow for synthetic exposure that does not require robust digital asset custody capabilities, as well as an effective route for hedging. As of late 2021, approximately 13 Commodity Futures Trading Commission-registered clearing futures commission merchants (FCMs) support clearing certain listed digital asset derivatives. Comparatively, the list of “digital-native” clearing FCMs and non-clearing FCMs remains short but is growing.
• Non-US markets: Offshore exchanges are market leaders in listed digital asset futures and options. These exchanges have historically been attractive to retail investors and are comparatively less regulated than their counterparts that are registered in the US. These firms are unable to offer products to US customers, although there are methods by which a US institutional firm could gain exposure to their offerings (e.g., offshore legal entities).
• Decentralized finance (DeFi) markets: DeFi refers to a growing financial ecosystem that offers traditional financial services, such as derivatives, using public blockchain infrastructure and smart contracts to facilitate transactions. Decentralized derivative protocols facilitate the issuing, servicing, trading and settling of various digital asset-based derivatives using smart contracts. The rise of DeFi usage has prompted a new wave of innovation and growth across the industry, including derivative protocols. Though these new protocols offer a variety of new, unique opportunities and products, there are several risks participants must consider.

What are some emerging themes?

The digital asset space is constantly evolving, driven by regulatory clarity, product innovation, and new players and/or protocols joining the market. This paper dives into four main emerging themes we see in the market, with our perspective on where these topics are headed:

1. Regulatory landscape: In the US, regulators have continued to treat digital asset activity under the lens of the existing legal and regulatory framework, including prohibiting derivatives that do not fit this existing framework. Certain market participants believe that this limitation hampers investment opportunities for US customers and may result in a movement to foreign markets with less regulation. That said, several working groups or ongoing initiatives have been stood up between regulatory bodies to review use cases, risks and policy options — signaling acknowledgment that these activities need to be addressed.
2. Development of bilateral derivatives: While other asset classes have well-defined contractual standards and definitions that can be used for bilateral products, there are currently no standardized legal documentation or conventions for digital asset derivatives. Without industry-standard conventions, transparency and liquidity in the bilateral derivative market will suffer (e.g., due to the burden of contractual negotiations). Industry trade associations are working to develop common legal standards and definitions for digital asset derivatives so these products can be integrated into the current ecosystem.
3. Market structure: If the derivatives regulatory reform coming out of the 2008 financial crisis was any indicator, it is likely that there will be a fragmented regulatory environment that will introduce layers of complexity to a market that has operated largely homogenously outside of the US and other regulated spaces. Likewise, although a large concentration of today’s digital asset-based derivative exposure sits with centralized exchanges, liquidity may become more fragmented based on product availability and fee compression as markets mature and become less volatile.
4. Product innovation and DeFi: The digital asset derivative market structure is expected to continue to evolve, as institutional users demand exposure to digital assets and more complex product offerings. The product suite will mirror traditional financial instruments to start, facilitated by smart contracts, but may then progress beyond traditional offerings (e.g., DeFi Option Vaults). On that note, we may see a migration away from centralized exchanges and towards DeFi in the longer term. The development of scaling solutions, which seek to lower transaction costs and increase transaction execution speed, should grow further in this space.