Notes 4/24: Crypto Derivatives

One of the biggest pieces of news last week was Coinbase’s decision to file for a license to operate a derivatives exchange in Bermuda. In its wake, another prominent cryptocurrency exchange Gemini jumped onto the news train and announced the launch of Gemini Foundation – a “non-US” derivatives exchange that is planned to be situated, as of this writing, nowhere.

According to data, trading volumes for cryptocurrency derivatives have stayed put amidst the turmoil of the last few months in cryptocurrencies even as those for their spot counterparts fell. Among cryptocurrency traders and enthusiasts, perpetual futures contracts, or contracts that do not expire, are a favorite.

Their volumes dipped only slightly, by 2%, after the Commodities Futures Trading Commission (CFTC) filed a lawsuit against Binance, the biggest venue for trading such contracts. Researchers have categorized perpetual futures contracts and Binance as “emitters” of bitcoin price volatility in the past.  

Trading Derivatives in Crypto

Derivatives can be useful instruments to hedge risk. But bitcoin and the larger cryptocurrency ecosystem do not produce cash flows or operate in quantifiable and knowable conditions. There is also insufficient data to back test trader strategies.

Therefore, in cryptocurrencies, derivatives trading is like gambling, a wild guess about future prices for assets that are unproven and mostly worthless. Coinbase and Gemini plan to make that guesswork even more risky and inscrutable by enabling the trading of perpetual futures contracts, the most popular derivative in crypto.

Yale professor and Nobel Prize winner Robert Shiller proposed perpetual futures contracts 30 years ago to trade derivatives in illiquid and hard to measure markets like real estate.

“[i]n deciding…whether to establish a market in perpetual futures rather than conventional futures, one must assess which is easier to measure: the true asset price or the dividend on the asset. If the former, then conventional futures contracts should suffice; if the latter, perpetual futures,” he wrote.

As with everything else, the crypto version has strayed far from the original idea.

A Risky Trade

Bitcoin and crypto fail on both counts outlined in Shiller’s original thesis. It is impossible to measure the true price of cryptocurrencies and they do not generate cash flows to produce dividends. Still crypto exchanges persist in hammering square pegs into round holes. They have designed perpetual futures with margin requirements that are calculated based on spurious trading volumes gathered from unregulated exchanges.

Examples of exchanges whose spot trading volumes have been used to calculate margins for perpetual futures are Bittrex, an exchange that fled the United States recently, and FTX, an exchange that crashed in less than a week last year.  

That is not the only problem.

Massive leverage positions at such exchanges further makes such products even more unhealthy for trader portfolios. Binance, the most popular venue for perpetual futures trading in crypto, offered 125X leverage, or 125 times the amount deposited by traders, to trade crypto perpetual futures. Gemini promises to offer up to 100X leverage at its exchange. It will also settle the trades in its worthless stablecoin, GUSD, to pump up its use cases.

Then there is the ever-present risk of regulation. Perpetual futures contracts are traded at offshore exchanges, in a land far far away from the strict rules that underpin most derivatives trading. The absence of regulation gives such exchanges carte blanche to function as they please.

In 2021, Binance paused trading for perpetual derivatives for one hour, locking traders in their positions and leverage. Traders unable to exit their positions and leverages during this time and their losses multiplied.    

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