The Derivatives Monster

The Derivatives Moment

Traditional Financial Markets

The global derivatives market is a main pillar of the international financial system and the economy as a whole. Today, businesses around the world use derivatives to effectively hedge risks and reduce uncertainty about future prices. Derivatives are financial instruments that are traded primarily over the counter (OTC).

Financial instruments universe

A derivative is a contract between a buyer and a seller, which, upon having been entered into, entails a transaction to be fulfilled at a later date. Over the lifetime of the contract, the value of a derivative fluctuates with the price of its “underlying”.

Underlying's can be financial instruments themselves, physical assets, or any risk that can be measured. The most common underlying's are bonds and interest rates.

Huge trading volumes contribute to global economy significantly.

Number of product lines per exchange in 2018

Total volumes of exchange traded derivatives contracts

Emerging Financial Markets (Cryptocurrencies)

Derivatives that are represented through tokens (Cryptocurrencies) are mathematical models that speculate on the price of underlying that can represent alternative assets in the same manner as traditional derivatives. Cryptocurrency tokens are special kind of virtual currency that reside on their own blockchains and represent an asset or utility. Tokenizing assets via Blockchain is maturing and explained here (Security Token Offering), here (Commodities) and here (CRE). More on 'Derivatives Token' you can read here.

The Crypto-derivative market is booming, and can help to stabilize prices. Bitcoin futures and other perpetual swap instruments are now trading, on average, 10x more volume than the underlying Bitcoin spot market. The total $ amount of bitcoin futures contracts opened – called open interest – at BitMEX stands at $1.1 billion. Bitcoin Spot 24h volume approx. $469,266,459 (all exchanges)!

At $5 billion to $10 billion a day, the amount of derivatives traded globally exceeds Bitcoin spot volume by 10 to 18 times

Since Bitcoin futures exchanges often do not have to hold the real asset (Bitcoins) as collateral, but trade 'Paper Bitcoins', its value of scarcity is diminished as unlimited Paper Bitcoins can be traded. This could result in a more declining Bitcoin Spot Market (real Bitcoin trading). This then could mean that lesser volume leads to easier manipulation of prices. Large traders (at current market capitalization) could probably move the price of Bitcoin by 10% with approx. $ 40 million only. In the traditional financial markets not possible. Manipulation could look like: open a short position on Bitcoins future market with high leverage, and sell Bitcoins (dump) via Spot Trading. This could earn you a great fortune. This is also the reason of SEC hesitating to approve Exchange Traded Fund (ETF) applications which enables institutions to enter this manipulatable market. In turn, the Cryptocurrency market needs the institutional money, resulting more volume to become more stable and less manipulatable.

What could possibly go wrong trading 100x levered products on the infamously volatile bitcoin?

Sources: Deutsche Börse, The Bank for International Settlements (BIS), The World Federation of Exchanges (WFE), Bloomberg, Bitwise, Skew, IWS FinTech