5 ways derivatives could change the crypto space in 2022

We've all heard about billions of dollars in futures contracts being liquidated that caused the intraday prices of Bitcoin and Ethereum to plummet 25%, but the truth is that the industry has been under pressure since BitMEX launched perpetual futures contracts in May 2016. The trouble with 100x leverage tools.

The derivatives industry is much more than these retail-driven instruments, as institutional clients, mutual funds, market makers and professional traders can all profit from the instrument's hedging capabilities.

In April 2020, $130 billion hedge fund Renaissance Technologies was allowed to invest in the bitcoin futures market using a Chicago Mercantile Exchange (CME)-listed vehicle. These trading giants are not like retail cryptocurrency traders, instead they focus on arbitrage and non-directional exposure.

Short-term correlations with traditional markets may rise

As an asset class, cryptocurrencies are becoming a proxy for global macroeconomic risk, whether crypto investors like it or not. This is not unique to Bitcoin, as in 2021, most commodity instruments suffer from this correlation. This short-term risk-on and risk-off strategy can seriously affect the price of Bitcoin even if the price of Bitcoin decouples every month.

BTC/USD (FTX) (blue, right) vs. US 10-year Treasury yield (orange, left) Source: TradingView

Note how the price of Bitcoin is steadily correlated with the U.S. 10-year Treasury note. Whenever investors demand higher returns for holding these fixed income instruments, there will be additional demand for exposure to cryptocurrencies.

In this case, derivatives are essential because most mutual funds cannot directly invest in cryptocurrencies, so using regulated futures contracts, such as CME bitcoin futures, allows them to enter the market.

Miners will use longer-term contracts as a hedging tool

From a miner's perspective, cryptocurrency traders don't realize that short-term price fluctuations don't make sense for their investments. As miners become more professional, their need to constantly sell coins is greatly reduced. This is exactly why derivative instruments were created in the first place.

For example, miners could sell quarterly futures contracts that expire in 3 months, effectively locking in the price for that time. Then, regardless of the price movement, miners know their rewards in advance from this moment.

Similar results can also be achieved by trading Bitcoin options contracts. For example, a miner could sell $40,000 worth of March 2022 call options, which would be more than enough to cover losses if the bitcoin price fell to $43,000, or 16% below the current $51,100. When the price is above $43,000, miners’ profits will be cut by 42%, so the option tool acts as an insurance.

Bitcoin's use as collateral for traditional finance will expand

Fidelity Digital Assets and crypto lending and trading platform Nexo recently announced a partnership to offer crypto lending services to institutional investors. The venture will allow bitcoin-backed cash loans not available in traditional financial markets.

The move could ease the pressure on companies like Tesla and The Block (formerly known as Square) to continue adding bitcoin to their balance sheets. Using it as collateral for day-to-day operations significantly increases their exposure limits to this asset class.

At the same time, even those firms that do not seek directional exposure to bitcoin and other cryptocurrencies may benefit from the sector's higher yields compared to traditional fixed-income products. Lending is the perfect use case for institutional clients who do not want direct exposure to Bitcoin’s volatility, but at the same time want higher returns on their assets.

Investors will use options market to generate 'fixed income'

The Deribit derivatives exchange currently holds 80% market share of the Bitcoin and Ethereum options markets. However, U.S.-regulated options markets such as CME and FTX US Derivatives (formerly LedgerX) will eventually gain traction.

Institutional traders like these tools because they offer the possibility to create semi-"fixed income" strategies, such as covered positions, iron eagles, bull call spreads, etc. Additionally, by combining call (buy) and put (sell) options, traders can set up an options trade with a predetermined maximum loss without taking the risk of being liquidated.

Global central banks are likely to keep interest rates near zero and below inflation. That means investors are forced to seek out markets that offer higher returns, even if it means taking some risk.

This is exactly why institutional investors will enter the crypto derivatives market in 2022 and will change the industry as we know it so far.

Reduced volatility is coming

As mentioned earlier, cryptocurrency derivatives are currently known for increasing volatility whenever unexpected price movements occur. These forced liquidation orders reflect the use of futures instruments to obtain excessive leverage, which is often caused by retail investors.

However, institutional investors will gain broader representation in the bitcoin and ethereum derivatives markets, increasing the volume of buying and selling of these instruments. Therefore, a $1 billion liquidation by retail traders has less impact on the price.

In short, the growing participation of professional players in crypto derivatives will reduce the impact of extreme price volatility by absorbing order flow. Over time, this effect will be reflected in reduced volatility, or at least avoid issues like the March 2020 crash, when BitMEX servers were "down" for 15 minutes.

Cointelegraph Chinese is a blockchain news information platform, and the information provided only represents the author's personal opinion, has nothing to do with the position of the Cointelegraph Chinese platform, and does not constitute any investment and financial advice. Readers are requested to establish correct currency concepts and investment concepts, and earnestly raise risk awareness.