Cryptocurrency: The future of futures?

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Many traders entering cryptocurrency markets from traditional finance may look to derivatives as vehicles for price speculation and hedging. There are plenty of choices when it comes to exchanges and instruments; however, traders should consider a few key differences between crypto futures and traditional futures before dipping a toe into this rapidly growing market.

Related: 3 things every crypto trader should know about derivatives exchanges

Different instruments

Traders entering cryptocurrency from the traditional markets will be accustomed to futures contracts with a fixed expiration date. Although fixed expiration contracts can be found in cryptocurrency markets, a significant proportion of crypto futures trading is in perpetual contracts, also known as perpetual swaps. This variation of a futures contract does not have a fixed end date, meaning the trader can hold an open position indefinitely.

Exchanges that offer perpetual contracts use a mechanism known as “funding rate” to periodically balance the price variances between the contract markets and the spot prices. If the funding rate is positive, the perpetual contract price is higher than the spot rate — longs pay shorts. Conversely, a negative funding rate means that shorts pay longs.

Moreover, traders that come to cryptocurrency from traditional finance may be used to the portability of their positions across different exchanges. In contrast, cryptocurrency exchanges generally operate as walled gardens, meaning it’s impossible to transfer derivatives contracts across platforms.

Related: Professional traders need a global crypto sea, not hundreds of lakes

Regulated vs. unregulated trading platforms

Most of the trading in cryptocurrency futures — around 85 to 90% — is yet to be regulated. This situation mainly arose because cryptocurrency futures markets sprang up while regulators were still grappling with more fundamental questions around the legal status of digital assets. BitMEX paved the way for cryptocurrency futures trading by using coin-margined and collateralized contracts. In doing so, the company avoided the regulatory requirements associated with fiat on-ramps. There are around a dozen major trading platforms currently, but only a small number of them have achieved regulated status.

Both the Chicago Mercantile Exchange (CME) and Bakkt are regulated by the United States Commodity Futures Trading Commission (CFTC). In Europe, Kraken Futures operates under a multilateral trading facility license awarded by the United Kingdom Financial Conduct Authority. In Switzerland, Vontobel and Leonteq offer mini-Bitcoin futures contracts via the SIX Swiss Exchange.

The regulatory situation may preclude traders in some countries from participating in trading on non-regulated venues. This circumstance is particularly true of the U.S., where exchanges are mindful that the CFTC is now pursuing BitMEX for violating Anti-Money Laundering regulations and the Bank Secrecy Act.

However, the U.S.-regulated crypto futures platforms have expanded their range of instruments beyond pure Bitcoin (BTC) futures, likely in response to increasing demand. The CME, for example, recently branched out beyond Bitcoin futures and options to provide Ether (ETH) futures too. In addition, Bakkt also offers Bitcoin monthly futures and options.

Unregulated platforms offer futures contracts and perpetual swaps against a broader range of altcoins, although only to traders in countries where they are permitted to operate. In any case, most liquidity remains concentrated in BTC and ETH futures, at least for now.

Operational implications

Differing regulatory landscapes, combined with how perpetual contracts are managed, result in some practical differences between crypto futures and traditional futures. As there is no central counterparty clearing system, exchanges expose themselves to a high degree of risk, particularly given that many offer high leverages of up to 125 times. Therefore, losing positions that reach the maintenance margin will be liquidated.

Exchanges typically divert any profits from liquidations into an insurance fund, which exists to protect traders’ profits when their counterparty does not have sufficient margin to cover the trade. The presence and relative health of an insurance fund is a crucial consideration when using an unregulated exchange. Without a fund, or if the fund becomes too low to cover the losses incurred by liquidations, profitable traders take on the risk of having their positions “auto-deleveraged” by the exchange.

Another critical operational consideration is exchange downtime. Many of the unregulated platforms have a reputation for servers crashing during periods of high volatility, resulting in traders being unable to close their positions before being liquidated. Therefore, it is worth researching a platform’s history of downtime before opening an account.

Low barriers to entry

The cryptocurrency futures markets generally have a very low barrier to entry. A trader can open an account, undergo the “know your customer” process, deposit funds, and start trading within a matter of minutes.

In contrast, the barriers to entry for exchange-traded futures are high due to the contract sizes involved, which are intended for institutional traders. This situation is also reflected in the regulated crypto futures offerings. Both the CME and Bakkt, the two regulated crypto futures trading venues, have contract sizes of 5 BTC and 1 BTC, respectively. With prices currently exceeding $31,000, these contracts are evidently only intended for those willing to make a significant investment.

However, blockchain offers significant potential to transform the futures markets beyond cryptocurrencies through asset tokenization. Suppose a futures contract for the Nasdaq-100 or S&P 500 was made available as a token. In that case, it could be traded in fractional increments, lowering barriers to entry and introducing new sources of liquidity into traditional markets.

Related: Understanding the systemic shift from digitization to tokenization of financial services

Such a scenario may benefit those looking to introduce a more fine-grained diversification to their portfolio, which is currently only possible via contracts for differences (CFD). While they perform a similar role in the financial markets, CFDs are only available via brokers, which reduces transparency for the trader. It also fragments the available liquidity in the broader markets.

Despite their rapid growth, cryptocurrency futures markets are still very much in their infancy, particularly since the institutional inflow to crypto is only getting started. As the markets grow and develop, we will likely see new and more sophisticated instruments emerge, along with some blurring of the boundaries between traditional and digital finance. Furthermore, it seems likely that the regulatory situation will continue to evolve as more funds flow in. One thing is for sure: cryptocurrency futures have a long future ahead.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Andy Flury is a serial entrepreneur and quantitative trading expert. Andy is a former Swiss Air Force pilot and led projects at the Swiss intelligence agency and various major banks. He also served as senior project manager and software architect at Siemens Switzerland AG. In 2010, Andy became partner and head of algorithmic trading at Linard Capital AG, a Switzerland-based quantitative hedge fund. Andy holds a master’s in industrial management and manufacturing engineering from ETH Zurich and an Executive MBA from the University of St. Gallen.