A maturing derivatives market: Bitcoin margined contracts losing dominance

17 Mar 2021

A maturing derivatives market: Bitcoin margined contracts losing dominance

Arguably, the first significant collateral use case for bitcoin came with the introduction and growth of the derivatives market in crypto. BTC collateralized derivatives have played an important role in BTC's price discovery.

BTC Futures Market - Share of Open Interest by Contract Margin

As bitcoin started to gain traction, demand for arenas to hedge and increase exposure arose. Exchange infrastructure inspired by the framework of the traditional finance scene was built, of course, with some disruptive innovations given the crypto sector's experimental nature. Initially, the derivative exchanges in crypto all utilized bitcoin as collateral for trades. Bitcoin was mainly used as collateral out of sheer convenience. Bitcoin became a convenient collateral in the derivative market for several reasons. First of all, the regulatory framework applied to the derivatives market is strict. This made it difficult, if not impossible, for new exchanges to offer derivative products using fiat currencies as collateral for trades. Secondly, the stablecoin market was relatively nascent and small by the time the first major derivative exchanges were built and started to gain traction. Third, bitcoin is a superb collateral for the exchanges. But why?

Bitcoin's fast, reliable, and global transaction infrastructure enables derivatives exchanges to expand globally at a rapid pace, as customers in every corner of the world are eligible and able to send collateral and start trading in mere minutes.
Bitcoin collateralized exchanges are the clearinghouse. The exchange itself acts as the clearinghouse and seize collateral when the counterparty defaults. The exchanges themselves decide the optimal maintenance margin threshold and automate the liquidation process while also building insurance funds to cope with extreme market movements.
By using bitcoin (or other crypto assets), the exchanges can offer trading products with far higher leverage than those of the regulated markets. While the higher tiers of leverage are extreme, and expected returns are more analogous with those of casinos, data from BitMEX clearly show that users are not shy to commit to trades with the highest tiers of leverage available.
Traders who don't want to have stablecoin exposure or sit with dollars have an option to put their bitcoin at work in leveraged trades.
The inverse nature of the bitcoin collateralized derivatives is ideal for shorting.

The Futures market

The BTC collateralized futures market has experienced strong growth since futures became more widely adopted between 2017 and 2018. However, throughout 2020, the BTC collateralized futures have lost massive market shares to its USD and stablecoin collateralized peers.In its essence, bitcoin collateralized futures exchanges work the following way: A trader post bitcoin as collateral and commits to a trade. If the counterparty defaults, the exchange act as a clearing house, seizing the position using auto-liquidation engines, stepping in to forcefully sell the trade in the market (if more collateral is not posted). Therefore, traders can decide to transfer additional collateral to the exchange and avoid liquidation. In other words, given Bitcoin's 24/7 up-time, traders can post more collateral at any time, if needed. Thus, traders can manage their margin balance in case the trade is about to become liquidated. Bitcoin-collateralized futures are inverse, meaning that the price is quoted in one currency, usually the dollar, and margined and settled in the base currency, bitcoin. Meaning that the traded contract is priced in USD but settled in BTC with the underlying contract being worth $1/BTCUSD, while the PnL calculations are priced in BTC.Trading on the futures exchanges is peer to peer. The counterparty is another trader, rather than the exchange itself. In a case of a massive, rapid price move, large numbers of bankruptcies may occur, resulting in a BTC deficit in the market. I.e., the funds are insufficient to cover the profits of the profitable traders. In this case, the deficit is proportionally distributed between the traders who made a profit that day. Meaning the traders get paid, but not the full amount. This process is called socialized losses. To prevent socialized losses, the derivatives exchanges have insurance funds. The insurance funds act as the last line of defense to prevent auto deleveraging. During normal volatility, the insurance fund is built up steadily by liquidating trades on the maintenance margin (0.5% of the margin). The open interest in the BTC collateralized futures market has trended upwards (when denominated in USD) ever since inception. As of Feb 3rd, around $6.7 billion worth of open interest was tied up in BTC collateralized futures trades. BTC Futures Market - Open Interest

Preview

In BTC terms, the open interest has fallen. It peaked at around 350,000 BTC on Feb 25th, 2020, and has since fallen to 182,606 BTC (as of Feb 3rd), while stablecoin and USD margined futures has taken large market shares.

Market composition: Bitcoin collateralized futures market

The bitcoin collateralized futures market blossomed during 2017 and 2018 and was then heavily dominated by BitMEX. In 2018, the trading volume of BitMEX surpassed the trading volume of the entire spot market. Now, there are many exchanges competing in the space, with OKEx being the largest exchange in terms of open interest in BTC collateralized futures.The bitcoin collateralized futures market is currently a space affiliated with fierce competition and many influential exchanges holding significant market share. The BTC collateralized futures market saw booming interest following the 2017 bull market, as traders sought to leverage their bitcoin to hedge and speculate amid the bear market. The market was then heavily dominated by BitMEX. The main reason behind BitMEX's dominance can be traced back to May 2016, when BitMEX launched the perpetual inverse swap contract (perp).The perp was an innovative derivative instrument. It shared most of the traits of traditional futures contracts while differentiating itself from futures contracts by not having an expiry date. By using funding rates, the perps maintain a close peg to the spot markets. This funding rate is the quintessential ingredient enabling the perps to trade without any expiry date. This quickly became a very popular derivative instrument in crypto, namely due to the convenience of not having to roll over any positions. According to a paper issued by Carol Alexander of University of Sussex Business School, the trading volume of BitMEX's perps surpassed those of the entire spot market in 2018, as illustrated in the chart below. Trading Volume of Different Bitcoin Products

Trading Volume of Different Bitcoin Products

Preview

The BitMEX dominance persisted for a while, but as exchanges saw the success of BitMEX's perpetual, they launched similar derivative instruments. Over time, this made the derivative scene more diverse, and throughout 2020 BitMEX lost its role as the market-leading BTC collateralized derivative platform, as visible in the chart below.BTC Collateralized Futures Market Dominance

BTC Collateralized Futures Market Dominance

Preview

On January 1st, 2020, BitMEX alone contributed to 58% of the open interest in the BTC collateralized futures market. By January 17th, 2021, BitMEX's dominance in the BTC collateralized futures market had declined to 15% of the total open interest for reasons we will discuss later in this report.Now, OKEx is the leading entity in the market, accounting for 25% of the total open interest. Interestingly, most of the open interest on OKEx is found in the futures contracts, whereas the perpetual contract has not really garnered the attention on OKEx as it has on other exchanges. Bybit has the largest BTC collateralized perpetual contract but does not offer any futures. Bybit holds 15% of the total open interest in the market. Huobi and Deribit offer both perps and futures on bitcoin and respectively contributes to 16% and 13% of the open interest in the BTC collateralized futures market.Binance is also a significant player in the BTC collateralized futures market, contributing to 14% of the total open interest. Yet, Binance's most popular derivative instrument, their linear perpetual swap, is collateralized in Tether. There are advantages of stablecoin-collateralized derivatives, and we will uncover them later in the discussion.FTX offers a vast amount of derivative instruments and is arguably the most innovative force in the derivative market. They allow traders to post bitcoin as collateral for their trades. However, they use a cross-collateralization model that leads the collateral to be converted to USD if the margin becomes insufficient. We, therefore, exclude them from the market composition. All the while, we both acknowledge their services, their usage of bitcoin collateral, and also their enormous growth over the last year.

Market sizing the bitcoin collateral held in the futures market

Our own calculations and estimations size the BTC collateral in the futures market to be somewhere between 18,200 and 60,000 BTC.The derivative market is relatively opaque. What we do know is the size of the open interest in the market. On February 3rd, 2021, the BTC collateralized futures market had a total of $6.7 billion worth of open interest or about 182 000 BTC. The open interest is not representative of the actual BTC held as collateral given that the futures markets are high leveraged. In order to estimate the size of the BTC collateral held by exchanges, we would either need to receive information from the derivative exchanges themselves on their AUM or the average leverage ratio of their positions in the market. Most exchanges were reluctant to disclose this information, so we're currently unable to conduct any precise information on the total collateral held on these exchanges. However, back in 2019, in a fresh breath of transparency, BitMEX published a blog on their leverage statistics from May 2018 to April 2019, disclosing the average leverage ratio of trades on the platform while also revealing the distribution of contracts held under various degrees of leverage.The reported weighted effective average leverage ratio trended between a whooping 15x-40x for the entire duration. However, a large bulk of the contracts traded on the platform were structured between 1-10x leverage. Given the maturing market and the lack of recent data, we will base our market sizing on a more conservative leverage ratio, and acknowledge that we might overstate the size of the collateral held on the derivative exchanges. Recently, Binance tweeted (and then later deleted) some stats that might indicate that these assumptions are too conservative.Below we've made a chart illustrating the amount of BTC held as collateral on the derivative exchanges under various leverage assumptions. Bitcoin Used as Collateral in the Futures Market (Various leverage assumptions)

Bitcoin Used as Collateral in the Futures Market

Preview

Given an assumed average leverage ratio across the BTC collateralized futures market of 5x (blue line), we find that around 36 500 BTC is currently used as collateral on the exchanges. Under higher average leverage ratios, such as 10x (red line), the amount of BTC held as collateral shrinks to 18 300 BTC. While an average leverage ratio of 3x (teal line) gives a collateral size of 60 869 BTC.

Collateral discussion

Stablecoin and USD collateralized futures have taken large market shares from BTC collateralized futures, and BTC collateralized futures now only account for 57% of the open interest in the futures market, compared to 86% on January 1st, 2020. As the derivative market in crypto has matured, more kinds of collateral have been introduced. With the launch of CME's BTC futures in December 2017, accredited investors could partake in leveraged bitcoin positions posting USD as margin (also settled in USD). Meanwhile, exchanges have also begun offering stablecoin-margined derivatives. The trend throughout 2020 has been that more traders have moved over to stablecoin and USD margined futures contracts, with bitcoin collateral losing major market shares the last year. This is illustrated in the chart below, showing that the total open interest of USD or stablecoin collateralized futures (teal) approaches the open interest of BTC collateralized futures. BTC collateralized futures now only account for 57% of the market.BTC Futures Market: Share of Open Interest by Contract Margin

Preview

Several forces have driven these developments. The catalyst has been BitMEX's fall from grace, with the main drivers being the "Bloody Thursday" March 12th crash and the October 1st CFTC charges on BitMEX. The March 12th crash impacted the leveraged long positions, as it led to a cascading of liquidations dragging bitcoin down $8 000 to $3 800 in the course of 24 hours. The crash ended as BitMEX went down for maintenance. Following this crash, the bitter consequences of over-leveraged trades became clear, and the derivative market's open interest took a hard hit. In addition to that, BitMEX's reputation was also impacted, and by examining the open interest in the market as a whole, it becomes clear that many traders moved from BitMEX's perpetual to other markets. Many of which use stablecoin as margin.On October 1st, BitMEX took another heavy hit as the CFTC charged the exchange for illegally operating a cryptocurrency derivatives platform and anti-money laundering violations. This led to a large outflow from BitMEX over to other competitors – at large to Binance. In addition, it led more exchanges implementing stricter KYC-procedures to avoid the same faith that struck BitMEX. The chart below illustrates the impact of these two events and how USD and stablecoin margined futures now contribute to a significant amount of the open interest in the futures market of $13 billion.BTC Futures Market - Open Interest

BTC Futures Market - Open Interest bitmex

Preview

The reasoning behind the movement of funds from BitMEX to stablecoin margined derivatives products could be coincidental, but there are several arguments as to why stablecoin-margined futures might be a better instrument than bitcoin-margined futures for leveraged crypto exposure.

Linear contracts

Firstly, the stablecoin-margined contracts are linear, meaning that exposure is constant, whereas the bitcoin-margined contracts are inverse. In a case where the trader enters a long position on an inverse contract and the bitcoin price declines, the underlying collateral for the trade will depreciate alongside the long position itself. As the value of the collateral declines, the risk of liquidation increases, meaning leveraged long trades on the inverse perpetuals are even more dangerous when collateralized in bitcoin than with stablecoins. The convexity of BTC margined contracts is unfavorable for longs.

Absolute dollar return

Secondly, stablecoin margined perpetuals are used more for absolute dollar return, than they are for hedging market exposure, meaning they are more frequently used by speculators and arbitrageurs.

Less complex

Thirdly, stablecoin-collateralized derivatives on altcoins are less complex than bitcoin-collateralized derivatives. Bitcoin collateralized derivatives on altcoin pairs are often solved by constructing quanto derivatives. They are collateralized and settled in BTC, but the underlying pair does not involve BTC. Meaning, that if a trader longs an ETHUSD quanto derivative, and ETHUSD goes up, while BTCUSD goes down, the trader realizes a BTC gain, but BTCUSD dropped, and in the end, her USD gain is much lower. Quanto contracts are thus more complex as they involve more variables, while stablecoin-collateralized trades are more straight-forward.These nuances could explain the 2020 trend of the market moving towards linear futures, highlighting that there clearly are some disadvantages to using bitcoin as collateral on derivatives. This has prompted both BitMEX and Deribit to seek to add new margin assets to their exchanges in 2021.

“The focus for 2021 is on delivering the new products and features our growing client base has been asking for, including support for additional margin assets, expanding the list of contracts we offer, and integrating more closely with the infrastructure and services that have become core to the industry.” — Ben Radclyffe, Commercial Director at 100x Group

“In line with several of our peers we are preparing the introduction of stablecoin margined products, final introduction date to be confirmed.” — Luuk Strijers, CCO Deribit

Yet, while stablecoins have some advantages compared to BTC as derivative collateral assets, the picture is not all black and white.

Inverse futures are ideal for hedging

The inverse payoff carries some advantages, especially for those who seek to hedge. A 1x leveraged short position on a bitcoin-collateralized future contract is a way for investors to hedge their USD value, in effect entering into a synthetic USD. Say a trader holds an account balance of 1 BTC, and the current bitcoin price is $30 000. If the trader wishes to hedge her position, she enters a short position of $30 000 dollars. Her account will maintain its USD value of $30 000, no matter which way the price moves. If she enters this hedge on the perpetual contract, the trader will be exposed to the funding rate of the perpetual. The funding rates vary. The annualized funding rate in 2017 was at 65.9%, while the annualized funding rate in 2018 was -7.6%. In 2019 the annualized funding was once again positive of 7%. A negative funding rate of -7.6% means that hedging using the inverse perpetuals during the bear market of 2018 came at a cost. In addition, the convexity of the inverse contracts enables shorts to make more BTC as the price falls, and lose less and less as the price rises. Hedgers using CME or stablecoin margined contracts have a fixed BTC exposure regardless of the price, as the USD exposure varies linearly with respect to price.

Bitcoin exposure

Also, bitcoin purchased to hedge a short CME position cannot be used as collateral. This presents some challenges for hedgers who hold physical bitcoin, and market makers who must divide capital between derivatives and spot markets with no cross-collateral relief.

No counterparty risk

Stablecoin exposure involves counterparty risk. Currently, there is one key event that might influence the stablecoin markets.Several lawmakers have introduced the STABLE act. This bill seeks to amend the Federal Deposit Insurance Act to provide for the classification and regulation of stablecoins.As proposed, this bill will impact the stablecoin sector. Any stablecoin issuer would need to obtain a banking charter and be in full compliance of existing banking regulations. Any stablecoin issuer would be required to obtain the approval of both the Federal Reserve and Federal Deposit Insurance Corporation six months before issuance, and stablecoin issuers would either need to obtain FDIC insurance or deposit dollar reserves directly at the federal reserve. This legislation is still pending, and the U.S. congress has not passed any substantive legislations on blockchain and crypto bills throughout 2020. But, if the STABLE act were to be realized, the implications would likely be huge and lead the market share of the BTC collateralized derivative instruments in the unregulated derivatives market to grow.