Cryptocurrencies: The Future of Futures?

Many traders entering the cryptocurrency market from the traditional financial industry may consider derivatives as a means of price speculation and hedging. There are many options when it comes to exchanges and instruments; However, traders should consider some of the key differences between crypto futures and traditional futures contracts before diving into this fast growing market.

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Different tools

Traders who import cryptocurrencies from traditional markets will be familiar with futures contracts with fixed expiration dates. While fixed-term contracts can be found in the cryptocurrency market, a significant percentage of crypto futures trading takes place in perpetual contracts, also known as swaps. This variant of the futures contract has no fixed end date, which means that the trader can hold the position open indefinitely.

Exchanges that offer open-ended contracts use a mechanism known as the funding ratio to regularly equalize the price difference between the contract market and the spot price. If the financing rate is positive, the price of the open-ended contract is higher than the spot rate – long pay short. On the contrary, a negative funding rate means a short time to pay in the long term.

Additionally, traders moving to cryptocurrencies from traditional finance may be familiar with the portability of their positions across different exchanges. In contrast, cryptocurrency exchanges often act as walled gardens, which means it is not possible to transfer derivative contracts across platforms.

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Regulated and unregulated trading platforms

Most of the trades in crypto futures – around 85 to 90% – remain unmanaged. This situation is mainly due to the rising market for crypto futures while regulators are still grappling with more fundamental questions about the legal status of digital assets. BitMEX paved the way for trading crypto futures using coin collateral and margin contracts. In this way, the company has avoided government requirements related to Fiat on slopes. There are currently around a dozen large trading platforms, but only a small number have achieved regulated status.

Both the Chicago Mercantile Exchange (CME) and Bakkt are regulated by the US Commodity Futures Trading Commission (CFTC). In Europe, Kraken Futures operates under a multilateral trading system license issued by the UK Financial Conduct Authority. In Switzerland, Vontobel and Leonteq offer mini Bitcoin futures contracts on the SIX Swiss Exchange.

The regulatory situation can prevent traders in some countries from trading in unregulated locations. This is especially true in the US, where exchanges find that the CFTC is currently prosecuting BitMEX for violating anti-money laundering and banking secrecy regulations.

However, the US-regulated crypto futures platforms have expanded their range of instruments beyond pure Bitcoin (BTC) futures and may thus be able to meet the growing demand. For example, CME has recently expanded beyond Bitcoin futures and options offering Ether (ETH) futures. In addition, Bakkt also offers monthly Bitcoin futures and options.

Unregulated platforms offer futures and perpetual swaps with a wider range of altcoins, but only for traders in countries where they are approved. In any case, most of the liquidity is focused on BTC and ETH futures, at least for now.

Importance of operation

The different regulatory contexts, combined with the way perpetual contracts are managed, lead to some practical differences between crypto futures and traditional futures. In the absence of a central counterparty clearing system, exchanges carry a high level of risk, in particular many offer high leverage of up to 125x. As a result, the lost positions that reach the Sustain Margin will be liquidated.

Exchanges typically flow all liquidation profits into an insurance fund that protects traders’ profits when their counterparty does not have enough margin to cover them. The presence and relative health of an insurance fund is an important factor to consider when using an unregulated exchange. If there is no fund or if the fund becomes too small to cover liquidation losses, profitable traders run the risk that their positions will be “automatically deleted on average” by the exchange.

Another important operational issue is replacement downtime. Many unregulated platforms are notorious for server crashes during periods of high volatility, which means that traders cannot close their positions before liquidating them. Therefore, before opening an account, you should research the platform downtime history.

Low entry barrier

Cryptocurrency futures markets typically have very low barriers to entry. A trader can open an account, go through the “Know Your Customer” process, make a deposit and start trading within minutes.

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

However, blockchain offers significant potential to transform the futures market through the tokenization of assets beyond cryptocurrencies. Let’s say futures contracts for Nasdaq-100 or S&P 500 are made available as tokens. In this case, it can be traded in small chunks, lowering barriers to entry and introducing new sources of liquidity into traditional markets.

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Such a scenario could be beneficial for those looking to diversify their portfolio more granularly, which is currently only possible through Contracts for Difference (CFDs). While they play a similar role in the financial markets, CFDs are only available through brokers, reducing transparency for traders. In addition, the available liquidity in the broader markets has been fragmented.

Despite its rapid growth, the crypto futures market is still in its infancy, especially as institutional inflows into cryptocurrencies are only just beginning. As the market moves and evolves, we will likely see new and more sophisticated tools emerge, blurring some of the lines between traditional and digital finance. In addition, it looks like the regulatory situation will continue to develop as the inflow of money increases. One thing is certain: crypto futures have a long future ahead of them.