Bitcoin and other crypto assets are normally always thinly traded due to all the talk about liquidity. Therefore, it is always difficult for investors that buy and sell large volumes to do it directly without any slippage, or even a change in price between the order and execution.
They normally turn to over-the-counter (OTC) desks to help them manage those trades; whether they are buying for the first time or just trading to generate alpha, which are normally known as above-market returns.
Due to this, these desks handle figures from 30 to 65 percent of the total crypto market, although it depends on the estimate that you believe.
There are tremendous temporary risks which OTC desks take. Traders like Yin and Martin normally have the responsibility of managing the risk by moving large amounts quickly and then offsetting on derivatives markets which includes Huobi, BitMEX, Bakkt, OKEx, and CME Bitcoin Futures. This is according to a report by CoinDesk.
Due to this, these two traders are among the most sophisticated on crypto derivatives exchanges. Below, they provide a few insights during their long-hour conversation with CoinDesk.
The Mentality of Investors Has Shifted
Since the early days of crypto, the mentality of investors has greatly shifted from venture-like to hedge-fund like.
“There’s a lot more velocity amongst the traders that are out there, whereas in the early days it was very much more a buy-and-hold” strategy, Martin said. “People these days understand that this market is super volatile and a lot of the different crypto funds and people that are out there, they are trying to add alpha for their shareholders.”
The Spot Market is Moved by the Derivatives Markets
What you first need to know is that derivatives exchanges is the one that begins the market moves, and this is more often than on spot exchanges.
“Because there are so many trading venues, it’s a constant question of, where is the action starting?” Yin said. “Often it’s starting on derivatives exchanges because that’s where a lot of people have connections and that’s where a lot of the most highly levered bets are taking place.”
“Crypto already is a fairly random, volatile walk in terms of price action and the collection of these derivatives and the exchanges that list them effectively act as leverage on top of that,” he went on. “Whenever you start to make a move, there’s a good chance it will get exacerbated because of the amount of open bets that are out there.”
One is an isolated example such as the May 17 flash crash. A small amount on spot markets can trigger a very large move on the offshore derivatives markets, specifically BitMEX, and this allows traders to manipulate the spot price to favor their derivatives markets position.
In theory, that is definitely possible on crypto derivatives markets that are regulated such as CME’s, but it is more costly and hard due to the high leverage. Therefore, that is not the only way the derivatives markets can fail.
“Where things tend to break down a bit and you get a lot more slippage is when you’ve simply exhausted everybody’s ability to really use the derivatives instruments to hedge, so whether that’s the amount of collateral that everyone’s posted is insufficient, or the market conditions are such that you really can’t get access to some of these platforms,” Yin said.
The Derivatives Markets is Dominated by Two Products
The perpetual swap is the most popular product and was reputedly invented by BitMEX. The close second to this is the Crypto Futures.
Various OTC desks are able to provide custom derivatives products and swaps which include contracts for difference, although those two products have managed to dominate the market volume so far.
There are Bitcoin options which are emerging. However, they still remain a small percentage of the overall volume. Providers like CME and Bakkt have made announcements to bring options on Bitcoin futures in the markets, the traders Martin and Yin said that these may be quite attractive for large investors that are entering crypto and also investors looking for a hedge against a big downside in a volatile market.
“I think it means there are more sophisticated hedging strategies. It allows people to be more comfortable with spot exposure, if it can be more easily hedged out,” Martin said. “These markets move really quickly and a lot of the bigger places that want to start trading, there’s a significant amount of headline risk attached to this. How do they protect against the crazy downside move? Options may very well help eliminate some of those risks for them.”