Investing in cryptocurrencies isn’t for the faint-hearted, and tackling the market with complex instruments such as derivatives is an even tougher challenge.
While not available to all investors, derivatives products have been rising in popularity with experienced traders and firms seeking to access crypto without being heavily exposed to volatile prices.
As the US Securities and Exchange Commission inches closer to a final decision on several proposals for bitcoin-linked exchange traded funds, the hype around derivatives is growing.
Juthica Chou, head of over-the-counter derivatives at crypto exchange Kraken and a former Goldman Sachs trader, gave Financial News the lowdown on the growing market on the Barron’s Live podcast.
Q: Can you explain how crypto derivatives work and why people are interested?
Crypto isn’t completely reinventing the wheel — we take products that exist in the traditional world and repurpose them, redeveloping the infrastructure for crypto-native use cases. The primary ones that folks trade are perpetual swaps and futures, which are linear products to get exposure to an asset, traded by everyone from retail investors and high-net-worth individuals to funds and larger hedge funds.
Oftentimes it’s just to get exposure and treat it as a diversifying asset that they want to take some position in, and sometimes they would rather do it in a derivative than in the spot market. When it comes to crypto custody there are complexities that come with that, and so sometimes a derivative is more favourable — in the same way it might be more favourable to take a position in a gold derivative or ETF, rather than physical gold.
The other set of derivatives that we have are convexity instruments like options which also exist in the traditional world, and we see folks use them for hedging purposes that are very similar to traditional commodities.
On top of that you have a whole host of companies that are developing infrastructure and use cases to enable broader use of bitcoin and cryptocurrencies, and in doing so they often warehouse risk on their balance sheet and they need hedging instruments. Sometimes they choose yield-generating instruments, sometimes they go for outright hedges and whatever the most liquid product is, but a lot of the use cases are really for hedging and speculating.
Q: Derivatives are one of the rare parts of crypto that are heavily regulated but they’re also the most complex and are banned for retail investors in the UK. Why do you think this is?
I think it’s not derivatives per se, it’s what happens in crypto. When you trade derivatives and crypto on an exchange, the exchange often functions as the matching engine, the clearing house, the prime broker, the custodian, the API, the user interface, everything in one unified platform which makes for a great customer experience compared to going through all the intermediaries that exist in the traditional financial infrastructure. But because of that, sometimes when people look at something like derivatives, they conflate a lot of the different elements.
If you look at what regulators are really taking issue with, it’s not the existence of derivatives products per se, it’s the level of leverage and margin available in many of those products. There’s not as much now, but there were exchanges that were offering 100-to-one leverage and I think a lot of that was for marketing and PR. Functionally if you looked at the large trading shops, nobody was getting even close to that level of leverage.
Q: If crypto adoption continues to rise, will derivatives become more popular? How will this market mature?
I think derivatives have already reached a critical mass where they’ll remain as popular as they are now. One of the similarities to the traditional markets is that in a lot of cases, the price discovery is taking place in the derivatives market where you get a wide range of participants. That makes them the most liquid and the most fungible, so when people want to look at where the price movements are happening first, it’s usually in the derivatives markets before the spot markets.
Once you have that dynamic, it tends to feed off itself because then people will come in and trade the derivatives. We’ll definitely see derivatives remain extremely popular, but in terms of particular products, that’s where we might over time see more of a shift towards options. As volatility comes down it enables other products to be built on top of these derivatives — an ETF for example is a little bit easier when you don’t have very large discrepancies and price movements, and you can rebalance more easily.
Q: In 2013 you co-founded LedgerX, the first firm in the US approved to offer crypto derivatives. You had to convince regulators this was a business they could support. What was that like?
It was very early when we founded LedgerX and really for the first year or two, we just spent time with regulators and the Commodity Futures Trading Commission on the question of jurisdiction: whether bitcoin is a commodity, and where it falls within US derivatives. I think we were very fortunate that the CFTC agreed with us that it fell into that regime and that they were fairly proactive in terms of taking a stance that bitcoin and ethereum are commodities and do fall into commodity derivatives.
That’s something that is extremely valuable when you’re a startup because if you’re trying to operate with opaque or unclear uncertain regulations, it’s very difficult to calculate. You’re already a moving target, you’re trying to hit these other moving targets, and you don’t know if something’s going to change in a couple of years that would render your business not viable. We were really fortunate that the CFTC took that stance and because of that today, the US derivatives space has one of the most clear regulatory regimes in terms of providing a clear path.
Q: LedgerX has just been acquired by major crypto exchange FTX, and bigger players means that the derivatives space is about to get a lot more crowded. Do you think there are any risks to having more businesses get into this market?
For derivatives, they’re not just zero sum games where there’s a winner and a loser. Broader access to those products is really important, and it’s really good for the space. I wouldn’t be surprised if we continue to see more M&A activity — it’s a very natural and sensible play for exchanges that want to get into derivatives, particularly in areas where there is a regulatory hurdle to launch a service platform.
Q: How do you think US regulation of crypto is progressing, particularly as companies like Coinbase are starting to make a lot of noise about the rules?
Regulation of derivatives is fairly clear. On the Securities and Exchange Commission’s side, it’s evolving but crypto is evolving much faster. In 2021 we’re still seeing lawsuits or issues coming up about initial coin offerings from four years ago — since then, we’ve had all the growth in decentralised finance, we have NFTs. It’s a difficult environment for regulators and it’s a difficult environment for companies, because there’s just no clarity.
That’s the dialogue that a lot of folks are pushing for, particularly from the SEC, and I think now that Coinbase has been publicly wanting that same sort of dialogue and guidance from regulators, I think we’ll probably see a bigger push along those lines.
Q: Why are crypto derivatives viewed as risky for platforms and banks to offer?
At the end of the day, there’s no help coming for these crypto platforms. There’s no bailouts, there’s no insurance funds, and everyone’s on their own to make sure that they have prudent risk management so that they can stay in the game and build a lasting company. Because of that, I think the incentives actually favour these platforms to be rooted and careful in a way that perhaps the traditional incentives do not, because of the external support that exists to save the day.
Q: Do you think that regulators will ever take a proactive approach towards helping crypto platforms manage their risk efficiently?
In the crypto space, it’s been built from scratch out of necessity. Part of the crypto ethos is personal responsibility, and so it’s been built to put the responsibility on the folks who are developing and maintaining these platforms.
Ultimately it is the private sector that has to drive the innovation and design of what is going to serve retail investors while providing the appropriate protections, and then the regulators might say, ‘yes you can do that’ or ‘no you can’t’. I don’t think the regulators have ever been prescriptive, and it’s not really in their DNA to be more aggressive than they have to be.
To the extent that these are hedging instruments, derivatives can be used fairly conservatively to allow retail investors to hold their position and maybe earn some yield. Those are things that do benefit retail investors over time, helping them to save in a prudent way while investing in a new asset class. Over the long term, a ban on retail investors will really be a disservice to them when compared to larger folks who do get access.
At the end of the day, if we offer financial instruments and they’re all only available to institutions, then what have we really done to democratise access to any of these financial services?
To contact the author of this story with feedback or news, email Emily Nicolle