Spot markets are still the dominant force in Bitcoin, but derivatives are slowly becoming a power as well. As more speculators enter the Bitcoin market, derivatives will take off and overpower the price discovery mechanisms of the spot market – be it direct or indirect. With derivatives booming and crypto on the verge of a new cycle, looking at how derivatives affect the market is imperative.

Speculate Efficiently, Settle Dynamically

Futures, options, swaps: whatever is your pick of derivatives poison, they all have a significant effect on markets. Cryptocurrencies are no different. Derivatives are a capital-efficient way to create exposure to a certain asset or hedge against exposure. 

In particular, futures and options tend to be the most liquid markets for quite contrasting reasons. Futures are standardized products that trade on singular terms while options offer flexibility in terms of execution price (strike price) and expiry of contracts.

Derivatives have hit an incredibly high threshold in cryptocurrency during 2019. Options seem to be on everyone’s tongue in 2019 and futures and swaps have already taken off. Derivatives markets offer insight into how speculators in the market are thinking.

For example, looking at Bitcoin options on Deribit, Mar. 2020 options have more contracts (open interest) than May 2020. This means options speculators are expecting something major to happen in March, and are not too worried about the halving event in May.

Another important aspect is how settlement plays out. Cash-settled derivatives are paid out in dollars, while physically-settled ones are paid out in Bitcoin. Physically-settled derivatives have higher implications on market dynamics because when they are settled, it has a significant effect on the spot market. 

In order to get 10 BTC of exposure to spot markets, one would need a capital of close to $100,000 now. But, if an investor decided to gain 10 BTC worth of exposure through a Mar. 2020 call option of strike price $10,000, it would cost approximately $8,300 at a prevailing premium price of $830.

Options and futures took off because people, more like “institutions”, realized they could get more upside for less capital, allowing them to deploy their capital elsewhere. In fact, this was the main use case for leverage before degenerate traders took over Wall Street.

As a result of all of this, derivatives markets gain traction and account for a major portion of each asset’s price discovery. Physically-settled derivatives influence price action depending on the state of a particular set of contracts on the day of expiry or settlement. 

We believe in the future, derivatives settlement will create the same volatility effect on the Bitcoin price and the spot Bitcoin market. Not just Bitcoin, actually, the entire crypto market. 

The institutionalization of financial markets was monopolized thanks to derivatives. Capital efficiency and dynamic settlement were at the heart of this issue. The same is inevitable for crypto. While institutions may not be able to capture Bitcoin and other decentralized networks, they sure can create a heavy influence on orderbook prices.