Research on the Cryptocurrency Derivatives Market (I) - What are Blockchain Derivatives?

introduction

As the price of digital currency has soared from the low point at the beginning of the year to the sky in the summer, and has recently gradually declined amid fluctuations, the market volatility that has experienced "big winds and waves" is stronger than other investment targets of the same period. Although the recent trading volume and price have gradually declined, and the decline in the price of the currency has made the public doubtful about the future of digital currency, a large number of investors in the market still like the high volatility of the digital currency market. It is precisely because of this high volatility that the arbitrage opportunities and investment risks are magnified , which has attracted a large number of investors to enter the spot market of digital currency. In order to attract more players and funds, the exchange has designed a variety of financial derivatives based on digital currency, which also meet the risk investment preferences of some investors who want to pursue extreme arbitrage .

Starting from this article, I will continue to research and analyze the derivatives market of digital currencies . Starting from the essence of the derivatives industry, I will try my best to discuss the basic gameplay of the industry’s main products, major exchanges, business models, and other aspects that need attention.

1. Overview of the derivatives market

The China Banking Regulatory Commission defines “derivatives” as follows: “A derivative is a financial contract whose value depends on one or more underlying assets or indices. The underlying types of contracts include forwards, futures, swaps, and options. Derivatives also include structured financial instruments that have one or more features of forwards, futures, swaps, and options.”

The above explanation is too academic. For commodity transactions in daily life, our first goal is practicality, rather than considering its risks, value, etc. However, for commodity dealers in the market, such as fruit, vegetable, and grain merchants, they have to bear the price volatility of commodities in different seasons and at different times during the transaction process. In order to reduce this risk, commodity contracts for a certain period of time in the future are derived from ordinary buying and selling transactions. Dealers control price risks and manufacturers ensure commodity sales.

The derivatives markets we will discuss below are all aimed at financial product markets.

1.1 Financial Derivatives Market

From the regular fairs of medieval merchants to the "Tulip Bubble" craze in the 17th century, when merchants bought tulips at an agreed price, to the current market of options, futures and other derivatives that meet various needs, after several centuries of development, the financial derivatives market has become one of the most popular financial products. Financial derivatives can be divided into five categories according to their own and contractual characteristics: forwards, futures, options, swaps and structured financial derivatives . Their value depends on one or more underlying assets, which are usually called contract underlying assets.

Here is a brief introduction to these types of derivatives: Forward: refers to a contract where the two parties agree to buy or sell a certain amount of a certain contract underlying asset at an agreed price at a certain time in the future. Futures: refers to a contract signed by the two parties to buy or sell a certain contract underlying asset at a certain price at a certain time in the future. Options: refers to a contract that gives the option buyer the right to buy or sell a certain amount of a certain financial asset at a price agreed by both parties within a specified period of time. Swap: A swap is a contract between the two parties to exchange cash flows that they believe to have equal economic value within a certain period of time in the future.

Since its inception, financial derivatives have been considered an effective tool to reduce market economic risks and stabilize international trade exchange rate risks. Its value is based on a variety of underlying assets such as exchange rates, interest rates, commodities, credit and stocks. With the change of investors' risk preferences and speculative demand, the development of the financial derivatives market is accelerating, with a wide variety of products, market segmentation, and rapid growth in transaction volume. According to data from the Bank for International Settlements, the total size of the global financial derivatives market in recent years is about 600 trillion US dollars, while the current spot market accounts for only about 12 % of the derivatives market . If over-the-counter derivatives are included, the overall size is likely to reach 200 trillion US dollars . It can be seen that the financial derivatives market is important to the overall financial market.

1.2 The Nature of Financial Derivatives

To think about the nature of financial derivatives, we first start from the basic characteristics of derivatives, including cross-period, leverage, linkage, uncertainty, high risk, hedging and speculation.

1. Cross-period and linkage:

Financial derivatives are contracts where the two parties agree to trade or choose whether to trade at a certain time in the future based on the prediction of the trend of interest rates, exchange rates, stock prices and other factors. The characteristics of cross-period transactions are very prominent. The value of derivatives is closely linked to the underlying product or underlying variable and changes regularly. Usually, the payment characteristics of this connection are stipulated in the derivative contract.

2. Leverage and high risk:

Financial derivatives transactions generally require only a small amount of margin or premium to sign a large forward contract or swap different financial instruments. The consequences of derivatives transactions depend on the accuracy of the trader's prediction and judgment of the future price (value) of the underlying instrument (variable). The unpredictable price of the underlying instrument determines the instability of the profit and loss of financial derivatives transactions.

3. Hedging risks and preserving value:

The use of financial derivatives can effectively avoid the risks brought about by drastic price fluctuations and is an effective risk management tool. Hedging allows companies to prevent the risk of spot prices falling at the time of delivery. Risks can be hedged by trading contracts equivalent to the spot quantity in the futures market.

4. Speculative:

Derivatives are a type of contract where one party (usually the buyer) can avoid risk through trading. So what is the role of the other party? The other party gains income by selling derivative contracts, while taking risks. The seller of derivatives trading earns income from selling derivatives by taking risks, which is a speculative behavior.

Due to the characteristics of financial derivatives, the most sensitive essence for traders is: risk hedging + speculation

Due to its characteristics, the speculative function of derivatives has been infinitely magnified, turning from an angel to a devil. Transactions have increasingly deviated from risk aversion and moved toward pure speculative gambling . The trading model has also been artificially designed to be more and more complex. The complex trading model, catalyzed by greed and fraud, has turned financial derivatives into weapons of mass destruction, causing harm to companies and markets. For example, the financial crisis in 2008 was destroyed by CDS derived from loan contracts between banks and housing loan customers.

1.3 Blockchain Derivatives Market

Since the advent of Bitcoin, blockchain technology has brought a large number of digital currencies, and derivatives based on digital currencies have gradually been invented and used by traders. Digital currency derivatives are the same as financial derivatives . The underlying assets are digital currencies or indices, which are derivatives related to digital assets. Financial derivatives can include digital currency derivatives, so all the characteristics of financial derivatives are applicable. In addition, it should be noted that the margin trading method only requires a certain percentage of margin to conduct full transactions, and does not require actual principal transfer. It is carried out by cash spread settlement, and the transaction has a leverage effect.

The current digital currency derivatives market is mainly divided into two categories: options and futures. Futures contract products are similar to traditional derivatives contracts and are generally available in all exchanges. There is a settlement and delivery time, which is divided into weekly, monthly, quarterly and other automatic delivery upon maturity. This contract can hedge and predict market risks and also play a hedging role.

However, the design of digital currency derivatives market products has the risk of being a "gambling tool". First, for ordinary futures contracts, some platforms support up to 100 times futures leverage. The high volatility of digital currency spot has far exceeded that of traditional financial markets. 100 times leverage will undoubtedly turn high volatility into "violent" volatility, and the risk of liquidation is extremely high. Secondly , the exchange has also designed a "perpetual contract", which, as the name suggests, is a futures contract that will not be delivered. Although it can lower the entry threshold for investors, increase market activity, and make it more convenient for investment institutions to enter the market, it has cut off the time limit and lost the essence of hedging risks. It is more like a "gambling tool" based on margin, and the possibility of liquidation and loss is relatively high.

Options contracts are relatively niche, mainly giving the holder the right, but not the obligation, to buy or sell an asset at a specific price on a specific date in the future. Only a few trading platforms support them.

1.4 Comparison of derivatives markets

1. In the futures contract settlement , except for Bakkt futures contracts, which are settled in kind, all others are settled in cash. The biggest problem with cash settlement is that it affects the circulation and demand of digital currencies in the market. In traditional commodity futures, all physical delivery is adopted. Although physical delivery accounts for a small proportion of the entire derivatives market, it is physical delivery and this potential possibility that makes the futures price changes synchronized with the related spot price changes, and gradually approach as the contract expiration date approaches.

2. The correlation is not strong . The correlation between the spot market and the derivatives market is relatively poor, so the role of using funds from the derivatives market to hedge risks is weakened.

3. The hedging effect of digital assets is weakened . Due to the high liquidity of assets and the lack of regular spot trading demand, the hedging demand is very low.

4. The risk is greater than that of traditional asset derivatives . The underlying assets of most derivatives are highly volatile. The high leverage tools make derivatives more volatile. The high volatility brings high risks, and the problems of margin calls and short positions are serious.

5. At present, investors in digital asset derivatives are mainly individuals and retail investors , while in the traditional derivatives market, institutional investors account for a large proportion.

II. Blockchain Derivatives Market Regulation

2.1. Current supervision

The development of the digital currency derivatives market is inseparable from the gradual growth of exchanges, and the key to the development of each exchange itself lies in the legality and compliance under the market supervision of each region. The regulatory attitude of each country towards exchanges determines the survival conditions of digital currency exchanges.

USA

First, let’s talk about the U.S. Securities and Exchange Commission (SEC), which is the most concerned in the industry. Up to now, the attitude of SEC remains the same as before. No B TC ’s E TF will be allowed to pass , and all submitted applications have fallen into the sea.

The Commodity Futures Trading Commission (CFTC) of the United States changed its chairman in July this year. In recent statements, the chairman reiterated the positioning of Bitcoin as a commodity . On this basis, the recognition of Ethereum is the same , and the classification of each token depends mainly on how the token is made. Bakkt launched Bitcoin options on December 10, which is the first Bitcoin option derivative approved by the CFTC. The Chicago Mercantile Exchange (CME) launched Bitcoin futures trading at the end of 2017 and authorized LedgeerX's digital asset derivatives clearing agency. The exchange not only needs to register with the above two institutions, but also needs to register with the New York State Department of Financial Services and the Financial Crimes Enforcement Network. These four institutions supervise and review the exchange. In general, the United States is open to this market under a more mature regulatory system.

European Union

The European Securities and Markets Authority (ESMA), the counterpart of the EU's financial regulator, has issued a report requiring exchanges to provide evidence of CFDs in the name of protecting investors. The EU's regulatory direction is mainly focused on the use of digital assets for money laundering, mainly in the fifth anti-money laundering bill issued by the EU, which clearly includes such exchanges in the scope of regulation. Recently, the statements of EU officials have focused on the EU's formulation of rules for the management of digital assets, and it can be expected that the regulation and supervision of exchanges will be further upgraded in the future.

South Korea

South Korean regulators completely banned Bitcoin derivatives at the end of 2017, but the supervision of exchanges mainly focuses on real-name registration, tax collection, ICO supervision, etc.

Japan

The Financial Services Agency of Japan has established a special digital asset monitoring agency, which is responsible for issuing operating licenses to exchanges. It has also set up a self-regulatory agency, the Japan Virtual Currency Exchange Association, to focus on supervising certain exchanges.

Singapore

The Monetary Authority of Singapore, as a regulatory body, has issued the "Guidelines on the Issuance of Digital Tokens", which stipulate that exchanges operate under existing laws and regulations of the Securities and Futures Act.

China

Clearance.

2.2 Uncertainty Analysis

1. Regulatory policies

As can be seen from 2.1, looking at the digital currency derivatives trading market in the world, a small number of countries have established corresponding digital currency regulatory departments through the efforts of various regulatory agencies in the past two years, forming a relatively complete regulatory system to manage the digital currency market in a legal and compliant manner. However, most countries have not yet formed clear and effective regulatory laws and regulations , and can only rely on individual cases to make judgments, and regulatory organizations are in the stage of legal proposal and formulation.

Due to the large differences in regulatory concepts, policies, and progress among countries, the impact on the digital currency derivatives market is relatively large, and the risks and uncertainties for both parties to the transaction are relatively high .

2. Unified rules

The biggest victim of the lack of regulatory agencies is actually the lack of protection for investors’ interests . Exchanges take advantage of the cross-regional nature of blockchain technology, so most trading platforms choose to register in offshore financial centers. Although investors can trade on any platform in different regions, due to the lack of a unified and fair rule framework in the industry and the different regulatory laws in different countries, investors’ rights cannot be legally protected. Derivatives trading is accompanied by high risks, and the low entry threshold makes it easier for both parties to default. Fraud and runaway teams are mixed in, which has a great impact on the healthy development of the industry.

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