Jump Crypto: 2022 will be the year of crypto derivatives
The decentralized derivatives market is on the brink of tremendous growth.Original Author: Shanav K Mehta
Translation by: Block unicorn
Despite the growing trading volume in the crypto derivatives market, the tools and infrastructure in this market are relatively immature compared to traditional financial markets. Given the level and quality of infrastructure development over the past year, along with the increasing participation of institutions, we believe that 2022 will be a year of breakthrough growth for crypto derivatives, accompanied by a more mature market.
In this article, we will discuss the current state of the market, the key infrastructure developments we believe will drive growth, and the areas where we expect to see this growth.
Overview
Today, crypto futures and options ("F&O") account for 57% of the total monthly trading volume. While this trading volume is generally healthy, we can measure the maturity of the market by the relative distribution of trading volume across different tools and venues.
Most of today's trading volume is concentrated in centralized perpetual futures exchanges, while options and related tools remain relatively new. As a benchmark, the trading volume of crypto options as a percentage of spot is about 2%; in the U.S. stock market, this figure is approximately 35 times higher.
Additionally, the decentralized derivatives market for futures and options is significantly underdeveloped compared to centralized counterparts. The following chart illustrates this relative market concentration.
We expect that two sets of factors will further drive the growth of crypto derivatives trading volume in 2022: 1) the rise of relevant infrastructure, and 2) increased institutional participation. A valuable exercise to better understand the latter is to comprehend why TradFi institutions use derivatives more extensively than the stock market. This can largely be attributed to four reasons:
1. Capital Efficiency: Margin trading is capital efficient as long as the potential drawdown percentage is lower than the leverage ratio.
2. Tax Efficiency: In the U.S., 60% of the profits from derivative contracts are taxed as long-term capital gains, regardless of the contract duration; in contrast, spot positions must be held for at least one year to qualify as long-term capital gains.
3. Hedging: Derivatives allow institutions to maintain long cash exposure while temporarily hedging.
4. Higher Liquidity: The derivatives market is more efficient for market makers to enter and exit, making these markets more liquid.
2021 witnessed the development of key infrastructure to better support and guide institutional liquidity (more details below), along with an increasing organic interest from institutions in participating in the crypto market. Naturally, increased institutional participation will reduce relative volatility, making derivatives trading more capital efficient.
Furthermore, as more institutions hold crypto assets on their balance sheets, derivatives will become increasingly important for hedging short-term volatility. The combination of these factors creates a perfect storm, and we believe it will drive the crypto derivatives market in the next 12-24 months.
Overall, we expect 2022 to be the year of crypto derivatives, with three main trends:
The rise of centralized and decentralized options infrastructure.
Growth in decentralized perpetual contract trading volume.
Ongoing innovation around new crypto primitives, such as structured vaults and perpetual options.
Centralized Infrastructure
Today, most derivatives trading volume exists on centralized exchanges, with the majority coming from perpetual futures. Initially led by BitMEX in 2016, the monthly trading volume of perpetual contracts for BTC+ETH hovers around $2.5 trillion, primarily led by Binance, CME, FTX, and others.
We expect this trading volume to continue increasing as organized participants enter the market, as centralized exchanges provide the regulatory and execution infrastructure these participants require.
With the ongoing growth of the perp futures market, we expect options platforms to follow suit. Today, the crypto options market has a monthly trading volume of $35 billion for BTC+ETH, which is relatively nascent compared to the perps market, primarily dominated by Deribit.
One key reason behind this may be that the historical volatility of most coin markets makes futures a sufficient tool for traders to express their outlook. Additionally, due to historically fewer organized parties holding cryptocurrencies on their balance sheets, the demand for options has not been as pronounced as for hedging tools.
We expect both of these factors to change with increased institutional participation. Over the next 12 months, we anticipate more organized participants will enter the centralized options market to support the growing demand as the overall pie continues to grow. We believe FTX's acquisition of LedgerX in October marks the beginning of this trend.
As these markets grow, liquidity will naturally disperse across various venues in terms of execution and capital efficiency. Therefore, liquidity networks like Paradigm will become increasingly important as core infrastructure to facilitate institutional participation.
Through Paradigm, institutions can submit automated, anonymous RFQs for futures and options trading, ensuring settlement with KYC counterparties. As more traditional financial institutions enter the crypto space, we believe this infrastructure will ensure ease of participation and lead to a significant increase in trading volume at centralized venues.
Decentralized Infrastructure
Similar to centralized venues, decentralized derivatives trading volume is primarily dominated by perpetual futures. Initially led by Perpetual Protocol and recently by dYdX, decentralized perp daily trading volume typically hovers around $5 billion.
While the growth over the past three months has been strong, decentralized perp trading volume accounts for less than 1% of the total crypto derivatives trading volume. We expect meaningful growth in this segment over the next 12-24 months, driven primarily by three factors:
Composability with other DeFi applications: As other projects and protocols launch and build on decentralized perpetual contract protocols, the value supported by these platforms will continue to grow.
Low-cost/high-speed execution infrastructure: Faster chains like Solana, along with Ethereum scaling solutions like Arbitrum, Optimism, and StarkEx/Net, provide lower transaction costs and better user experiences, which we expect will attract higher trading volumes.
A typical example is the StarkEx instance recently implemented by dYdX, which offloads computation from the chain and has reduced trading costs by an order of magnitude over the past three months. We believe that whether through EVM or otherwise, we are in the early stages of scalability and expect these solutions to make the decentralized derivatives trading experience smoother in the next 12 months.
Projects like HXRO have already begun laying the foundational infrastructure that is crucial for the growth of on-chain decentralized futures and options like Solana.
- Open networks: Unlike centralized venues, decentralized protocols are permissionless. As cryptocurrency penetration continues to grow and reach more remote areas of the world, we expect some users who may not have access to centralized infrastructure will begin to interact globally through decentralized protocols.
With the ongoing growth of the decentralized futures market, we expect the options market to follow suit. Today, the decentralized options market is just a small part of the overall derivatives market, with most mature protocols existing on the Ethereum mainnet.
However, three long-standing factors that have suppressed the growth of the decentralized options market are beginning to see viable solutions, and we expect these solutions to help unlock these markets in the next 12 months:
- Trading fees + block time: Depending on the holding period, trading fees for options contracts can significantly impact the profitability of trades. High transaction fees on Ethereum have historically made decentralized options trading an unfavorable proposition. Additionally, longer block times can lead to uncertainty in trade execution and may pose challenges.
Especially for multi-leg trades (Multi-Leg Options order strategies involve simultaneously buying and selling options with multiple strike prices, expiration dates, or sensitivities to the underlying asset price), unless the trades are atomic. These two challenges also make market-making based on order book models difficult.
Moreover, protocols that allow leverage require liquidators to take on positions that have a risk of deteriorating. If liquidators must pay high gas fees to liquidate positions and reduce platform risk, this will suppress participation. To mitigate this, protocols must share a higher proportion of liquidations with them, making the long-term business model of the protocol unsustainable.
With the emergence of faster chains like Solana and Ethereum scaling solutions like Arbitrum and Starkware, we now have low-cost, high-speed execution environments that can alleviate these challenges and facilitate viable options trading.
- Protocols that sell options typically require liquidity to underwrite these positions. Most operate through AMM structures to obtain this liquidity. However, this often exposes liquidity pools to unhedged delta risk, which can lead to significant impermanent loss.
Such events have previously caused protocols like Charm on Ethereum to temporarily halt their options products. Like TradFi options sellers, options protocols must delta-hedge their liquidity pools to limit impermanent loss.
This is typically done through futures, which until recently were an emerging market in DeFi. As these primitives continue to evolve, we expect options protocols to become more liquid and thus more active.
- Due to the aforementioned block time constraints and the inability to construct atomic liquidations, many existing DeFi options implementations require full collateralization. With faster chains like Solana and robust liquidation engines built around more frequent market updates, we anticipate protocols like Zeta will be able to offer under-collateralized options.
We expect another set of primitives to accelerate the adoption of decentralized options to be structured DeFi options vaults ("DOVs"). DOVs are game-changers as they not only democratize access to implied volatility-driven organic yields but also provide scalable ways to manage nonlinear risks.
Through basic strategies like covered calls and cash-secured puts, DOV venues offer retail traders a way to hedge yields and provide liquidity to underlying options protocols. Options platforms like Ribbon have already expanded their TVL to $300 million, while new venues like Friktion (over $100 million TVL) and Katana (over $45 million TVL) have rapidly grown within weeks of launch, indicating strong market interest.
As these protocols continue to expand, we expect the decentralized options trading experience to become smoother.
Overall, the phase of thriving decentralized options has finally been established, and we anticipate a significant influx of capital into this space over the next 12-24 months, particularly in Solana and Ethereum scaling solutions.
In addition to decentralized futures, options, and structured products, we are excited to continue seeing innovative crypto-native products (such as perpetual options) being developed in the sandbox. Inspired by the success of perpetual futures products, Dave White and Sam Bankman-Fried proposed perpetual options products in their original paper.
By taking a weighted average, a basket of options with different maturities can replicate perpetual options, where each option is weighted in an exponentially weighted arithmetic manner (i.e., 50% contracts expiring today, 25% contracts expiring tomorrow, etc.), making replication relatively straightforward. Protocols like 0101 have also implemented floating strike prices, which are exponentially weighted moving averages of the underlying asset price over time, allowing for the perpetual merging of all strike prices while retaining their perpetual characteristics.
Finally, we are also seeing the emergence of protocols like Deri, which offer perpetual futures and perpetual options, allowing users to trade derivatives in a very DeFi-native manner, providing options and futures for hedging, speculation, and arbitrage, all on-chain. We hope to see many of these products on mainnet soon.
Conclusion
We firmly believe that the decentralized derivatives market is on the brink of tremendous growth in the next 12-24 months. The infrastructure to unleash these products and support the next wave of billion-dollar protocols is already in place. As we enter 2022, we are very excited to support some of the most fundamental projects driving this revolution, including Paradigm, Zeta Markets, Friktion, Lyra, Drift, and others.
