TradFi Exchange Structures Will Win Crypto Derivatives Market

BlackRock’s application to launch a spot Bitcoin exchange-traded fund (ETF) has sparked conversations that crypto’s path to acceptance may lie with the system it tried to replace. Moreover, lower spot and derivatives exchange trading volumes suggest trust is at an all-time low.

In June, the US Commodity Futures Trading Commission (CFTC) sued Binance for offering US companies illegal access to its derivatives trading desk. The exchange allegedly overrode its safety nets, allowing big US firms to inject liquidity into its order book.

Since March, the exchange’s share of spot volumes has fallen, netting Asian rivals extra business. A later US Securities and Exchange Commission (SEC) lawsuit, investigations in France, and rejected applications in Germany and the Netherlands have forced investors to exercise greater caution.

The exchange’s derivatives business has also been on the decline. 

Investors with low-risk tolerance avoid speculation in derivatives even more than for spot trading, as losses can escalate quickly if bets don’t work out. For this reason, the Australian Securities and Investments Commission (ASIC) only allows exchanges to offer derivatives to wholesale customers. 

How Crypto Derivatives Fit Into the US Market

The only legal way for companies to offer derivatives in the US is through registering with the CFTC. 

The CME Group is the largest registered derivatives exchange. Like traditional stock exchanges, CME separates clearinghouse activity from order book matching. 

This approach, adopted by the CME Group and Cboe’s new crypto business, Cboe Digital, has attracted retail and institutional businesses. Their registration with the CFTC allows them to offer futures contracts in Bitcoin (BTC) and Ethereum (ETH). 

Futures contracts allow investors to hedge against risk by buying a futures contract that guarantees the provider will deliver the asset at a given price.

So far, the US SEC has allowed several Bitcoin futures ETFs that track contracts whose prices are provided by the CME Group. Futures ETFs are one of the ways institutions can get regulated exposure to Bitcoin.

Now, as several firms apply to launch funds that directly track Bitcoin, does the future of crypto lie in the hands of Wall Street? Or will lawmakers put power back in the hands of the average investor?

Let’s find out.

Tesla Stock, Anyone?

In the early days, exchanges worked through an open-outcry system. Brokers would receive client orders over the telephone or through back-office channels.

They would signal with their fingers and call out the name of the stock they wanted to sell. Another broker, using different hand signals, would call out the name of a stock they wanted to buy.

If both agreed to exchange the stock, the transaction would be executed and recorded at the end of the trading day. In those days, trades were written down in paper order books.

Nowadays, most exchanges operate an electronic order book. Like the open-outcry system, the order book matches buy and sell orders.

A crucial difference is that the electronic system cannot disadvantage the investor since it records all matched orders with a timestamp. In the early days, a broker could match orders that would benefit themselves more than their customers.

Not only are investors protected, they can trade with the same confidence as Wall Street firms. But what happens when technology works against them? 

What happens when products become so fast or complex they disadvantage the average Joe? Sophisticated algorithms can exploit market conditions faster than any human can.

Is it possible to have the safety of investor protections without disadvantaging the customer? Is the notion of a regulated crypto exchange a compromise crypto traders can accept?

Poor Risk Management Hurts Direct Investors

The recent collapse of FTX before the CFTC could rule on its derivatives application suggests crypto investors have an appetite for exotic products. Despite its overall decline, Binance’s derivatives business accounted for one-third of spot and derivative trade volume in July.

Still, the volume drop suggests traders are starting to doubt its direct investor model. Riskier trades like shorts and margin trading can expose investors to significant risk.

In addition to the perils of price manipulation, customers can bear the brunt of conflicts of interest that can be subtly manipulated to disadvantage them. In the case of derivatives, any action against the customer can quickly multiply their losses.

Derivatives Exchange Reduces Risk Through Business Separation

CME, the largest derivatives exchange, reduces counterparty risk by separating exchange and clearinghouse functions. The two-tier system offers greater investor protection than an exchange offering direct investments.

Cboe, another regulated derivatives venue, recently formed Cboe Digital. Its new business offers crypto investors the same two-tier structure it uses for traditional derivatives.

According to Cboe’s Digital President, John Palmer, having a separate clearinghouse adds an extra layer of protection. It also foreshadows a future where the building blocks of traditional finance will make their way into crypto.

“Many pillars of the foundational aspects of these existing markets will find their way to spot crypto assets for the benefit of all investors in the form of better liquidity, price discovery, transparency, regulatory oversight, and trust.”

Additionally, being a regulated exchange means Cboe Digital must separate “customer assets from own assets and the value of intermediaries.” FTX and Binance, on the other hand, have been accused of mixing customer and corporate funds.

The Role Bitcoin ETFs Could Play

Several nascent or upcoming regulatory regimes cite the separation of customer and corporate funds as a requirement to qualify for a crypto exchange license. So far, US-based crypto exchanges have walked a fine line, either choosing not to apply for traditional licenses or offering US customers a narrow range of products and services.

As a result, corporates looking for regulated crypto products have had few options. Several companies have applied to bring Bitcoin under the banner of traditional finance through an ETF.

Palmer sees future Bitcoin ETFs as complementary to Cboe’s crypto derivatives. 

“The expansion of ETP and ETF products offering access to crypto assets will likely drive additional trading volume in both the spot and existing derivatives markets. Participants providing liquidity and in the create and redeem process will look to hedge their exposure in these existing markets.”

Additionally, he believes the gap between regulated markets and US spot crypto assets will close over time. More businesses will come under regulation to benefit the man on the street. Then everybody wins.

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