Options Growth Will Ignite Innovation in the Bitcoin Market – But Not in the Way You Think

Options Growth Will Ignite Innovation in the Bitcoin Market – But Not in the Way You Think 1

Richard Rosenblum is co-founder and co-head of trading at crypto liquidity provider GSR. The opinions below are the author’s and do not reflect the position of CoinDesk.

Like futures, the launch of bitcoin options on major exchanges has been met with anticipation.

Hopeful observers believe the CME’s and Bakkt’s entry into the burgeoning options market will further encourage institutional participation. It will – but not necessarily in the way they expect.

For major institutions, miners and other corporates involved in the space, options open a new, powerful tool for managing risk and volatility. But, as we can see from other financial markets, these capabilities won’t come from the listed options themselves. Instead, the real action will take place in over-the-counter hedges. While these corporate-focused products will rely on vanilla option liquidity, they will move volumes on exchanges.

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Before we explain why this is the case, it’s worth highlighting the growing demand for options as a means to hedging. Options have been the fastest-growing product segment of the crypto market in 2019, with the trajectory of volumes likely to accelerate in 2020. Crypto derivatives volumes are nascent compared to the spot market and the size by which some financial derivatives dwarf their respective spot markets. Nonetheless, the emergence of a variety of derivatives should have a significant influence on the growth of the space.

Now, to understand how the options market will serve as the foundation for corporate risk management, I can draw upon my experience managing hedging programs at Goldman Sachs for some of the world’s biggest corporations. There, the focus was on helping entities with natural exposures hedge their risks. On the supply side, the biggest yearly trade in commodities was when Mexico would buy puts to hedge their royalties on the country’s oil production. On the demand side, airlines and shipping companies would come to market to lock in forward prices to hedge their consumption. However, these entities rarely traded “listed” exchange products directly. Characteristics of listed options products are not a good fit for corporate risk, they are more meant for specialists and speculation. Corporate entities prefer to trade products that are specifically built for them, that utilize the liquidity of the exchange-listed products.

In the crypto world, the single-day expiration date of these products means traders need to deal with the volatility of the expiry day, which could be prone to emotional sentiment or other non-economic factors. A single-day hedge is likely too short in duration for a corporation like a miner to properly protect the value of their outputs or market exposure. Instead, custom-built swaps and options strategies provide a better solution for many in the ecosystem as a hedge, as they would allow the parties to hedge ratably each day as they balance out exposure over longer periods.

Further parallels can be drawn between oil producers and bitcoin miners. Mining costs vary as new equipment comes to market and electricity prices fluctuate. Bitcoin volatility also eats at profitability. With major miners having gone public and/or reporting to a group of shareholders, the pressure to maintain a good balance sheet is growing. Additionally, margin compression resulting from the upcoming halving is likely to push miners to better manage the risk of volatility. More risk will lie in the hands of fewer miners as the market consolidates. Like oil producers, these companies will increasingly look towards hedging solutions to ensure the costs of mining will not outpace market pricing of the resulting digital assets. Lenders will also begin to mandate that miners hedge so they will still be able to meet their obligations as borrowers in the event of a bear market.

Corporates – whether they be oil companies or bitcoin miners – usually do not trade directly on exchanges. They require a different product offering and manner of doing business. In addition to the temporal mismatch resulting from hedging daily risk with a single-day “bullet” expiry, futures exchanges are difficult to connect to, as entities must trade through an FCM (Futures Clearing Merchant). This creates space for hedging products tailor-made for crypto-native firms. However, these products still need to hedge the core volatility risk somewhere, so it is first necessary for liquidity to build on listed products. The emergence of liquidity in the listed options market will be the foundation for these types of hedges.

Once companies can hedge these listed products, the risk that is left is more of a residual nature. Market makers are primed to take on these risks and be the trading counterparty for these hedges.

The existence of listed vanilla options on mainstream exchanges is only the beginning. For corporates, miners and others, the excitement lies in what can be done once saturation of underlying liquidity in volatility arrives. This is the base on which a whole host of other volatility-related products can be built, particularly as it relates to corporate hedging and risk management. Ultimately, this helps reduce unwanted exposures and enables more investment. In this way, listed options serve as the starting point for a whole new array of products and services.

Disclosure Read More

The leader in blockchain news, CoinDesk is a media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. CoinDesk is an independent operating subsidiary of Digital Currency Group, which invests in cryptocurrencies and blockchain startups.

Options Growth Will Ignite Innovation in the Bitcoin Market – But Not in the Way You Think 2
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CryptoCurrencyUSDChange 1hChange 24hChange 7d
Bitcoin39,194 0.47 % 2.33 % 0.30 %
Ethereum2,643.5 1.30 % 5.12 % 15.31 %
Tether1.000 0.04 % 0.14 % 0.29 %
Binance Coin331.13 0.63 % 2.82 % 5.63 %
Cardano1.360 0.12 % 1.63 % 7.19 %
XRP0.7246 0.58 % 1.25 % 12.81 %
USD Coin1.000 0.15 % 0.17 % 0.13 %
Dogecoin0.2000 0.41 % 1.43 % 2.24 %
Polkadot18.60 0.73 % 6.72 % 29.86 %
Binance USD1.000 0.30 % 0.35 % 0.32 %

bitcoin
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ethereum
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tether
Tether (USDT) $ 1.00
binance-coin
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cardano
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xrp
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usd-coin
USD Coin (USDC) $ 1.00
dogecoin
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polkadot
Polkadot (DOT) $ 18.87
binance-usd
Binance USD (BUSD) $ 1.00