These are the three questions any self-respecting crypto punter asks themselves:

  1. When moon?
  2. When Lambo?
  3. When liquid options?

If I knew the answers to questions 1 and 2, HDR Long Term Capital Management would not be a figment of my imagination, but a fee-guzzling hedge fund posting returns that rival Renaissance Technologies. By the way, I recently read somewhere that since its inception, Ren Tech earned over $100 billion in net gains AFTER fees of 4 and 40. Jim Simons is the Samuel L Jackson of investing; he is one bad ass mother fucker.

As the CEO of the largest crypto derivatives trading platform, I do however have a somewhat informed opinion on the third question. For those of you ringing in 2020 with a resolve to read even less text and more Instagram here is the summary:

The liquid crypto delta one trading products obviate the need for traders to rush into traditional screen options trading platforms like in traditional asset classes. That does not mean that volatility products will not pick up liquidity. As more participants rediscover the need to smooth out volatile cash flows and earn yield on their Bitcoin, both insurance and yield products with embedded options will become popular. These structured products will lead the way towards a more mature crypto derivatives market, and that liquidity will leak into vanilla options traded by sophisticated traders. BitMEX will be present in the areas of the market where we can add value.

Delta One Dominance

Traders use delta one products to obtain leveraged directional exposure to an asset. Traders always want more leverage when they are prescient; that’s how you earn more ducats. Traditional trading platforms and exchanges, baring shady CFD brokers / bucket shops, offer limited leverage.

Unless you are a very large hedge fund, bank, or financial institution, you will not have access to a large amount of leverage. Exchanges endeavor to protect their seat holders who are on the hook for bankrupt traders by limiting leverage. The most liquid equity futures contract globally is the CME’s Globex S&P E-mini contract. I believe the maintenance margin offered by the exchange equates to max 5x leverage. 5x leverage ain’t the nuts when a large daily move in the underlying is considered 1%.

Brokers may offer higher leverage trading FX pairs, but obtaining 100x or greater leverage is getting increasingly difficult. Even if you can obtain high leverage, these exchanges or brokers do not limit your liability. When the Swiss National Bank removed the CHF/EUR peg in January 2015, a few shops sued customers for large losses.That’s not a good look.

Since the choices are either low leverage offered at the exchange level, or high leverage offered by a broker (with the risk of total financial ruin), traders in search of safe leverage must resort to options. By purchasing out of the money (OTM) call and put options, traders can enjoy much higher leverage and limited liability.

The OTM options will trade cheap because the strike price is far enough away from the current spot price to dampen the premium. You pay less for an outcome that is less likely to happen. If the trader is wrong, he only loses the premium. This way, traders construct leveraged positive convexity trades.

The other, and arguably more important facet which will reduce the premium is low observed volatility levels for equities, fixed income, and currencies. If the asset price moves very little and is OTM, the premium will be cheaper, which offers larger gearing.

As a result of this market structure, options appeal to speculators. In turn, speculators bring the gift of liquidity on both sides of a market. Life is all about discovering cheap convexity. Traditional asset class options markets offer convexity, leverage, and safety to speculators. Delta one products offer none of these characteristics, therefore, speculators add a significant amount of liquidity and open interest to the options markets.

Crypto derivatives feature a completely different market structure.

Suing your customers is bad business and almost impossible when the margin currency, Bitcoin, is barely recognised as real money. As a result, all platforms adopted a limited liability stance from the outset. You can only lose your initial margin on BitMEX, no matter how big your position is.

Nothing in life is free, unless you are a politician running for election. If traders can only lose what they put in, then in volatile and jumpy markets, winners cannot enjoy their full unrealised profit. There will be situations where the market gaps up or down and the platform does not possess enough equity to pay out winners in full. That is where the socialised loss system plays a role. 

The socialised loss system ensures the platform is solvent under all market conditions. Crypto trading platforms did not start by selling seats to well-heeled institutions willing to put their balance sheets on the line so punters can go 100x on one of the most volatile assets in human history.

I can only speak for BitMEX, but if Bitcoin goes to zero or infinity in one tick, we will be solvent. That is how much safety our socialised loss system provides.

A limited liability and socialised loss margin system sounds attractive in theory, but without the third piece, the insurance fund, it is still deficient. In a two-trader system where one person is long and other side short, the maximum return on equity (ROE) is 100%. That is because you can only win what the other side has placed as margin. This platform could offer 1,000x leverage and it would still be a nothingburger. The leverage is irrelevant if you can’t raise your ROE substantially above 100%.

An additional pot of funds which pays out winners when the losers go bankrupt is needed to raise ROE above 100%. Traditional exchanges partner with a clearinghouse which provides such a backstop from guarantee bonds. Usually seat holders must purchase these bonds; in return they receive a fee on every trade.

However, if I came to you in 2015 and asked you to give me some Bitcoin to help traders use 100x leverage, you probably would have suffered a myocardial infarction laughing at my expense. BitMEX and other platforms had to find another source of funds to backstop the market. The insurance fund is that pool of money. The BitMEX insurance fund currently holds approximately 33,500 Bitcoin.

Pop goes the weasel: with an insurance fund the potential ROE in a socialised system rises above 100%. Mathematically, the larger the insurance fund, the larger the potential ROE of a new trade becomes. The number of traders on a platform who have different price expectations on the long and short side also affects the potential ROE. The more punters, the greater chance that a liquidation order will be cleared in the market at better than bankruptcy price. As a result, the insurance fund will grow.

Assume that all crypto derivatives platforms have the same number of active users (I could posit that BitMEX has the most, but I can’t verify that without knowing the active user base of all competitors. And alas: I don’t have that information). The only public data which all socialised loss platforms post is their insurance fund. BitMEX has the largest fund by an order of magnitude. Therefore, on BitMEX a trader will have the highest pre-trade potential ROE.

If we assume a non-zero insurance fund balance, then the crypto delta one markets begin to confer some juicy convexity for traders. Consider this:

  1. Traders can only lose what they put in. Their downside loss is capped.
  2. Traders can make more when they are right than when they are wrong, regardless of going long or short. That means their return profile is always positively convex.
  3. Traders can use high leverage.

In essence, the crypto capital market structure has wrapped options into a delta one product. The return profile of a crypto future or swap hasn’t changed. On the leveraged notional, a 1% rise in price equals a 1% rise in the contract. However, on an ROE basis the trader has purchased an option with the premium as the initial margin. 

Crypto Options

Various crypto platforms have over the years offered options markets. While the liquidity is definitely better than five years ago when I entered the space, it still is pretty illiquid. Many traders lament the lack of “proper” liquid screen market of calls and puts of various strikes.

Traders who cut their teeth trading equity and FX options want the same trading weapons in crypto. However, the crypto option is a breech loaded musket compared to the crypto perpetual swap Gatling gun. Charge that hill if you dare.

Trading options is orders of magnitude more complicated than trading futures and swaps. Delta, Vega, Theta, Rho, Gamma, dVega / dVol, I could go on with the alphabet letter soup of the option greeks. I still remember the weekly quizzes on options math and the greeks the MD would give me during my internship on the derivatives sales desk at Deutsche Bank. Given volatility sales and trading desks employ tens of thousands but not millions, most traders of all stripes barely understand how these markets are priced.

Case in point: one day I was sitting with a trader who traded Variance Swaps. A Variance Swap allows the trader to have constant vega across all strikes. If you don’t know what that means, this story will be comforting. The trader had a fancy spreadsheet which calculated all the option greeks and told him his daily PNL. All he had to do was vigorously press F9 to generate quotes. I asked him how those were calculated. He responded that he didn’t know, the quants made the spreadsheet and he just followed it blindly.

Moral of the story: this shit is complicated. 

Strike one! Traders will always do what is easiest if they can generate the same return profile. 

Crypto volatility is very high. We are currently in a low volatility regime and 30 day realised volatility is around 40%. When pricing an option, the higher the volatility the more expensive the call or put. Therefore, option buyers, the speculators, must post high amounts of capital to obtain convex trades. In order to be cheaper than the BitMEX XBTUSD perpetual swap, the most liquid crypto derivatives product, the premium must be less than 1%. That is not possible when the underlying asset has such a high realised volatility.

Strike two! Traders will always gravitate to the product with the most leverage.

Market makers, I haven’t forgotten about you. For every buyer there is a seller. Writing options is a tough business. If the volatility is high, margin requirements for writers of options will be very expensive. Market makers must be able to write naked options while quoting. Writing naked call options on an asset that popped 40% in a few hours when Xi Jinping mentioned the word “blockchain” is risky. As a result, the margining systems employed by various platforms are extremely conservative.

The same set of crypto market makers quote crypto delta one and options products. They must decide how to allocate their capital. If the option requires more capital due to margin requirements and has less flow because it’s less understood and offers less leverage, they will provide less liquidity. If the brave speculator turns up to trade an option and you can drive a Tesla pickup truck through the spread, she will hightail it back to XBTUSD.

Strike three (you’re out)! Traders prefer the liquid to the illiquid derivative.

I hope you enjoyed a nice primer on the crypto derivatives market structure and why delta one products will be preferred to options by speculators. 

Delta One:

  • High leverage
  • Limited liability which translates into a max loss of 100% of initial margin, but a max upside that vastly exceeds 100%. Also known as positive convexity.
  • Liquidity

Options:

  • High premiums because of high implied volatility, which translates into low leverage or gearing.
  • Limited liability as you can only lose your premium.
  • Illiquid

After laying out what won’t work, in the next voluminous installment I will get into my views on what sort of option / volatility products will become popular in 2020.

Glossary of Terms

For those of you who didn’t get any of what I just said, I’m feeling generous. Here’s a glossary:

Delta – The change in the value of a derivative contract with respect to the price of the underlying asset.

Delta One – Derivatives where delta equals one. This term will be used to refer to futures and swaps products of the crypto space. I was a practicing delta one trader during my time working for the man.

Socialised Loss System – This is the dominant margining system used by all liquid crypto derivatives platforms. In this system, if there is not enough money to pay out winners due to bankrupt losers, the winners’ unrealized profit is reduced, or their position is closed early.

Initial Margin / Limited Liability – A complement to the socialised loss system. Traders can only lose a position’s initial margin. The trading platform cannot go after other financial assets held outside of its system. This is different than most brokers offering any sort of derivatives / leveraged trading, they can and will go after the entirety of a traders’ financial net worth if losses exceed the initial margin.

Insurance Fund – This is the guarantee fund attached to a socialised loss system. On BitMEX, if you are liquidated, the system takes over your position and closes it in the market. If there is equity left over after closure, those funds are deposited into the insurance fund. The losers pay into the fund with their leftover equity. The fund is tapped when a liquidation order cannot be closed at a price which is above its bankruptcy price.

Volatility Products – Derivatives where the delta is greater than one. This term will be used to refer to options products of all stripes. When trading options, you are not just trading directionally but also for convexity and yield.

Convexity – This is the asymmetric nature of a payoff curve. A positively convex trade is one where you make more money when you are right than when you are wrong, assuming the same asset price movement on the up or downside. Buying an option is a positively convex trade. A negatively convex trade is one where you lose more money when you are wrong than when you are right, assuming the same asset price movement on the up or downside. Selling or writing an option is a negatively convex trade. Convexity is not free, the price for this return profile is the premium attached to any option.

Yield – A trade that yields a fixed known payoff by expiry. Selling a covered call option is a yield trade. E.g. A miner expects to produce 100 Bitcoin in one year sells 100 $10,000 Strike December 2020 Bitcoin / USD Call Options and receives 20 Bitcoin premium from the buyer. The miner knows a priori that this trade will yield 20 Bitcoin of income regardless of where the price of Bitcoin settles in one year.