For all the talk about liquidity, bitcoin and other crypto-assets are thinly traded. Investors that buy and sell large volumes can't do so directly, without slippage, or a change in the price between order and execution.
They turn to over-the-counter (OTC) desks to manage those trades, whether buying crypto for the first time, or trading to generate alpha (above-market returns).
As a result, these desks handle anywhere from 30 percent to 65 percent of total crypto market volume, depending on whose estimate you believe. To get a look inside this business, CoinDesk Research talked to two veteran OTC traders in a live webinar on Oct. 28.
Martin Garcia is managing director and co-head of trading at Genesis Trading. Yinfeng Shao is a former trader at Circle and now the CEO of a development-stage OTC firm, Reciprocity Trading.
OTC desks take on tremendous, temporary risk. Traders like Martin and Yin are tasked with managing that risk by moving large amounts quickly and offsetting it on derivatives markets, including BitMEX, Huobi, OKEx, CME Bitcoin Futures and Bakkt. (For background, CoinDesk Research has produced a white paper on the state of crypto derivatives markets. You can download it for free here.)
As a result, they are among the most sophisticated traders on crypto derivatives exchanges. Here are a few of the insights Martin and Yin shared during our hour-long conversation. Sign up and listen to the entire webinar here, and check out our other live conversations at coindesk.com/webinars.
1. Investors' mentality has shifted
The mentality of investors has changed since the earlier days of crypto, from venture-like to hedge-fund-like.
"There's a lot more velocity amongst the traders that are out there, whereas in the early days it was very much more a buy-and-hold" strategy, Martin said. "People these days understand that this market is super volatile and a lot of the different crypto funds and people that are out there, they are trying to add alpha for their shareholders."
2. Derivatives markets move the spot market
First of all, market moves get started on derivatives exchanges more often than on spot exchanges.
"Because there are so many trading venues, it's a constant question of, where is the action starting?" Yin said. "Often it's starting on derivatives exchanges because that's where a lot of people have connections and that's where a lot of the most highly levered bets are taking place."
"Crypto already is a fairly random, volatile walk in terms of price action and the collection of these derivatives and the exchanges that list them effectively act as leverage on top of that," he went on. "Whenever you start to make a move, there's a good chance it will get exacerbated because of the amount of open bets that are out there."
In isolated examples, like the May 17 flash crash, a small amount on spot markets can cause a large move on the offshore derivatives markets, specifically BitMEX, allowing traders to manipulate the spot price in favor of their derivatives markets position.
Theoretically, that's possible on regulated crypto derivatives markets like CME's, but it's more expensive and difficult because the leverage is not as high.
That's not the only way derivatives markets can fail.
"Where things tend to break down a bit and you get a lot more slippage is when you've simply exhausted everybody's ability to really use the derivatives instruments to hedge, so whether that's the amount of collateral that everyone's posted is insufficient, or the market conditions are such that you really can't get access to some of these platforms," Yin said.
3. Two products dominate derivatives
The most popular product is the perpetual swap, reputedly invented by BitMEX. Crypto futures are a close second. A handful of OTC desks can provide swaps and custom derivative products, including contracts for difference, but those two products have dominated market volume so far.
Bitcoin options are emerging, but remain a small percentage of overall volume. As providers including Bakkt and CME have announced plans to bring options on bitcoin futures into the markets, Yin and Martin said these may prove attractive for large investors entering crypto, looking for a hedge against a big downside in a volatile market.
"I think it means there are more sophisticated hedging strategies. It allows people to be more comfortable with spot exposure, if it can be more easily hedged out," Martin said. "These markets move really quickly and a lot of the bigger places that want to start trading, there's a significant amount of headline risk attached to this. How do they protect against the crazy downside move? Options may very well help eliminate some of those risks for them."
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This is the first in a new series of webinars we're running. If you like what you hear, get in touch (galen@coindesk.com) and let us know which topics and guests we should feature next.
Ivan Ajvazovskij painting via Wikimedia Commons