The Role of Derivatives in Bitcoin's S-Curve

Louis Sykes
April 13, 2022

From the desk of Louis Sykes @haumicharts

Every day the blossoming crypto asset class makes strides toward what appears to be its inevitable maturation.

Almost all breakthrough technologies follow an Adoption S-Curve; more on that here.

Chart credit: Osprey Funds

Most look at Bitcoin on the S-Curve through the lens of standard metrics of volatility or network data.

Still, an often underappreciated element of Bitcoin's maturation is the rising cohort of traders approaching the market from the perspective of yield.

An influx of capital in the coming years will come not just from the directional side but instead to capture yield.

In many aspects, we're already seeing this play out. The number of firms yielding the carry on the basis trade has grown exponentially over the last year.

The first time Bitcoin crossed the mid 40,000s, the forward three-month futures traded at a 25% premium. The second time, it was trading slightly below 10%. And, more recently, it was half that, at just 5%.

Data: Glassnode

The same applies to funding rates, which use perpetual swaps over traditional calendar futures. There are two dynamics at play here:

  • When funding rates are high (perpetuals trading at premiums versus spot), trading firms short perpetuals and long spot, extracting yield.
  • When funding rates are negative, quant firms long perpetuals over spot for the aforementioned cash-and-carry trade.

In both cases, open value has received a permanent boost, particularly since the creation of the US futures ETF.

The end result is that funding looks like this -- the excessive funding we've seen in previous cycles is stuck in a relatively neutral range:

Data: Glassnode

What's the net impact?

As these yield opportunities get arbitraged out of the market, it makes it materially more efficient. Apart from the funds competing in these trades, this is a net gain for everyone involved.

From the perspective of an analyst, it only makes your job more dynamic and nuanced.

The historical correlations that traditional derivative metrics previously had are slowly eroding as we crawl further into maturation along Bitcoin's S-Curve.

While this topic deserves its own post, the infamous "liquidation cascades" are a great example.

As a greater proportion of open value is becoming delta-neutral positions extracting yield, this will more than certainly decrease the quantity and severity of these events.

Another rudimentary testament to these changes is that the savviest of traders went to cash in November not by selling spot, but by hedging their spot via shorting calendar futures.

As this selling wasn't spot in nature, even the most sophisticated of on-chain metrics produced over the last few years lagged behind this selling.

This post hasn't even covered the infant options market, which if the growth of futures is anything to go by, will likely 2x or 3x in open value by this year.

To quantify Bitcoin's maturation, many tend to focus on standard metrics like user adoption, volatility, and market size.

But the growing market efficiency due in large part to the influx of capital being deployed into yield opportunities via derivatives is another natural progression that I haven't seen get much attention in this discussion.

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Allstarcharts Team

 

 

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