It is All Derivative
What's holding the industry back
‘I bought the call options’, said one of the characters in the movie Dumb Money, which narrates a David versus Goliath tale set in the financial markets. It is about how an army of Reddit users took sophisticated investors head-on. Consequently, one of the larger hedge funds, Melvin Capital, had to shut shop after losing billions of dollars.
I have been constantly thinking about crypto derivatives since last Friday. Maybe we could all rally together and hunt down hedge funds like the GameStop crowd did last year.
Currently, the market landscape for derivatives feels lethargic. While thinking through how the landscape is likely to change, I started to think about how financial primitives in crypto are nothing but replications of TradFi primitives with different infrastructures. Generally, it is safe to assume that crypto financial primitives will follow the same course as TradFi.
Following what happened in traditional derivatives markets like India in the last decade will explain what we can expect in crypto. Why do I say India? Because in the last decade, India’s derivatives market has evolved substantially, and I had a front-row view of it in Mumbai - India’s financial capital.
Emerging A Market
India’s National Stock Exchange (NSE) is the leading market regarding the number of contracts traded (this is not the notional value). Equity derivatives volume has picked up in India in the last few years.
According to the Economic Times, India’s derivatives market volume is ~400 times the underlying cash or spot market. Usually, this number is five to ten times the underlying cash market. Derivatives volume constitutes 99.6% of the overall volume in India, compared to ~70% in the US. Options dominate the derivatives volume with a 99% share.
But why did this change happen in the first place? Maybe we could replicate some of it with products in DeFi.
For a long time, India only had derivatives products with monthly expiry. One of India's exchanges, the NSE, started offering short-dated options in FY 2017 with weekly options for Bank NIFTY; it launched weekly options for the NIFTY 50 Index in FY 2019. As of FY 2023, weekly options account for 95% of the trades.
Opening a dematerialised (demat) account was tedious before the internet and mobile penetration. With the FinTech revolution in India, opening a demat account within minutes became the norm. This has been facilitated by access to financial markets via apps like Zerodha, coupled with increased internet access. As a side note, the average cost of 1GB of data in India is $0.16 compared to $6 in the US.
Zerodha was launched in 2010 with significant discounts on brokerage charges. By 2013, it was among the very few tech platforms with a user-friendly UX. By 2017, Zerodha had already launched an education platform (Varsity), a trading API (Kite.Trade), and a mutual fund investing platform (Coin). Zerodha’s strategy, in general, forced all major brokers to launch tech platforms that were more user-friendly.
Following Zerodha’s success, investment platforms like Groww, Dezerv, and Wint hit the market, trying to address the different needs of investors. This development contributes towards increasing the number of people participating in the markets. It was not a single app that improved the market.
The Growth Economy
India has a demographic advantage among the major economies. The dependency ratio of India (~48%), the percentage of dependents compared to the workforce, is among the lowest in major economies.
With the FinTech revolution and a huge workforce, India is often compared to China in the 1980s, with almost a consensus view that it will be among the fastest-growing major economies in the world in the near future, meaning India is likely to remain among the preferred investment geographies.
Despite the growth, the Indian market has significant room to grow. Paytm’s red herring prospectus states that as of 2020, only ~3% of the Indian population participated in the stock market vs 55% in the US. Although this number has grown over the last few years, it remains significantly low compared to developed markets like the US. India has a per capita GDP of ~$2400, compared to ~$77k in the US.
How It Relates To Crypto
What has this got to do with crypto? One may hypothesise that an average crypto user lies somewhere along the spectrum of emerging markets like India and developed markets like the US. Some drivers for the growth of India’s derivatives market can apply to crypto markets. While the share of derivatives volume (as a percentage of total spot + derivatives volume) in India is 99%, it is around 78% for crypto.
But unlike India’s derivatives volume mix, which is heavily skewed towards options, futures are more popular among crypto traders for reasons we describe later in the piece.
Options vs Futures
In traditional markets, the maximum available leverage depends on the nature of the underlying asset. It is essentially a function of the volatility of the underlying asset. For example, available leverage in the currencies market is typically much higher than in equities because currencies are much less volatile than equities. Typically, the initial margin for stock futures is 3–12% of a contract’s notional value.
This means the available leverage is capped at 33X. However, options inherently offer more leverage since the buyer knows exactly how much they stand to lose. When the options premia (the amount you pay to buy an option) are low, the leverage factor in options can be more than 100X. This is why options end up dominating the notional volume in many markets like India.
The story is different in crypto. Perpetual futures were a hit product with the launch of BitMex (probably because 100X leverage was easily available). It is likely that since leverage is so abundantly available in futures, a more straightforward product than options, options never took off.
Keep reading with a 7-day free trial
Subscribe to Decentralised.co to keep reading this post and get 7 days of free access to the full post archives.