Cover Story: Mirroring the mainstream markets

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on November 25, 2019 - December 01, 2019.

Growth is lacking in the spot market even as more exchanges come into the space. The spot market is increasingly becoming a red ocean. Venturing into the futures market seems to be a way for them to increase revenue. - Ong

The DeFi movement is democratising the financial sector as people can easily operate a decentralised exchange or even decentralised financial institutions at a much lower cost than traditional ones and fewer regulations, says Vong

The price of cryptocurrencies moves quickly and has high volatility ... We recommend that investors use various resources to do their research on the people behind these exchanges to find out their backgrounds and the histories of these companies. - Ayyar

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Interest in bitcoins and other cryptocurrencies seems to be waning, according to Google Trends. There was a sharp spike in interest when bitcoin hit an all-time high of about US$20,000 in December 2017, but it declined within six months and flattened in the second quarter of last year when the price fell 85% from its peak.

Nevertheless, this has not stopped the cryptocurrency market from evolving. Industry players have continued to provide investors and traders with more ways to utilise their digital tokens.

For instance, investors and traders now have easier access to cryptocurrency derivatives such as futures and options contracts, which allow them to long or short bitcoins and other digital currencies. They can also use these products to hedge their positions or speculate on cryptocurrency prices, with a leverage of up to 125 times.

Investors and traders can also take loans by pledging their virtual money to blockchain start-ups or lend their digital coins to generate a return over a period of time. These trends indicate that cryptocurrencies are slowly but surely mimicking the offerings of traditional financial markets.

“People are able to increasingly perform various trading and financing activities in the cryptocurrency space, just like how they are able to do in the traditional financial space,” says EquitiesTracker Holdings Bhd chief future officer Andrew Vong.

Vong is the instructor of EquitiesTracker’s cryptocurrency masterclass. He has been in the IT sector for more than a decade.


crypto-derivatives Boom

Bobby Ong, co-founder of CoinGecko, which provides fundamental analysis on the cryptocurrency market, has observed a boom in the crypto-derivatives market this year.

For one, Binance — one of the largest cryptocurrency exchanges in the world — launched its futures platform in September to allow the trading of bitcoin and ether futures contracts. In February, popular US-based cryptocurrency exchange Kraken acquired London-based futures trading start-up Crypto Facilities for an undisclosed price that was widely expected to be at least US$100 million.

Closer to home, Singapore-based cryptocurrency exchange Huobi, which was founded in China, launched its derivatives market in selected countries in November last year. It has gained a lot of traction in this market.

“Several other smaller exchanges have also jumped onto the derivatives bandwagon this year. The market is gaining traction, which is why we have decided to track the performance of these derivative products and exchanges,” says Ong.

There are currently at least 20 exchanges in the market offering more than 100 derivative products, according to CoinGecko. This does not include traditional futures exchanges such as the Chicago Mercantile Exchange and Intercontinental Exchange.

Several factors have contributed to the boom, says Ong. First, these exchanges are seeking further growth amid a saturated market and waning interest in cryptocurrencies.

“Growth is lacking in the spot market even as more exchanges come into the space. The spot market is increasingly becoming a red ocean. Venturing into the futures market seems to be a way for them to increase revenue,” he adds.  

“If you look at the traditional exchanges, the trading volumes in their futures markets are also much higher than those in the spot markets. In the cryptocurrency space, this has not happened yet.”

Also, investors and traders are getting more sophisticated and demanding more products to execute various trading strategies, says Ong.

Luno head of Asia Vijay Ayyar says, “Cryptocurrencies are an emerging asset class driven by demand and exchanges are simply catering for that demand by providing a platform to trade these assets.”

He adds that the market demand for derivatives also comes from the growing participation of institutional traders. “They are looking for derivatives to place bets on the price [of a particular cryptocurrency] without having to buy the underlying assets. These products allow them to take short positions easily and hence, are quite popular.”

Luno facilitates cryptocurrency storage, transactions and trading activities.

Perpetual swap futures contracts, which essentially are futures contracts without an expiry date and designed to be traded close to their underlying assets (bitcoins or other cryptocurrencies), are a popular derivatives product offered by cryptocurrency exchanges. BitMEX, a cryptocurrency exchange and derivatives trading platform registered in Seychelles, was the first to introduce perpetual swap futures contracts that allow investors to leverage up to 100 times.

Market players are exploring the possibility of launching futures contracts that will let investors leverage up to 1,000 times, Angelina Kwan said at the Securities Commission Malaysia’s annual SCxSC Fintech Conference last month.

Kwan was previously managing director and head of regulatory compliance at the Hong Kong Exchanges and Clearing Ltd. She is also a former chief operating officer of BitMEX.  

By comparison, investors can only leverage up to 17 times when trading FBM KLCI futures contracts. “The cryptocurrency industry take its cue from the foreign exchange (forex) industry. Forex brokers offer much higher leverage, with some even going as high as 3,000 times,” says Ong.

“This will probably increase as new players come into the industry and want to stand out by offering higher leverage. There is news that Blade, another derivatives platform, wants to offer leverage of 150 times.”

Ayyar says there is such a high level of leverage because many cryptocurrency exchanges are unregulated. “The margins offered are different and settlement is typically made in bitcoin or another cryptocurrency rather than fiat currencies.”

Will this pose a systemic risk to the cryptocurrency market that can eventually spill over into the traditional financial markets? Ong says it is unlikely as most institutional players are not invested in these products yet. “Any boom and bust will be quite self-contained in the cryptocurrency market for now.”

Luno general manager for Southeast Asia David Low agrees. He does not think these products will pose a risk to the cryptocurrency market as they are still new and the adoption level remains low.

“However, in the long run, if a substantial number of traders adopt trading products offered at an unusually high rate of leverage, that will likely mean a significant loss and panic selling in the market when the market swings against them, which may push cryptocurrency prices further downwards,” he says.

Low foresees that such products may be banned or have the leverage reduced in the future when regulations governing cryptocurrencies and other digital assets tighten globally. “Cryptocurrency exchanges [that are regulated] will not be allowed to offer unusually high leverage to the public. In Malaysia, regulated exchanges such as Luno are not allowed to offer such products,” he says.

Ong says some cryptocurrency exchanges are starting to offer options contracts, which allow traders to buy or sell the underlying assets of those contracts. However, the options market is still small.


Decentralised finance trend emerging

Meanwhile, investors who want to generate returns by lending their cryptocurrencies or borrow cash by pledging their digital tokens are benefiting from the decentralised finance, or DeFi, trend. DeFi aims to liberalise the way the financial industry is operated by using blockchain technology, which is essentially a decentralised network.

Several blockchain start-ups that operate like banks but deal in cryptocurrencies rather than fiat money have emerged recently and received funding from venture capitalists around the globe. The back-end systems of these start-ups are underpinned by blockchain technology and can be set up at a much lower cost than traditional banking operations.  

EquitiesTracker’s Vong says DeFi seeks to replicate what exchanges, banks and other financial institutions are doing but execute them in a more convenient manner using smart contracts via decentralised networks such as the Ethereum blockchain.  

For instance, a centralised exchange like Bursa Malaysia requires investors to open a Central Depository System account to trade shares on its platform. When an investor makes an order, it is matched on Bursa’s platform with the help of a broker. All trading activities and investor information is stored by the system, which is operated by the centralised exchange.

A decentralised exchange works in the same way, but investors do not need to register their personal information with the exchange. An order placed by an investor is matched on the decentralised network and executed using smart contracts. All the trading information and activities are recorded on the decentralised network, which is maintained by various groups of people globally. Investors on a decentralised exchange deposit funds and make trades using cryptocurrencies.

Vong says the DeFi movement is democratising the financial sector as people can easily operate a decentralised exchange or even decentralised financial institutions at a much lower cost than traditional ones and fewer regulations.

DeFi start-up Compound, an automated lending platform, operates like a bank in that it allows investors to lend out their cryptocurrencies in exchange for a return or pledge their digital tokens as collateral when taking out a loan. According to its website, users are allowed to place their cryptocurrencies in a “liquidity pool” at an interest rate. The platform then allows users to borrow from the pool at a specified interest rate.

The website points out that the interest rate lenders earn changes frequently and depends on how much excess liquidity there is in the liquidity pool — the higher the liquidity, the lower the rate.

On the borrower’s side, the interest rate depends mainly on the quality and amount of collateral pledged. The cryptocurrencies accepted by Compound Finance are ETH, ZRX, BAT, DAI, USDC, REP and WBTC.  

Secured Automated Lending Technology and MakerDAO are two other platforms that provide similar lending and borrowing facilities.

Ong points out that provides the public with some information on the historical lending and borrowing rates provided by some of these platforms. For instance, the website shows that the interest earned by ether lenders on Compound Finance was 0.05% per annum as at Nov 7. The rate was 0.1% on May 30. The borrowing rates were 2.63% and 3.09% on those days respectively.

Meanwhile, a project called BASIC is expected to be launched in South Korea, says Vong. “They want to be a crypto bank [and be involved in the lending and borrowing business]. Let’s say you are a lender and you place RM100,000 worth of cryptocurrency with them for a given period. They would give you a return of 8%, for example, and lend out your cryptocurrency at 12%, thereby earning the 4% difference.”

As cryptocurrencies are a volatile asset class, the loan-to-value ratio may be lower than that of traditional assets. “For instance, you may pledge your cryptocurrencies worth RM100,000 as collateral and only get a loan of RM40,000, which is a loan-to-value ratio of 40%,” says Vong.

He adds that the borrower receives the RM40,000 loan in the form of stablecoins, which he can sell over the counter for cash. “If the borrower is not able to pay off the loan within a specified period of time, the collateral is liquidated.”

But how do DeFi companies make their risk assessments? Vong says in the case of BASIC, it hires experts who previously worked at banks and are familiar with the financial industry.

“The back-end is similar to those at traditional financial institutions. They hire experts and implement all the necessary processes to do risk assessments and come up with methods to decide on the rates,” he adds.


Largely unregulated

Industry players say many exchanges that offer derivatives trading are unregulated and investors should conduct due diligence on the exchanges and contracts they intend to trade. “The price of cryptocurrencies moves quickly and has high volatility. It is not reassuring that most of these derivatives exchanges are unregulated. We recommend that investors use various resources to do their research on the people behind these exchanges to find out their backgrounds and the histories of these companies,” says Luno’s Ayyar.

He adds that investors should always prioritise the security and storage of their cryptocurrencies.

EquitiesTracker’s Vong advises retail investors to stay away from highly leveraged perpetual swap futures contracts. “As much as I am a crypto advocate, I tell retail investors to stay away from such a highly speculative tool,” he says.

However, derivatives such as futures contracts are good for businesses like mining companies, which generate revenue and profit in cryptocurrencies. These businesses can hedge their positions by locking in future profits with derivatives.

How are the regulators of traditional financial markets responding to these trends? Ayyar says they are trying to regulate cryptocurrencies as an asset class and each of them has made different levels of progress.

Some markets have made a lot of progress. For instance, the US Commodity Futures Trading Commission is trying to regulate derivatives. Ayyar expects more countries to move in this direction.

Japan has regulated its cryptocurrency exchanges, including those that offer derivatives. As a result, bitFlyer offered futures contracts with a lower leverage of up to four times, compared with 25 times previously, says Ong.

On DeFi start-ups, Vong is unsure how regulators will react to such a trend. “After all, the trend is still at an early stage and has not really gained traction among the public. Most people are used to trading and transacting via the traditional financial system,” he says.

As to whether such a trend will pose a risk to the stability of the financial system, Vong says this will not happen anytime soon. “The industry is still in its infancy and quite far away from such a trend becoming mainstream.”