The Next Leg of the Crypto Trade

Could 2021 mark the end of the growth for the crypto spot market and the plateauing of many spot-only players? Might seem an odd question to ask when BTC and ETH have made new all time highs, volatility is high, and spot trading volumes are exploding. One might jump to the conclusion that this question is rooted in looming regulatory risks. Acknowledging there may indeed be such risks in the wings, the bigger risk to continued growth of the spot market, judging by history and precedent, may be the success of regulated margin crypto products. This is the setup to the “next leg of the crypto trade” for students of market structure.

There have been no fewer than eight bitcoin ETFs filed in the US in 2021, BTC and ETH futures are already listed in the US, and ErisX is planning to launch margin BTC and ETH futures in the second half of this year (pending CFTC approval). What are the potential implications for the crypto spot market?

Exchange traded, cleared, regulated margin securities and derivatives will have a number of important structural impacts on the crypto markets:

Buyside Trading Mandates

Asset managers may be prohibited from investing in physical commodities per their fund mandate, or in the case of those regulated under the Investment Company Act of 1940 (The 40 Act), by regulation. Some mandates may go further to limit trading only to liquid products listed and cleared by regulated exchanges and clearing houses. Such mandate-constrained funds are unable to participate in the crypto spot markets. Access to ETFs and/or futures products will open up access to the crypto markets for some of these funds.

ETF Authorized Participant Creation/Redemption

Assuming that an approved ETF is structured as an open-ended trust, the fund manager will be required to hold crypto in a trust and either add or reduce the trust’s crypto assets in response to the creation/redemption of ETF shares, which in turn are created/redeemed in response to changes in market demand. As demand grows, more shares are created and the assets of the trust grow. As demand softens, shares are redeemed and the assets of the trust are reduced.

Creations/redemptions are processed by authorized participants (APs), market making firms authorized by the fund to create/redeem shares. In the case of a creation, the APs will short shares of the ETF to buyers to meet demand and use the proceeds from the sale to buy the underlying commodity to deliver to the trust back to newly created shares. These newly created shares are then used to settle the short sale (on T+2). Redemptions are processed in reverse: APs purchase shares from sellers and simultaneously look to sell the underlying commodity which will be removed from the ETF trust. APs must only deliver/sell the underlying commodity in the case where their net trading results in a creation/redemption of ETF shares. Because they don’t always end up with a net creation or redemption, APs don’t need to buy/sell physical commodities to offset every ETF share. Instead they use futures contracts to hedge their positions.

Futures are a superior hedging tool to the spot market. Margin and settlement guarantees enable a more symmetrical and capital efficient offset to the ETFs for APs, and market makers, and trading firms generally. Where a physical settlement becomes necessary, market participants can make use of physically settled futures, request an exchange for physical (EFP) with a specialized dealing desk to convert their futures to physical commodities, or trade directly on a spot market. In the case where both spot and futures trade on a single market, additional cost and operational efficiencies can be gained.

The complementary nature of ETFs and futures will drive demand for, and trading in, both products. Likely at the expense of the spot market.

Capital Efficiency

Due to the margin-eligible, cleared nature of ETFs and futures, APs, market makers, as well as professional trading firms will benefit from all of the associated capital efficiencies that exist when trading such products. These include leverage, prime brokerage (credit), netting, and settlement guarantee. In other words they will not suffer the same costs and burdens that exist in the spot market where margin is prohibited, trades are generally required to be fully pre-funded, and counterparties face settlement risk.

Price Discovery & Liquidity

Listed ETFs and futures will benefit from the transparency and oversight of regulated exchanges including fair access to quotations, standard published fees, and market surveillance to prevent fraud and manipulation. Quote competition on a price/time priority high performance matching engine drives tighter spreads and all-to-all trading allows market depth to accumulate in fewer aggregation points. Market participants can access liquidity and transparent prices with less effort and cost. Compared with spot OTC bespoke and exclusive liquidity streams that lack transparency, are priced per counterparty at “the threshold of pain”, and face settlement risk, exchange traded products are again, more efficient.

Anecdotally, markups in the OTC market may run up to as much as 4–8% (400–800bps), where transparent central limit order book fees and spreads can be in the range of 0.40% (0–40bps), 1000 to 2000 times less.

The Basis Trade

Despite greater liquidity and price discovery, the price of ETFs and futures will diverge from time-to-time creating an arbitrage opportunity. So, in addition to hedging, market participants will also have the opportunity to trade the basis, driving further liquidity to the ETF and futures markets.

Implications for Crypto Market Structure

All things being equal, trading and liquidity will flow to the most efficient markets and instruments. Our hypothesis is that the introduction of margin eligible ETFs and futures will kick off a virtuous cycle:

  1. Investors trade ETFs to benefit from their capital efficiency, leverage, price discovery, fair access, transparent fees, and availability through traditional brokerage channels — including the entrance of new mandate-constrained investors who can’t invest in spot.
  2. Market makers and APs concentrate their liquidity provision to ETFs where the largest demand is accumulating.
  3. Market makers and APs hedge their ETF liquidity in the futures markets, enabling them to quote tighter spreads and greater depth in the ETFs.
  4. Arbitrage opportunities from the basis trade between ETFs and futures drive further market activity in both.
  5. Investors further benefit from the resulting tighter spreads and increased liquidity driving more demand for the ETFs.
  6. Repeat.

The ETF + futures virtuous cycle has the potential to create dramatic growth. Any player that isn’t positioned to trade or offer regulated, margin eligible securities and futures that can fit into traditional brokerage, prime brokerage, and FCM contexts will be at an extreme disadvantage in such a scenario. Hence, the highly anticipated launch of ETFs and margin derivatives in the US may herald the mainstreaming of crypto, but it also portends substantial challenges for spot-only businesses.

How are you positioned for the next leg of the crypto trade?

In our next post, we will review the history of GLD as a potentially useful precedent.

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