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What Happens When Crypto Derivatives Crash?

Despite the ongoing crypto winter, the cryptocurrency derivatives market continues to grow at a fast pace to become a major asset class. In fact, the crypto derivatives volume grew faster than spot markets in January 2023, according to data from CryptoCompare.

Statistically speaking, the derivatives volume in January was up over 76% from the previous month to $2.04 trillion, the largest percentage increase since January 2021, when volume rose 114%.

Crypto derivatives trading now represents 70.3% of the entire cryptocurrency market, up from 68% in December, according to CryptoCompare data, which noted, “this suggests that price increases were driven by derivative market speculation rather than spot market accumulation.”

Meanwhile, the leading cryptocurrency exchange, Binance, continued to be the largest derivatives exchange as well, with $1.26 trillion recorded in January, followed by Bybit, which had a $301 billion volume. This saw Bybit recording its highest-ever market share in derivative markets at 14.6% in this new year.

It’s clear derivatives are big in the crypto market. But what are they? A derivative is any security with a price dependent on the underlying asset. For example, in the stock market, a derivative’s value comes from the underlying stock. In the same way, crypto derivatives get their value from the underlying crypto asset. 

Crypto derivatives function similarly to traditional derivatives in that they are contracts between a buyer and a seller. The main difference is that cryptocurrency derivatives are often more volatile because the prices of cryptocurrencies can fluctuate rapidly. Nevertheless, both types of derivatives rely on the underlying asset’s value for their worth.

Now, what happens when crypto derivatives crash? Given that they account for so much of the crypto market volume, when crypto derivatives crash, it can have a domino effect on the prices. This is because when derivatives crash, it can create a ripple effect that can cause other markets (spot markets) to crash as well, leading to a decrease in overall value.

The crypto industry has already been facing regulatory scrutiny, which has amplified after the collapse of the crypto exchange FTX. Earlier this year, in an article titled “Crypto Contagion, Underscores Why Global Regulators Must Act Fast to Stem Risk,” published on the IMF website, the authors argued that with “while broad bans might be disproportionate, we believe targeted restrictions offer better policy outcomes provided there is sufficient regulatory capacity.”

This targeted restriction involves limiting the use of some crypto derivatives, a step taken in Japan and the United Kingdom. 

Industry Body Provides Clarification 

The International Swaps and Derivatives Association (ISDA) recently released a global framework for trading derivatives linked to crypto assets to avoid now-defunct crypto exchange FTX-style collapses and spread confusion over asset ownership.

The collapse of FTX led to the loss of billions of dollars of customer assets — “or worse, a total vanishing of their assets,” raising questions about who owns assets held by a crypto exchange or intermediary. As such, ISDA also published discussion papers exploring the legal questions raised by FTX’s bankruptcy.

The ISDA’s new trade definitions will apply to all new trades in the crypto market to reflect the underlying assets. The framework’s purpose for trading digital asset derivatives is to clarify what happens when things go wrong in an underlying market. This way, it sets out the rights and obligations of both sides to a derivatives trade following the market disturbance.

“Recent failures in the crypto market have emphasised the importance of having a clear, consistent contractual framework that spells out the rights and obligations of both parties following a default,” said ISDA chief executive Scott O’Malia. “All customers, whether retail or institutional, should know their assets are protected and understand their rights in the event of a default,” he added.

While most of the problems plaguing crypto this past year have occurred in the spot cryptocurrency market, many of the legal uncertainties could also affect digital asset derivatives.

ISDA, which oversees the template banks use to trade trillions of dollars in derivatives globally, will now include the body’s first standard documentation for trading digital asset derivatives. This framework standardises derivatives trading documentation, which is a critical part of the industry. 

The ISDA has already updated definitions and trade supplements, replacing legacy trades with new and updated documents that are specifically tailored for the unique characteristics of digital assets and provide further legal clarity. It also provides an official fallback protocol for crypto. 

The guidance also identifies several focus areas that are important to consider when trading these types of derivatives, including collateral arrangements and market risk. In addition, the ISDA framework sets out clear provisions that should be included in relevant documents to address any legal issues that may arise from trading these products. 

This new standard is an important step for policymakers and market participants who wish to engage in this type of activity. It provides them with a standardised contractual framework and documentation which can be used when negotiating transactions involving digital asset derivatives. Furthermore, it helps ensure that all parties understand the risks associated with such trades and can make informed decisions about them.

Initially, it will only cover non-deliverable forwards and options on Bitcoin and Ether. However, the agreement could be expanded in the future to cover additional product types, including tokenised securities and other digital assets executed on distributed ledger technology (DLT), ISDA said.

More Clarity for the Industry 

As cryptocurrencies become more widely accepted as investment products, the need for an official fallback protocol to accommodate new standards and products has become increasingly important. 

This regulation, as such, has been in response to the increasing popularity of crypto derivatives and asset trading platforms. This is an important development for the industry, given that it will help ensure customer assets are protected from potential legal issues when trading crypto derivatives in the future.

Over the last nearly 40 years, ISDA has developed standardised legal documents as individual derivatives markets have grown in maturity, helping to ensure they function safely and efficiently. Now, it aims to provide the same clarity to crypto asset investors.

The publication of this global framework by a published industry body such as the ISDA is welcome news for investors and other market participants who have been preparing for digital asset derivative trading but did not know what to expect in terms of collateral treatment or other considerations. Now they have an official document to refer to when they need guidance. 

The guidance aims to help hedge market participants by providing a framework for increased transparency and making additional recommendations. And by increasing transparency in the derivatives market, the agency can better protect investors and encourage healthy competition among traders.

In addition, the guidance seeks to provide an extra layer of protection when engaging in derivative trades involving digital assets. It can help hedge risk by introducing contractual standards, making it easier for market participants to understand their obligations when entering these types of trades. 

It also seeks to promote efficient digital asset trading by introducing contractual standards that can be used across different jurisdictions. It should reduce the need for costly investigations or enforcement actions.

This is especially important given the increasing number of firms offering digital asset derivatives trading services. The guidance is aimed at helping financial service institutions, and customers understand the risks associated with digital asset derivatives trading and guiding how to ensure they comply with applicable regulations. 

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