As we move into 2023 after a particularly challenging year marked by several black swan events all throughout the DeFi space, it appears interesting to perform a broad assessment of the current state of the derivative market and analyze each of its key components in order to highlight the dynamics that will most likely impact if not led the development of the market in this coming year. 

Main insights

• The Grayscale premium trade aftermath will most likely continue to have ripple effects onto the industry and potentially cause additional contagion among key industry players (GDC, Gemini, …) if no settlement can be found among the different parties.

• Futures and Perpetuals volumes should start to rise again from their 2022 year-end bottom levels, as the space start to rebuild with more transparency and better fit to market products attracting new institutional investors prioritizing derivatives to gain exposure to BTC and ETH ecosystems.

• Investors will have to remain cautious of the regulatory risk given the increasing scrutiny of international regulators on crypto assets and the regulatory by enforcement strategy employed by the SEC in the US.

• The emergence of new investment vehicles in the derivative market (structured vaults, perpetual options…) could bootstrap the emergence of new interesting opportunities for investors while enabling the inflow of additional liquidity in the market.

Grayscale premium trade

Despite its already dramatic effect on the entire industry over the past year which led the to the bankruptcy of several key industry players (FTX, 3AC, …), the aftermath of the industry wide Grayscale Premium trade still continues to spread contagion and fear throughout the market following the recent collapse of FTX and its ripple effects on Genesis, DCG and Gemini**.**

Furthermore, adding fuel to the fire, the refusal of Grayscale to show public proof of its BTC holdings as well as the growing public tensions between Gemini and Grayscale’s parent company DCG over a $1B liability recently increased the selling pressure on $GBTC shares pushing the Grayscale discount over -40% towards the end of 2022. As such, it appears important for investors to remain cautious of this risk in their investment choice during the first half of 2023 and price in the eventuality of additional headwind across the crypto sector coming from this unresolved situation.

Grayscale premium TLDR

Initially profitable the Grayscale trade consisted for eligible institutional investors to exchange with Grayscale a given amount of BTC for $GBTC shares to then resell those shares on the secondary market at a premium to retail investors who prior to 2019 couldn’t get any real exposure to BTC on traditional financial market outside of $GBTC. However, the situation quickly reversed in 2021 with this premium becoming a discount following the added selling pressure on $GBTC coming from an increasing number of institutional investors entering the trade as well as the growing options at hand for retails investors to get exposure to BTC through BTC future ETFs (CME, …).

Resilience of the derivative market

All throughout this past year, the derivative market showed growing signs of maturity as it continued to gain additional market shares against the spot market while also being able to ensure sufficient liquidity during the several period of high volatility that we encountered.

Indeed, even though the future and perpetuals markets suffered from a steep decline in volume across the year following the collapse of numerous institutional market participants on both the seller and buyer side (3AC, FTX, …), we can see that those markets reveal themselves mature enough to enable investors to hedge their portfolio risks during period of high risks as shows the below peak volume of future trading during the collapse of FTX.

Inability of the option market to reach mainstream adoption

On the contrary of perpetuals and futures which quickly became soon after their release among the most popular and traded assets on both centralized and decentralized derivative marketplaces, option derivatives still remain a pretty nascent and low volume market focusing mostly on BTC and ETH.

Nonetheless, existing use-cases in risk management such as custom options strategies for Liquidity providers enabling to hedge the convexity of the impermanent loss risk or underdeveloped option products such as hash rate options enabling miners to hedge away the hash rate risk on their mining ROI could create new opportunities for this asset class in the short term future. Similarly, new type of options such as everlasting options still complex to price could also become a really interesting tool if able to find a good market fit in the ever-changing DeFi landscape. As such, investors should remain informed on this asset class as its current underdevelopment could hide an important untapped growth potential.

Increasing regulatory risk

Following the recent demise of numerous high profile crypto companies involved in the Grayscale premium trade the hope for more regulatory transparency through the approval of a spot BTC ETF under the actual SEC chair Gary Gensler disappeared altogether. Worst, due to the massive implication of SBF in the draft of the forthcoming crypto bill scheduled to be soon presented in front of the Congress, chances of congressional vote on a “crypto bill” appear now pretty slim and investors will most likely have to wait for the election of a new administration to see the passing of a crypto bill bringing more clarity onto the sector. Consequently, investors will have to remain in the meantime cautious of the regulatory risk coming from the pretty aggressive legislation by enforcement led by the SEC when investing in tokenized derivatives.

On the other hand, for pure derivative products falling under the purview of the CFTC, investors will also need to remain aware of the regulatory risk and of the previous decisions of the commissions which despite being more consistent than the SEC still remain nonetheless willing to assert its authority on this new sector.

Dominance of centralized derivative marketplace

 In line with the situation observed in the spot market, both from a volume and open interest standpoint centralized derivative marketplaces still remain ahead of fully decentralized marketplaces by several orders of magnitude despite the recent scandals which tainted several centralized derivative actors and the increasing trend among crypto native users to rely more and more on self-custody.

However, with the current growing momentum around Ethereum scaling solution enabling low gas fees and the increasing reliance of the DeFi sector on a growing number of AMM pools requiring liquidity hedging, it is to expect that the market share of the decentralized derivative marketplace will likely increase over the course of the upcoming year.

Tether’s monopoly challenged  

Building-up on its growing momentum following the different 2021 USDT scandals, USDC continued all throughout 2022 to consolidate its place of best USDT alternative for investors wary of transparent auditing process and even came close to challenge Tether in terms of market cap despite a continued dominance of the latter in terms of daily volume traded. 

Nonetheless, given its highly transparent auditing process and partnership with major players such as VISA or BlackRock, USDC seems on a good path to be able to challenge further Tether’s monopoly throughout the coming year as it already did successfully inside the Ethereum ecosystem. 

Brewing derivative innovation

Despite an interesting pace of innovation in the derivative sector with several new tools designed over the past year and a half (everlasting options, structured vault, floating strike options …) the adoption and infrastructural development around this new market segment was not able to follow-up given the larger focus on the numerous scandals that impacted the market over this past year which induced a liquidity crunch and a flight to safety from investors. Nonetheless, despite this mild set back, those new products seem now really well positioned to be able to finally hit the market and offer interesting new range of investment types all across the DeFi space during the course of 2023.

Disclaimer: All information/documents contained in this blog rely solely  on my personal beliefs, and do not constitute professional investment advice.

Be careful in your investment and do not invest more than you can afford to lose.