Out of Options: The Sparsity of Hedging Solutions in the Crypto Space

This article was originally published in Hackeroon on 20th May 2021.

This bull run has seen a slew of institutional investors open their minds and their balance sheets to cryptocurrencies, with many of the financially initiated arguing that this institutional adoption is leading to the first crypto supercycle — whereby the price of crypto assets rise across the board to such a degree that previous market booms pale in comparison.

Data provider Bitcoin Treasuries posits that 6.76% of the total supply of BTC is held by institutional players, with notable high-profile entrants to the movement ranging from Tesla to revered hedge fund Brevan Howard. Alongside their own adoption, institutions are also working to facilitate ease of access to cryptocurrency use for their retail client bases, with Visa and Mastercard looking to implement crypto transactions, and PayPal allowing digital asset checkouts at all of its 29 million merchants by the end of the year.

Traditionally however, the sheer volatility of crypto markets has deterred mass-market adoption, and hindered its perceived viability as a means of transaction and a store of value. The inordinate returns and asset price appreciation which occurs during bull runs provides a temporary alleviation of this fear, as the double-edged sword of volatility falls in favour of crypto holders, however the spectre of correction and crash lingers soberingly in the background.

In search of solutions

As the number of market participants grows, the search for hedging instruments intensifies. This is particularly true for large, publicly listed institutions who put crypto on their balance sheets, as they are conscious of their fiduciary duty to their shareholders. As it currently stands, the options they currently find themselves presented with are few and far between; and those that do exist come with drawbacks, consequences, and barriers to entry so pronounced that in many cases they incite users to simply take their chances with the vicissitudes of volatility.

Take, for example, one of the most commonly used tools to counter crypto volatility; stop losses. Stop-losses are orders placed on trading platforms to sell an asset if its value falls to a certain pre-determined price set by the trader. They’re designed to limit an investor’s loss on a position when the market moves against them.

These aren’t static tools, however, and there are differing forms of stop losses; trailing stop losses, for example, are placed just like an ordinary stop loss when entering a position, but will follow the price as it moves up and remain stationary if the price moves down.

This allows traders to capitalize on price rallies and lock in profits when pullbacks occur. However, both ordinary and trailing stop losses have one common and irrevocable flaw; they both close out positions as soon as their price level has been hit, removing users’ market exposure and the possibility of benefitting from any further upside movement.

Partial stop losses provide some mitigation to this, but are essentially just a less aggressive iterations of the same instrument. These are stop losses which, similar to the previously mentioned versions, are set at a particular price floor by a user, however rather than closing out the full position only close out a portion of it. While not completely removing a users’ market exposure, they do significantly reduce it. And, in doing so, significantly and irreversibly reduce the potential for additional gains.

A better option?

Market participants who are looking for a solution which gives them the possibility to exit a position, but not the obligation, have the choice of using options contracts. Put and call options allow traders to buy and sell, respectively, an asset at a predetermined price on a given expiration date, but do not obligate them to do so. A call option on Eth at $3,000 on 1st June, for example, would allow the contract holder to sell their Eth at this guaranteed price on that specific date, even if its market price at the time is far below this. If the market price is higher — $4,000, for example — they have no obligation to fulfill the options contract, and can sell it on an exchange for its spot price, benefitting from the $1,000 difference in price.

Again, however, there are a number of flaws in these instruments which contribute to an adverse market environment for retail and institutional players alike. The expiry dates on these option contracts, for example, can serve as a major hindrance for adoption; call options provide volatility protection for a certain period of time, however when these contracts reach maturity they aren’t automatically renewed, and holders are left without protection from volatility. Investors would have to manually renew their protection by purchasing a new call option, which often incurs substantial brokerage fees and commission, eroding profit margins and ROI.

Far more fundamentally than this, however, is the problem of liquidity; while there may be an active and well-traded options market for major cryptocurrencies like BTC and ETH, this depth of liquidity simply doesn’t exist for more niche currencies, and for Decentralized Finance (DeFi) and obscure altcoins it’s virtually non-existent.

This means that DeFi enthusiasts are left with little choice but to accept the perils of volatility, and simply hope for the best and try to time their trades in a way which allows them to frontrun the market; a highly risky practice, bordering on fantasy.

Fuel to the fire

And finally, just when the situation seemed to be as inhospitable for investors as feasibly possible, the regulatory authorities enter the scene to compound the problem; in October of last year, the FCA issued a blanket ban on all crypto derivatives for retail investors, with the irony being that they cited extreme volatility as the cause of this legislation. This closes off one avenue of hedging solutions to retail traders entirely, and leaves them with even fewer options than before.

It would seem, therefore, that there is not only considerable demand for hedging solutions, but a serious and fundamental need for them.

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