Satoshi Nakamoto introduced a novel form of decentralized and peer-to-peer money on October 31, 2008, publishing the Bitcoin white paper. It was a banner day in the history of finance, yet only a few tech-nerds realized its implications at the time, and many people still haven’t grasped them even today. Warren Buffett, CEO of Berkshire Hathaway, prophesied in 2018 that “cryptocurrencies will come to a bad ending.” Despite his well-reasoned conviction, recent developments have proved the Sage\’s conclusion a bit hasty.
The ending is nowhere in sight. On the contrary, the emergent reality of decentralized and user-centric finance, commonly referred to as DeFi, has become too significant to deny in recent years. 13 years following Satoshi\’s whitepaper, October. 19, 2021, became yet another historic landmark in bitcoin\’s journey. Following a long-drawn evaluation, the U.S. Securities and Exchange Commission (SEC) finally allowed ProShare to launch the first-ever Bitcoin Futures ETF ($BITO).
The ETF is trading on the New York Stock Exchange (NYSE) as a regulated financial instrument, facilitating greater institutional participation in the broader blockchain-cryptocurrency domain. On the one hand, bitcoin’s price soared to a six-month high of $60,000 in anticipation of the launch. On the other, $BITO became the second-best ETF debut of all time, with over $1 billion in day-one trading volume.
According to analyst Eric Balchunas, $BITO in fact recorded the best day-one figures in the history of ETFs, in terms of its ‘natural’ trading volume, sans seed capital. He further claims that it “traded more than 99.5 percent of all ETFs,” including prominent ones like $DIA, $ARKK, and $SLV.
Although motivating as well as promising, such developments may bring the sustainability of DeFi to question. Is it all speculative hype? Or, do these innovations genuinely represent long-term prospects and value? And above all, will crypto-markets ever mitigate volatility concerns and become stable enough to be relevant for practical and day-to-day business processes?
These questions have far-reaching implications. To address them is to merely scratch the surface, never discovering the epicenter. Moreover, such attempts fail to do justice to the domain’s complex and dynamic nature. Notwithstanding, the rise of crypto-based futures, and derivatives in general, could be seen as a step forward in solving the concerns implicit in the above questions. Therefore, it is also necessary to scrutinize its significance in determining DeFi’s progress.
Towards Certainty and Stability
Uncertainty is detrimental to business, and the crypto and digital assets sector isn’t an exception to this rule. On the contrary, stability and sustainability lead to successful businesses, more often than not.
SEC Chairman Gary Gensler hasn’t called for banning cryptocurrencies in the U.S., but the relationship between regulators and the “Wild West” of the crypto landscape has predominantly been antagonistic. However, as DeFi has matured, and proven its staying power, U.S. regulators\’ views seem to have matured as well.
In recent remarks, Gensler has called for striking a balance between preserving the innovations stemming from DeFi’s ascent and protecting investors against financial stability concerns. It’s certainly a more nuanced point of view than what we’ve seen in China, who declared “all cryptocurrency transactions illegal” in a recent ban, even as it develops its own national digital currency.
DeFi has so far overcome many such challenges, even surpassing prevalent expectations, and it is in this vein that crypto-based futures make the industry self-sufficient in enabling stable means for business transactions and investments.
According to William L. Silber, the primary economic functions of financial futures are risk transfer (hedging) and price discovery, besides enhancing transactions efficiency and liquidity. Though he argues in the context of traditional markets, his assertion applies to crypto-futures as well. At least insofar as the existing futures market in crypto inherits much of its rudimentary concepts from the traditional counterpart.
Presently, on-chain and off-chain vendors can offset the volatility of open cryptocurrency markets using DeFi futures. Several crypto-exchange platforms, such as Phemex, enable futures contracts trading in a simple and user-friendly manner. This allows even amateurs and non-professional traders to efficiently manage risk through flexible futures with low barriers to entry. Businesses, particularly SMEs, also gain a vantage point to foresee operational costs, providing greater degrees of certainty than have been historically possible.
Preserving the Scope for Speculation
The idea of financial speculation often carries a negative connotation, especially when it’s conflated with gambling or betting. However, almost every leading economy relies on speculation in some form, participating in forex and money markets globally. Whether speculation at the level of economic policy-making is for better or worse is besides the point, but it is not inherently bad, and can actually facilitate microeconomic growth.
Choice is crucial to the smooth and efficient functioning of free markets. It is also a foundational principle for DeFi, particularly in view of its community orientation. Crypto markets must be conducive to productive speculation while ensuring stability and hedging opportunities. The more than $4.14 billion locked in DeFi derivatives and the parabolic rise of yield farming, among other factors, substantially demonstrates the demand for speculative products in crypto.
Futures trading serves as a harmonious meeting point for hedgers and speculators. One buys long, while the other sells short. Arbitrageurs play a role in establishing consistent pricing across markets, reaping their share of economic gains. But the scope for sustainable, speculation-driven returns is much broader than the simplistic coming together of risk-shedders and risk-takers. Trading interest rate futures is a manifestation of this scope, and despite its nascence, DeFi has promising offerings in this regard.
Platforms like Unreal Finance tokenize “unrealized” future yields and make them available to the owner for instant use. In general, most yield farming protocols, including Compound and AAVE, offer dynamic interest rates based on supply-demand metrics. Although returns are otherwise high, the possibility of loss due to fluctuating rates therefore remains for lenders and borrowers. But because tokenized futures are tradeable, individuals can sell them in secondary (or native) marketplaces to immediately reap future interest at the current rate.
On the other hand, speculators can gain risk exposure through these futures, without having to own the underlying yield-bearing assets. Due to the significant cost benefits, even smaller investors with low capital access can also participate in the tokenized yield futures market.
A Sign of Maturity
DeFi futures have multifarious benefits over their conventional futures counterparts: faster settlement, wider access, lower costs, and ease of use. The scope for innovation is also much higher, particularly in terms of building integrated systems. But over and above these immediate outcomes, the emergence of robust futures platforms and products is a sign of DeFi’s maturity.
As a whole, the burgeoning DeFi sector is steadily creating viable alternatives to legacy financial instruments and services. Futures are only one of them, but they are decisive in paving the way forward. For a detailed understanding of the economic significance of financial futures, reading Silber’s work is worthwhile. For now, suffice it to say that efficient and competitive futures markets will facilitate better capital formation among the industry’s diverse stakeholders.
Leading institutional investors and venture capitalists have been particularly enthusiastic about crypto-based instruments recently. For instance, a16z has a dedicated $2.2 billion crypto venture fund, the company’s third, and largest, fund for this sector. Alternative smart-contract based funds have also emerged, such as those offered by Hillstone.Finance. Interestingly, veterans from the traditional sector are actively involved in these projects, underscoring indirect institutional participation.
Besides democratizing venture capital distribution, the DeFi phenomenon taps into deep knowledge pools and allows for greater accountability. Projects become more reliable as well. And in these contexts, regulated crypto-based futures, like $BITO and other upcoming ETFs, have immense significance for DeFi’s progress. First, they will further enhance the possibility and ease of institutional participation. Second, they will inspire the creation of more user-centric and open-source alternatives.
DeFi still needs multiple elements to become a complete financial system, relevant for general and specific purposes alike. To reiterate, crypto-futures are one of these crucial elements, already up and running. And considering the pace at which the industry is progressing, it won’t be long before the other necessary tools and instruments become a reality. How these parts come together to form the whole, and how they mature to bring real utility to the mass market, remains to be seen.