As crypto derivatives are becoming increasingly popular, German regulators are looking into potential risks for retail investors.
The German financial markets authority BaFin has launched a survey to gain an understanding of the market of derivatives on crypto assets. According to the announcement, the demand for crypto derivatives by German retail traders has increased from August 2018 to January 2019 by almost 72%.
The BaFin defines “Crypto-Asset” as any digital investment vehicle that is not a financial investment according to German law. Hence, Security Tokens are not included in the definition; instead, “Crypto-Assets” refers in particular to digital currencies and Utility Tokens.
Most retail investors don’t understand how derivatives work
The reason for the survey is the BaFin’s concern that derivatives are putting investors at an increased risk. Most derivatives work with margins, meaning investors only have to provide a fraction of the actual trading volume as collateral.
On the leading crypto derivatives exchange BitMEX, investors can trade with a margin of only 1%. That means, to open a long position in Bitcoin worth $1 million, an investor would only have to provide $10,000 as collateral. Other exchanges, for example the regulated CME, ask for margins as high as 37% for their Bitcoin-Futures.
Investors can use these tools to bet on rising or falling prices without having to buy the underlying asset. That makes these trades attractive, as capital requirements are significantly lower. On the flip-side, the risk goes up as well, as investors can lose much more than their initial collateral.
That’s why regulators have issued warnings in the past and recommend retail investors not to engage in derivatives trading. For good reasons: Most retail investors lose money when trading derivatives, as they either don’t understand how these instruments work or don’t have enough experience.
Trading volumes on derivatives markets exceed spot markets by a factor of 10 to 18
Derivatives are primarily and institutional trading tool. Institutional investors use derivatives to speculate on prices and to hedge their portfolios to protect against downside risks. Derivatives form an integral part of institutional trading strategies on both traditional markets as well as crypto markets.
That’s the primary reason why they have become so popular during the bear market in 2018. After the crash in December 2017, it has become apparent that hedging instruments are needed to protect from sudden price drops.
Since then, the supply and demand of crypto derivatives have gone up significantly. Today, derivatives trading volumes exceed trading volumes of the underlying assets by a factor between 10 and 18.
Market manipulation puts retail investors at risk
One has to keep in mind the low liquidity of crypto spot markets. Due to this low liquidity, it is relatively easy for whales to manipulate the underlying asset and reap the benefits on the derivatives market. This kind of market manipulation happens frequently, and it’s something regulators might want to look into.
In its survey, the BaFin also points to market manipulation as high risk and says that “only a few market participants are dominating the market for cryptocurrencies.”
That’s why the BaFin now asks for more market insights to get a thorough understanding of the market structure and the potential need for further regulations. If you wish to participate, you can download the survey here.