Are derivatives the real underlying asset?

In equity markets, probably.

In crypto markets, it’s not so obvious.

Market Makers. Source: Scanz.com

In this article I am going to:

One largely overlooked aspect of trading is market structure. To be a good trader, one just needs to buy or sell before others do. Predicting when that is going to happen is where billions are made, and having a thorough understanding of the market structure behind how big players are positioned or how big positions are played is one of the market’s most predictive resources.

Market Structure

This refers to the technical construct that financial instruments operate on. Understanding market structure allows you to see how liquidity is positioned. These insights can give you a framework for both understanding why something is happening and how to act on it.

Recently, gamma squeezes have become a colloquial term. They represent the phenomenon of dealer positioning (Gary), an inevitable result of how equity markets are structured. In short, when you buy derivatives to the upside on an asset, a dealer will sell you the derivative and hedge against that by buying the ‘underlying’. When the acceleration of upside derivative purchases increases, so does the purchasing of the underlying by cash heavy dealers, resulting in exponential rises as seen in Gamestop and AMC. Monitoring the call or put volume prior to a gamma squeeze could give actionable insights on how to trade it.

How can these dealers be so involved if they impact the market so much? The answer is liquidity. Some of these market-making dealers are legally obliged to place bids under certain market conditions, which protects the infrastructure of the ‘underlying’. This became standard practice after the 1987 crash which was brought about by an overcrowded trade in portfolio insurance. In other words, the crash was a technical reaction to how the market was structured around portfolio insurance. There were not enough market-making firms willing to place a bid on that frightful morning — which regulators deemed unacceptable. Market makers have since become one of the primary driving forces of US equity markets.

The arguably black swan events of 2008 and March 2020 were two moments in time where this market-making backstop failed. In both cases, market conditions were so dire that prices were capitulating downwards and there seemed to be no buyers left— until the central banks made their money printing intentions clear. We have since seen an unparalleled rise in the US equity markets in notional terms. This concept of notional value is of the utmost importance.

Notional Value vs. Real Value

Below is a graph of the S&P 500 index priced in USD. It has looked pretty good since 2009 when quantitative easing measures began taking place.

SPX Index. Source: Bloomberg Global Macro Investor

Now compare the index against the Fed’s balance sheet.

S&P 500 / Fed Balance Sheet Ratio. Source Bloomberg: Global Macro Investor

As you can see, the value of the index in 2007/2008 was around 0.0016. So for every $1 on the Fed’s balance sheet, there existed ~$0.0016 of value in the S&P 500 index. Quantitative easing and bank bailouts brought floods of new capital into the system and onto the Fed’s balance sheet, pushing the value of the index to the 0.0004/0.0006 territory.

The index has not even come close to its previous highs in relative real value. Meanwhile, in USD notional value, there exists a precipitous rise. This leads to the forgone conclusion that each unit of USD is actively losing its relative real value.

In other words, prices are rising. Real value can be measured by notional value less inflation (resulting in spending power) but how do we measure inflation? You can listen to what the Fed reports in it’s CPI numbers or you can measure your purchases. Below is a comparison of the price of candy verse the weight of the candy between 2014 and 2018.

Source: Brand View

The notional value of these candies has not changed, yet the real value of what you are purchasing has declined substantially. This pattern of decreasing returns or increasing prices is common across many industries such as education, groceries, commodities, ride-sharing services, and streaming platforms. This is not a specific issue, it is a systemic problem.

Dan Held, the head of growth at the Kraken crypto exchange, recently posted an interesting perspective on the relative value of the USD.

Source: Dan Held’s LinkedIn

Scarcity, physical or digital, has made its way to the front of the debate about where assets derive their value. One thing is certain; the US dollar is not scarce.

According to Visualist Capitalist’ research on the world’s money supply, the derivatives markets outsize the stock markets by a factor of 11.

$ is in billions. Source: Visualist Capitalist

That final estimate of the world’s derivatives is $1,000,000,000,000,000.

One quadrillion US dollars.

Source: XDC News

If that estimate is correct, then for every $1 in a stock market, there are $11 dollars derived from that. These $11 serve a variety of purposes such as supply side hedging, but most are cash settled speculations. These are side bets, and bets on side bets, and bets on bets on sidebets. The sheer quantity of the value of side bets changes how the initial bet plays out. Similar to the reflexivity principle discussed by George Soros or the concept of Gary as described by legendary market maker and fund manager, Cem Karsan. Cem’s concepts of second order greeks are truly insightful. For more information on second order greeks and dealer positioning (Gary), read his analysis of equity market structure here.

Physicists deal with the same issues of reflexivity as financial markets, but in a more fundamental sense — the observer effect.

“In physics, the observer effect is the disturbance of an observed system by the act of observation.[1] [2] This is often the result of instruments that, by necessity, alter the state of what they measure in some manner. A common example is checking the pressure in an automobile tire; this is difficult to do without letting out some of the air, thus changing the pressure. Similarly, it is not possible to see any object without light hitting the object, and causing it to reflect that light. While the effects of observation are often negligible, the object still experiences a change.”

Financial markets are dynamic entities with infinitely complex combinations of observers and their intentions, and they compound this observer effect through the use of derivatives.

Crypto Market Structure

Things are a bit different in crypto. The whales in the equity markets are usually large traditional funds or market makers. The whales in crypto, on the other hand, are often early adopters, emerging funds, or individual traders. For large traders, simply opening a position can cause a market to rise or fall, especially in lower market cap altcoins. For example, nearly half of the ~$40 billion market cap of Dogecoin is held by a handful of wallets. What if they decide to market sell at the same time? That is the equivalent of the management of EA sports and nearly half of its stockholders selling all their shares simultaneously. This creates levels of sustained volatility unmatched in traditional equity markets, aside from perhaps penny stocks or OTC stocks where market caps are in the low millions and majority share owners can get away with acting shady.

This volatility has proven itself to be a feature, rather than a bug. Due to the way exchanges operate and distribute leverage, cascading liquidations can easily result from large traders moving positions. In a sense, the cascading liquidations are crypto’s version of a decentralized gamma squeeze across centralized exchanges. This liquidation effect is present in traditional markets as well but to a much smaller extent because of the standards practiced since the 1987 crash, the relative size of retail traders when compared to institutional investors, and leverage distributions. You are not going to see the S&P 500 index drop 50% in a week, but Bitcoin might.

In this tweet thread, Sam Trabucco, a quantitative trader from Alameda Research, describes his perspective on the differences of how equity and crypto markets interact with their respective derivative counterparts and how to ‘time the market’. He explains there are all sorts of new variables contributing to this volatility such as regulatory concerns, coin listings on major exchanges and provocative tweets from Elon Musk. These examples detail the relative instability of crypto markets. A deeply liquid derivative market is not backstopping the crypto spot markets in the same way traditional spot markets experience. This creates very different outcomes and increases volatility.

Crypto’s volatility has turned many investors away from it but often, these investors don’t understand it’s market structure. As stated, the S&P 500 index won’t fall 50% in a week, and if it did, the US equity markets would not be able to handle it on their own. Banks would be bailed out by the government, money would be printed to buy the dip and loan out to other market participants, margin calls would be a major issue, and the borrowing markets would freeze until further notice. Meanwhile, in cryptoland, 50% weekly drops have been seen for over a decade. These recurring events have made traders, platforms, and institutions battle tested and ready for more volatility.

A few weeks ago, the crypto markets dropped by nearly 50% from a total market cap of $2.2 trillion to about $1.4 trillion within a week. DeFi lending and borrowing markets did not shut down, DEXes worked fine, no one had to be bailed out, and there was no intervention by centralized authorities to clean up any mess. The only issues were with CEXes — centralized exchanges (Coinbase — of course, Binance, Gemini, etc) not being able to absorb the increased volume of transactions or withdrawals — but even these issues were very temporary. From this perspective, some could argue that the market structure of crypto markets is more stable than the market structure of equity markets.

So which is the underlying asset?

In equities, spot transactions are impacted more by derivatives than derivatives are impacted by spot due to the size of the derivatives in notional terms. This leads one to believe that derivatives have become the real underlying asset.

In crypto, it’s not so clear. Crypto derivatives are relatively very niche to equity derivatives. The existence of multiple futures exchanges and premiums is another factor that muddies the answer. For example, there have been times Bitcoin futures traded 10% higher on Coinbase than on other exchanges like Binance or FTX. This simply doesn’t happen on the single exchange (CME) where all S&P futures contracts are traded. Bitcoin’s premium has been as high as 20% in South Korea due to restrictions on foreigners trading the South Korean Won — it eventually gets arbitraged out or resets to equilibrium, but that is a non-existent phenomenon in equity markets. This uncorrelated price pattern and assortment of price oracles across different futures contracts and exchanges creates a convolution of data that has yet to be shown to affect crypto spot transactions the same way that traditional markets’ spot transactions are affected.

Things are evolving, an astounding amount of crypto projects have received funding over the past year and one of the primary talking points on improving crypto as a whole is to improve its derivative markets — options in particular. Will that lead to the problematic and reflexive reactions as shown in the traditional equity markets?

Only time will tell.