Analysis of ETF and leveraged tokens in cryptocurrency derivatives

Exchange Traded Fund (ETF) is an open-end fund with variable fund shares listed and traded on the exchange, mostly passively managed funds, used to track the return on underlying assets such as gold, stock indexes, commodity indexes, etc. . The characteristics of low fees and flexible and fast transactions have made ETFs a mainstream investment tool around the world.

In 1990, the world’s first stock index ETF-Index Participating Unit Funds (TIPs) was launched on the Toronto Stock Exchange in Canada.

The characteristics of “exchange trading” and “1:1 tracking stock index” mark its uniqueness. Ordinary open-end funds are generally sold through direct sales of fund companies or agency agencies (such as commercial banks, securities business departments), only off-market subscription and redemption, and the price is calculated based on the net value of the fund after the closing of the day. As a special open-end fund, ETF can be traded in the secondary market in real time on the exchange, thus greatly improving the flexibility of trading. This epoch-making fund marked the emergence of a brand-new trading model.

In 2005, the world’s first inverse stock index leveraged ETF, the XACT Bear Fund, was launched on the Stockholm Stock Exchange in Sweden.

“Inverse” and “leverage” are its biggest innovations-its pursuit of about 1.5 times the return of the index change. Over the next ten years, leveraged ETFs developed rapidly in Europe and North America, resulting in leveraged ETFs with huge trading volumes such as triple Nasdaq shorts (SQQQ), triple Dow shorts (SDOW), and 1.5x panic index (UVXY).

Today, stock index ETFs have become one of the most important financial derivatives of stocks. According to the “ETF Industry Development Report (2021)” released by the Shanghai Stock Exchange, as of the end of 2020, there are 7,527 ETFs listed and traded globally, with total assets exceeding US$7.9 trillion. In addition to traditional underlying assets such as gold, stock indexes, and commodity indexes, cryptocurrency ETFs with cryptocurrencies as their underlying assets have also emerged.

The buds of cryptocurrency ETFs

The simple understanding of a cryptocurrency ETF is to turn the underlying financial assets of a traditional ETF into a cryptocurrency. This is the application of the existing and mature derivatives model to a new asset class. The discussion about cryptocurrency ETFs has been around for a long time. As early as 2013, Winklevoss and Cameron applied to the US SEC for the issuance of a Bitcoin  ETF for the first time . Over the past eight years, many institutions have filed applications with the US SEC, but none of them has been approved so far-either outright rejection or repeated extensions.

1627465892566149In July 2021, the U.S. SEC extended its review of Tianqiao Capital’s Bitcoin ETF application. Skybridge Capital submitted an application on May 6, and the US SEC has extended the initial 45-day review period to August 25.

History is always surprisingly similar, and this time the Toronto Stock Exchange is at the forefront of the times.

On February 18, 2021, the world’s first cryptocurrency ETF, Purpose Bitcoin ETF (code BTCC), was listed on the Toronto Stock Exchange.

1627465892569509Since its listing, the asset scale of Purpose Bitcoin ETF has continued to rise. On July 7, the ETF’s asset management scale exceeded 22,400 BTC, a record high.

Cryptocurrency transactions often have the characteristics of high barriers to entry and high transaction costs. An important significance of issuing cryptocurrency ETFs is to lower the threshold for investing in cryptocurrencies. Compared with other investment methods, cryptocurrency ETFs have lower management fees, lower premiums, and no lock-up period (compared to the products of companies such as Grayscale). They can even be bought and sold through securities accounts. In addition, since the holders of cryptocurrency ETFs do not directly hold cryptocurrencies, investors do not need to worry about the storage and security of digital assets. This means that with the development of cryptocurrency ETFs, they are likely to attract more investors and incremental funds to enter this market.

Leveraged ETF: Probably the lowest cost leveraged investment method

On April 16, 2021, the world’s first cryptocurrency leveraged ETF, Beta Pro Bitcoin ETF (code: HBIT), was listed on the Toronto Stock Exchange. As a reverse ETF of Bitcoin, its income has a negative correlation with the price of Bitcoin. .

Unlike traditional ETFs that track underlying assets at a 1:1 ratio, the beta value of leveraged ETFs is more flexible and can be positive or negative. Currently, the more common stock index leveraged ETFs include triple Nasdaq shorts (SQQQ), triple Dow shorts (SDOW), 2x panic index (TVIX) and 3x short emerging markets (YANG).

For investors, cryptocurrency leveraged ETFs provide a lower-cost leveraged trading method. Compared with general leveraged investment tools, leveraged ETFs provide lower barriers to entry-whether it is the threshold of investment scale or the requirements for professionalism. On the other hand, compared with futures instruments, leveraged ETFs have no position restrictions, no margin is required, and they will not be forcibly liquidated due to liquidation. Therefore, the operational risk of leveraged ETFs is also lower.

1627465892585735The world’s first cryptocurrency leveraged ETF is listed on the Toronto Stock Exchange (Source: Toronto Stock Exchange)

Leveraged Tokens: “Leveraged ETF” in the currency circle

While the world’s first encryption currency leveraged ETF was listed until April 2021, but the currency Ann represented encryption currency exchange as early as after the 2019 launch of a similar leveraged investment vehicles – leverage tokens (leveraged token).

Leveraged tokens, that is, tokens with leverage function, aim to provide leverage multiple rewards for changes in the price of cryptocurrency assets. As a leveraged trading tool, leveraged tokens have basically the same advantages as leveraged ETFs. Compared with cryptocurrency leveraged investment tools such as contracts and futures, leveraged tokens not only have lower investment access thresholds (whether it is capital threshold or professional requirements), but also do not need to pay margin, and there is no risk of liquidation.

The operating mechanism of leveraged tokens

Stock index leveraged ETFs can achieve leverage and reverse income effects by introducing financial derivatives such as stock index futures and stock swaps. The subject of leveraged tokens is a perpetual contract of cryptocurrency. (Perpetual contracts are an innovation based on traditional futures. Perpetual contracts are only settled in cash and not delivered.)

1627465892594665The underlying assets of leveraged tokens are mainly cryptocurrency perpetual contracts

There are currently two main types of leveraged tokens on the market-fixed leveraged tokens and floating leveraged tokens. The characteristic of fixed-leverage tokens is to adjust positions regularly every day to maintain a fixed leverage ratio; while floating-leverage tokens are adjusted irregularly, and their leverage ratio fluctuates with the transaction.

The operating mechanism of fixed leverage tokens

Fixed-leverage tokens need to be adjusted regularly every day, because their beta value is not equal to 1. When the underlying asset price changes, the net value and risk exposure change by different extents, and the leverage multiples of leveraged tokens will change and need to be checked regularly. The underlying assets can be adjusted to maintain a fixed leverage.

For the convenience of explanation, suppose 1 BTC is 100 U.S. dollars (USDT), the underlying assets of a triple leveraged BTC token are 3 BTCs, and the risk exposure is 300 U.S. dollars. Suppose an investor buys a triple leveraged token with 100 USD. If the price of BTC rises by 5%, the net value of leveraged tokens rises by 15%. At this time, the net value of BTC is 105 US dollars, and the net asset value of investors is 115 US dollars, and the corresponding risk exposure is 315 US dollars. After the price change, the actual leverage of the token has changed, and the current leverage is 315/115=2.74-no longer three times leverage. In this case, the underlying assets of leveraged tokens need to be increased by another 30 US dollars, increasing the risk exposure to 345 US dollars, so as to maintain three times the leverage. Similarly, if the price of the underlying asset falls, leveraged tokens also need to adjust their positions to reduce exposure and restore the leverage ratio to 3 times.

Applicable scenarios of fixed-leverage tokens and “volatility decay”

For long leveraged tokens, when the market rises, the value of the underlying assets will increase, and the leveraged tokens will become an automatic compound interest system, and leverage will continue to be added to the increase in net value. When the market falls, the value of the underlying assets decreases, and leveraged tokens become a batch stop loss system, removing the leverage that reduces the net value.

For a long leveraged token, the corresponding asset package behind it will continue to change, which is equivalent to automatically chasing ups and downs every day. Such derivatives are only suitable for unilateral market, not for volatile market without trend. When there is a unilateral trend in the market, regardless of the direction of the ups and downs, the profit and loss of leveraged tokens will be better than ordinary leveraged transactions. In a fluctuating market without a trend, the net value of leveraged tokens will experience additional wear and tear. This effect is called “Volatility Drag”. The effect of “volatility attenuation” is mainly related to the three factors of leverage, volatility, and number of trading days. The higher the leverage, the greater the volatility, and the greater the number of trading days, the greater the wear and tear of net worth.

1627465892603626The shaded part indicates that the profit and loss of the 1.5X leveraged token is better than the profit and loss of the underlying asset X1.5

From fixed lever to floating lever

At present, more exchanges have launched floating leveraged tokens. Floating leveraged tokens do not have a regular position adjustment system, and position adjustments will only be carried out when there is an extreme change in the price of the underlying asset. This means that the “ordinary” market fluctuations will not trigger rebalancing, and the value of the token will remain correlated with the value of the underlying asset.

In addition to considering the correlation between the value of the token and the price of the underlying asset, the trading defects of the regular position adjustment system may also be an important reason for the shift of leveraged tokens from fixed leverage to floating leverage. In order to study this issue, let us first look at the traditional financial market. Li M (2014) studied the impact of stock index leveraged ETFs on the performance of constituent stocks. Research has found that many stock traders blame leveraged ETFs for the violent market volatility in the last hour of trading. The author uses the event research method to test and finds that the constituent stocks of stock index leveraged ETFs often experience increased trading volume and volatility in the last hour of trading. The author infers that this may be related to the rebalancing of leveraged ETFs before the daily close.

If the underlying asset price rises compared to the previous day: ① For long ETFs with a beta greater than 0, the profit will be leveraged to promote the rise. ②For short ETFs with a beta less than 0, the part of the loss will be deleveraged, which will also promote the rise. Conversely, when the price of the underlying asset falls, leveraged ETFs will also push it down.

In addition to the crowded trading situation, the open fixed position adjustment time may be used by the counterparty. For example, the leveraged products of MXC Matcha are regularly “rebalanced” at 0:00 Singapore time every day, which may cause counterparties to conduct targeted transactions around 0:00. This may also be one of the reasons that contributed to the shift of leveraged tokens from fixed leverage to floating leverage. It is expected that future cryptocurrency leveraged ETFs will also use more floating leverage.

Concluding remarks

Due to the characteristics of weak regulation, cryptocurrency exchanges have a higher degree of freedom when launching derivatives. Coupled with the hotness of cryptocurrency trading represented by Bitcoin and Ethereum, the cryptocurrency derivatives market has seen explosive growth in the past two years, with various products emerging in an endless stream, and more exchanges have begun to launch cryptocurrency derivatives.

According to CoinGecko data, 2020 annual volume and market share of the top four currency exchange are encrypted security token (Binance), Ou Yi ( OKEx ), fire coin  (Huobi) and  Coinbase . It is worth mentioning that the top three exchanges were all founded by the Chinese team.

162746589260719324-hour trading volume of the four major cryptocurrency exchanges (July 16, 2021; unit: 100 million U.S. dollars)

It can be seen that in the two exchanges with the largest trading volume, the trading volume of derivatives has exceeded the spot trading. The reason why Coinbase did not carry out the derivatives business may be more to meet the regulatory requirements of the Nasdaq listing.

As the world’s largest cryptocurrency exchange by trading volume and market share, eight of the top ten products on Binance Exchange are derivatives. In addition to the accelerated transformation of traditional cryptocurrency exchanges to derivatives trading, there are also emerging exchanges that focus on derivatives, such as the FTX exchange.

1627465892725459Top 10 products by trading volume on Binance Exchange (July 16, 2021)

Most of the cryptocurrency derivatives are based on the existing more mature derivatives model, and made targeted improvements to the characteristics of cryptocurrencies on the original basis. Regardless of the design of derivatives or the improvement of market rules, cryptocurrency derivatives are still in a state of rapid iteration.

For a mature financial market, the transaction scale of derivatives is often much larger than the spot transaction scale in the end. After derivatives transactions reach a certain scale, they often affect the spot market in turn. It is believed that with the completion of relevant laws and regulations, cryptocurrency derivatives represented by cryptocurrency ETFs will usher in greater development opportunities in the next few years.

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