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How Can Futures Trading Redefine Cryptocurrency Exchanges?

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Over the course of a year, from May 2017 until now, Bitcoin has varied between $1,500 in value to nearly $20,000, and then back down to as low as $6,200 – an increase of 1,233% and subsequent decrease of nearly 70%. This extreme volatility creates ample FUD (Fear, Uncertainty, and Doubt) in the cryptocurrency market, since most altcoins base their prices against BTC. Investors worry that a drop of 70% in less than three months could easily happen again, and given the fact that BTC isn’t physically based on anything, the market is heavily governed by the willingness of individuals and firms to invest in the potential of a cryptocurrency.

There is an option in traditional stock markets to trade future contracts both for material goods (such as corn, oil, etc.) and financial assets (currency, stocks, etc.). In December 2017, both the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) announced that they would begin trading future contracts of Bitcoin. Some believe that trading future contracts will help stabilize the cryptocurrency market, as it has done with other markets, but others are wary of putting government entities in control of cryptocurrency trading. Decentralized exchanges are a great idea, but they often fall short in some areas: can hybrid exchanges with the ability to trade future contracts pick up the slack?

We would like to thank the team at EMX (EverMarkets) for their contributions to the design and implementation of the research as well as the analysis of the results.

What is a Futures Contract?

Futures are essentially an agreement to buy or sell an asset (in this case Bitcoin) on a specified future date at a specific price. Once the contract has been entered, both parties deposit collateral (post margin) and they will then have exposure to the underlying asset. Traders will realize gains or losses when they close the trade, which could be anytime, even before the future expiration date. When trading futures, the goal is not necessarily to maximize profit but to instead to reduce the risk involved; this typically has greater implications when it comes to physical goods, since it allows companies a chance to guard against increasing prices for materials that are crucial to their operation.

With Bitcoin future contracts the rules are exactly the same, but the intentions behind the contracts themselves are a bit different. BTC futures are based on the price of BTC, allowing speculators to place a “bet” on what they think the price of BTC will be in the future. Being able to invest in futures allows people to make money on BTC without having to directly invest in the coin. This opens the door to two major consequences:

  • It offers regulation in an otherwise unregulated market. Bitcoin futures can be traded on regulated exchanges, which reduces the risks for fraud and theft.
  • Even in areas where trading BTC is banned, the trading of Bitcoin futures allows investors to still be able to speculate on the market, which helps to increase exposure and confidence in BTC.

Currently, most future contract markets and cryptocurrency exchanges are completely centralized, which leads to higher fees, lower accessibility, and the need for a clearinghouse to monitor the future contracts. With the addition of smart contracts, platforms are able to manage real world future contracts using digital contracts, which means there is potential to trade physical commodities such as flour, oil, or onions on the blockchain. If you are wondering if it could be possible to completely decentralize an exchange and a clearinghouse, then the short answer is yes. The long answer, however, is important to learn in order to understand why we should decentralize them and why creating hybrids may be the best option.

Investigating the Current Exchange Structure

EMX, blockchain

Investors who wish to trade, hold, and speculate on cryptocurrencies and future contracts currently don’t have that many options in terms of the exchanges they can use. There are the strictly centralized exchanges, such as Coinbase (Gdax), Binance, and Bitmex, and there are the decentralized options like IDEX and CryptoBridge. Bitmex, however, is limited to trading futures and perpetual contracts, but otherwise it is governed by the same conditions that affect centralized platforms. The primary differences between centralized and decentralized exchanges are fee schedules, the organization of their servers, accessibility, and their ability to provide collateral.

  • Fee schedules on centralized exchanges are set by the exchange itself, a seemingly arbitrary number. Decentralized exchanges set fees based on operational costs, since they have to pay to write to the blockchain. Both are lower than traditional markets, considering the CME pulled in $2.6 billion during 2017 thanks to the fees.
  • Servers are organized differently between the exchanges, primarily in the way they handle funds. On a centralized exchange users must keep their money on the server, which makes it vulnerable to thieves, government seizure, and outages. On a decentralized exchange, the users only interact with the server while performing a trade, and their money is kept in a short-term escrow wallet that will default the funds back to the owner in the event of a problem.
  • Centralized exchanges are governed by local laws and regulations while decentralized exchanges allow for anonymity and global access.
  • Centralized exchanges are able to provide collateral for future contract trading, typically backed by their own token, while decentralized exchanges must rely on community support for such a task.

To better understand these exchanges, we will look specifically at Bitmex and IDEX; taking them as a centralized and decentralized option respectively. We will examine Bitmex because of its ability to trade futures and IDEX because it supports real time, high transaction trading on the blockchain.

Bitmex, and all centralized exchanges, requires you to deposit and withdraw your funds from their servers (encrypted and kept in cold storage), and although Bitmex doesn’t have any maximum limits on deposits or withdrawals, it is common for centralized exchanges to enforce daily caps. These funds become inaccessible by the user if the website goes offline, is seized by a government entity, or any other type of situation that changes the condition of the exchange’s servers. The ability to trade on these exchanges is also often limited geographically, being subject to government regulations (BTC is currently banned in 8 countries).

Given that Bitmex is a futures exchange, they have a complex fee schedule that is based on how much leverage the investor wishes to use, whether they are a maker or a taker. For a traditional BTC futures contract, trading with 100x leverage, the maker earns a rebate of 0.0250% while the taker pays a fee of 0.0750%, while the settlement fee is 0.0500%.

Regardless of fees, a future contract cannot be secured without the process of a clearinghouse (CH) to back the funds. What the CH essentially does is accept payment from both sides of the contract, hold the funds until the contract ends, and then pay out the money accordingly. Bitmex also has an insurance fund that helps ensure contracts are paid accordingly by liquidating contracts that exceed specific, preset percentages of gains or losses. This CH functions in the traditional sense, but Bitmex is unable to execute trades on anything besides certain cryptocurrencies, and all of them are traded against Bitcoin.

IDEX, a decentralized exchange that is limited to ETH, is comprised of a trading engine, a smart contract, and a transaction queue arbiter that processes the order of trades. Trading through a decentralized process is different from using an exchange in that instead of keeping your funds on a centrally-located server, you agree to send the funds to the receiving party and IDEX confirms that you have done so. These trades must be authorized by the user’s private keys, ensuring that the user is in full control of their assets, even if IDEX goes offline, is hacked, or is seized by government entities.

Because IDEX uses the Ethereum blockchain to fulfill the transactions of its users, the fees tend to be a bit higher than those on the centralized exchanges. IDEX charges 0.2% for the market taker and 0.1% for the market maker, and the market taker must also pay the gas fee to place the transaction on the blockchain, which is based on market prices. The gas prices used by IDEX are non negotiable because IDEX queues all of the transactions in order, ensuring they are written to the block and appropriately added/deducted from the users’ wallets – if one transaction had less gas than the one before it then it would slow down the entire process.

Being decentralized, anyone can trade on IDEX regardless of their physical location and identity, so long as they have a compatible wallet and the appropriate funds. IDEX does have minimum trading requirements (0.15 ETH for makers and 0.05 ETH [equivalent] for takers) in order to keep gas prices to a minimum. There are no caps on the amount of money that can be traded nor on the frequency of withdrawals/trades that a user may make.

The approach of a completely decentralized exchange can quickly become expensive when the cost of ETH gas increases, while taking the centralized approach offers too many opportunities for interference in the cryptocurrency market, not to mention restrictions when it comes to trading future contracts and across international borders.

The Birth of Hybrid Exchanges

hybrid exchange, cryptocurrency

Just like in nature, a vacuum cannot exist for long in the market before something moves in to fill that void. Blockchain technology is currently in the stages of discovering voids and filling them, helping people come to realize the need for decentralization, one industry at a time. But pure decentralization isn’t always the most efficient, especially when you can take the best of both worlds and blend them into something far superior than their individual parts.

Hybrid exchanges like EMX and Market Protocol base their operations on the use of smart contracts to govern user interactions, much like decentralized exchanges, but they also rely on the community to verify prices and validate the trades. Typically in a hybrid exchange, the users’ currency will not be stored on the exchange, but will temporarily be held in escrow while the transaction/trade is being made and stored on the blockchain.

Market Protocol is a decentralized protocol that creates a trustless trading system through smart contracts on the Ethereum blockchain, combining the use of community nodes with blockchain technology to promote the trading of any asset, whether it be digital or in the real world. Traders will be able to easily enter long and short positions in any contract that they find liquidity in, contributing funds to a collateral pool before the trade is executed. The trade will be governed by a smart contract acting as the clearinghouse, and the contract will distribute the funds based on the agreed-upon rules, settlement date, or when traders opt to end the contract early.

Market Protocol charges no fees themselves, but third parties have the option to create “markets” by hosting an order book and setting their transaction fees. These nodes don’t have any control over user funds, and are more of a posting board where traders can post and broadcast orders. Market Protocol may move away from this in the future, replacing these nodes with full decentralization to help with scalability issues. It is important to note that all smart contracts and collateral pool balances are publicly available on the blockchain, and that no person or entity controls the flow of assets nor the order matching, contact creation, or dispute resolution.

bitcoin, futures contract

EMX allows users to trade equity, bonds, and commodity futures, as well as cryptocurrency futures like BTC, ETH, and LTC, on a hybrid centralized/decentralized platform fueled by blockchain technology. Its pivotal component being the implementation of periodic pro-rata call auctions instead of real-time limit order book trading, a choice that will help level the playing field for all traders regardless of size or geographical location.  Auctions also reduce the possibility of flash crashes, as it allows the market more time to process information and post orders.

EMX will be issuing their own token, the EMX token, which is used as the main currency of collateral at the clearinghouse.  Traders will post EMX onto smart contracts on the Ethereum blockchain, which holds custody of the funds, and the exchange and clearinghouse will monitor and maintain that collateral, ensuring that each trader has the funds necessary to fulfill their obligations.  This hybrid approach ensures that everyone can trust that the funds are safe and the clearinghouse will remain solvent. Since data will be batch written to the blockchain, EMX will charge a platform fee. Traders will also have an option to borrow tokens from a margin syndicate, paying a borrowing fee for doing so.

Because EMX will be reinventing the roles of the broker, the clearing house and the exchange aim to reduce fees and increase transparency by reducing the total parties involved. By allowing global access with fewer restrictions than the current futures exchanges, they will allow for more people to trade, speculate, and hedge in the global capital markets.  A student in Asia who wants exposure to the next Apple or Google can do so on EMX with little to no barriers to entry. As long as they have crypto, they can trade on EMX. The crypto-in, crypto-out feature of EMX means that people can quickly and easily access global stock, bond, commodity, and crypto markets to trade and diversify their holdings.

Opening Future Contract Trading to the World

Combining transparency, global accessibility, complete security, and a fair trading field would create the ideal exchange. And although we haven’t seen it yet, EMX might be the closest thing we have so far. Their aim in bringing the global market to everyone’s doorstep is a lofty one, but if they are able to pull it off we may actually start seeing the huge impact that blockchain technology can have on everyday life. We’ve bounced between the extremes; first the traditional markets that were heavily regulated then the markets based on the blockchain that aims to shrug off government control. Centralized and decentralized methods tried to fix our problems, but in reality a combination of the two may lead to greater progress, allowing for easy blockchain auditing to appease governments while also providing fair trade to all.

We’ve created an infographic to better explain this idea to you:

decentralized exchange, blockchain

All materials on this site are for informational purposes only. None of the material should be interpreted as investment advice.

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