Regulation and compliance are key to building crypto derivatives

For crypto to fully mature, regulated derivatives are non-negotiable.

Derivatives already contain 70-75% of the volume of crypto transactionswith leading institutional players. Although the number of regulated victims is increasing, the majority of the volume – about 95% – takes place in “offshore” locations, i.e. in unregulated or lightly regulated jurisdictions. This exposes investors to risks such as market manipulation and fraud, and leaves consumers without protection.

Fortunately, there are a growing number of ways for crypto-exchanges, especially in Europe, to meet the demands of risk-averse institutional investors whose main concerns are compliance, security and regulation.

What can we learn from market history?

Historically, spot markets have served as primary sources of liquidity and primary price-determining venues. As markets mature, derivative markets often take the lead, involving more information and future expectations. This transition has been seen in commodity and equity markets around the world, signaling a shift towards more advanced trading strategies – a key indicator of a mature market.

Similarly, in the crypto space, for a mature and balanced crypto market, access to spot and derivative trading is essential. Futures and options play and always will play an important role in managing risk, hedging and improving capital efficiency. They are critical to attracting sustainable institutional participation, ensuring capital efficiency and enabling a wide range of trading strategies.

However, only a regulated exchange can provide the security and compliance necessary for large financial customers. In order for crypto exchanges to offer EU-regulated crypto derivatives like perpetual swaps, it is necessary to obtain a MiFID license. There is no doubt that the demand for derivatives is growing – about 3 trillion dollars. MiFID will bring much-needed transparency and protection to the crypto markets, giving us oversight commensurate with traditional financial services. This increases market integrity and helps curb fraud.

Regulated exchanges can attract a wide range of institutional clients with demand for crypto derivatives. And they can be a source of innovation. The growing appetite for complex products such as perpetual swaps reflects the maturity of trading strategies, if they are monitored. Effective use of these tools is critical to promoting market integrity and creating sustainable yield opportunities.

Real institutional risk management

As we see in 2024, hedge funds and family offices will diversify away from Bitcoin and Ether and focus more on stablecoins, derivatives and emerging products. These players know that there is volatility in all markets, and trading comes with inherent risks – and crypto is no different. Rapid market swings can quickly turn profitable positions into losses. Derivatives are generally more risky than spot markets due to factors such as leverage and complexity because their value is derived from the underlying asset.

Access alone is not enough. Although regulated exchanges offer suitable crypto derivatives products, they cannot protect traders from potential losses. They can only provide protection against dangerous practices, abuses and bad actors.

Compliance is another critical part of crypto’s decentralized, cross-border landscape, where regulatory loopholes can exacerbate risks. Regulators in reputable jurisdictions are enforcing stricter standards for platforms offering crypto derivatives, requiring exchanges to register, maintain adequate capital, and implement strong anti-money laundering (AML) and know-your-customer (KYC) practices.

Storage has matured the most in terms of relevance since the last bull run.

Institutions need custodians who combine technical expertise in keeping crypto assets safe with the same rigorous custody as traditional asset management. Leading custodians bridge this gap through secure storage, operational transparency and robust security measures, thereby reducing the risks associated with hackers or technical failures.

As a result, institutions gain confidence in the crypto market and regulated custodians can comply with their own operational standards.

The industry must learn from past mistakes. Focusing solely on liquidity without adequate licensing, advanced compliance practices and other trust factors in reputable jurisdictions can have disastrous consequences. Web pages about “Proof of Reserves” do not represent anything without other guarantees. Global financial audits (usually from Big 4 accounting firms), ISO and SOC2 marks are essential for institutional and retail users to consider and prioritize when choosing a crypto platform or partner.

Today’s institutional players seek a market that effectively balances spot liquidity with derivatives for risk management and capital efficiency. The complementary roles of spot and derivatives markets can create a sustainable and growing crypto-ecosystem where transparency, security and compliance enable broad participation.

Therefore, regulated products and safe custody should be prioritized if exchanges want to offer integrated trading options for institutional investors by 2025.