The State Of Crypto Derivatives

This episode delves into the intricate evolution of the crypto derivatives market, revealing how past crises have forged a path for more transparent, institutionally-focused financial instruments and strategies.

The Genesis of Arbalos: Lessons from the 2022 Chaos

• Josh Lim and Shailang, seasoned traders from Galaxy/Genesis and Ledger Prime respectively, recount their experiences during the tumultuous 2022 market cycle. Josh, from a sell-side perspective, and Shailang, from the buy-side, witnessed firsthand the "proliferation of correlated risk" where diverse strategies ultimately converged into market beta during downturns.
• Josh Lim observed, "everything boiled down to just market beta in a sort of a correlation one environment on the downside." This highlighted a critical flaw: concentrated risk in a few large books and correlated risk types across dealing desks.
• The founding of Arbalos (later acquired by Falcon X) was driven by the need for increased transparency, trust, and robust counterparty risk management, drawing inspiration from the stringently enforced rules of DeFi (Decentralized Finance), which refers to financial services built on blockchain technology that operate without traditional intermediaries.
• They aimed to build a firm that combined the integrity of DeFi protocols with the flexibility and structuring know-how of CFI (Centralized Finance), which involves traditional financial institutions or centralized exchanges.

Shailang's Perspective: The Unwind and the Path Forward

• Shailang detailed Ledger Prime's journey, which was part of Ledger Holdings (including Ledger X, a CFTC-regulated derivatives exchange). FTX acquired Ledger Holdings primarily for the Ledger X license.
  • CFTC (Commodity Futures Trading Commission) is the U.S. regulatory agency responsible for overseeing derivatives markets.
• The FTX collapse directly impacted Ledger Prime. Shailang noted that many market-neutral or quantitative funds also collapsed due to counterparty or credit risk, revealing that high returns were often "masked as counterparty or credit risk right or regulatory risk."
• This experience underscored the need for solutions from both a top-down (firm procedures) and bottom-up (DeFi primitives and infrastructure) perspective to enforce better risk management.
• Strategic Implication: For Crypto AI researchers, the emphasis on DeFi primitives and transparent rails highlights opportunities for AI in risk modeling, automated auditing, and developing more resilient financial infrastructure.

Market Evolution: From "One Big Trade" to Bifurcated Capital

• Josh Lim explained that while crypto trading often involves understanding retail capital flows and rotations, the current cycle differs. Capital is now bifurcated between "crypto proper" (on-chain assets) and traditional market instruments (like ETFs and crypto-exposed equities).
• These capital pools are distinct and don't mix as freely as in the previous cycle. The ETF (Exchange Traded Fund), a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same way a regular stock can, acts as a container for traditional capital entering crypto.
• The previous cycle's rally, particularly in altcoins, was fueled by widespread unsecured lending, which is less prevalent now. There's a greater focus on fundamental value and durability, leading to concentration in assets like Bitcoin.
• Actionable Insight: Investors should recognize the distinct behaviors of on-chain capital versus ETF-driven capital. This bifurcation impacts cross-asset correlations and rotation strategies.

Understanding the Crypto Derivatives Market

• Josh Lim provided a foundational overview of derivatives: financial instruments whose value is derived from an underlying asset, like Bitcoin.
  • Options offer asymmetric payouts (e.g., a call option allows profit from price increases without equivalent downside).
  • Perpetual Futures (Perps) are linear instruments without an expiry date, popular on exchanges like Binance and OKX, featuring a funding rate (a periodic payment exchanged between long and short traders to keep the perp price close to the spot price).
• Two key levers in pricing derivatives are the forward price (cost to hold a position open) and, for non-linear instruments, implied volatility (the market's expectation of future price movement, influencing option prices).
• The options market has grown significantly, moving beyond simple buy/sell transactions to complex structures. Josh noted, "You can also think about all these different types of things that exist in crypto as all of them having some sort of optionality embedded in them." This includes liquidity provision in AMM (Automated Market Maker) pools, which are decentralized exchange protocols that rely on mathematical formulas to price assets.
• Strategic Implication: The increasing complexity and embedded optionality in crypto instruments demand sophisticated modeling. AI researchers can find applications in pricing exotic derivatives, managing complex option books, and identifying mispriced volatility.

The Dominance of Perpetual Futures (Perps)

• Josh explained that perps gained popularity due to their ease of access and low friction for users wanting leveraged exposure to crypto without needing to fully fund spot purchases immediately.
• They originated partly because crypto was a fully funded product, and perps offered a way to get pre-funding and leverage.
• Shailang added that perps lack expiration and strike risk, simplifying trading. He speculated, "I wouldn't be surprised with the current administration that perpetual as a concept does you know become legal in the US in some form and we might see you know perpetuals in other asset classes outside of crypto."
• Investor Insight: While perps offer easy leverage, understanding funding rate dynamics is crucial, as these costs can significantly impact profitability, especially as market convexity changes.

Categorizing Crypto Funds

• Shailang outlined two broad fund categories: venture and liquid. Within liquid funds, he identified three types:
  • Quant market neutral / delta neutral (strategies aiming to profit regardless of market direction by offsetting long and short positions).
  • Directional (discretionary or systematic).
  • Emerging on-chain asset management using DeFi rails.
• Ledger Prime historically offered quantitative market-neutral funds, capitalizing on crypto's inefficiencies. Shailang anticipates crypto strategies will increasingly integrate into traditional multi-strategy funds like Millennium and Citadel.
• Funds are also starting to touch non-crypto assets like MicroStrategy (MSTR) derivatives, blurring lines.
• Researcher Note: The evolution of fund strategies towards hybrid models (crypto + tradfi assets, on-chain + off-chain) creates new datasets and complexities for AI-driven portfolio optimization and risk management.

Identifying Market Inefficiencies

• Shailang noted that early inefficiencies (e.g., simple arbitrage between centralized exchanges) have largely disappeared.
• Current inefficiencies might be found in DeFi, such as cross-chain arbitrage or DeFi-CFI arbitrage, though these are also becoming more competitive.
• As the crypto market matures and risk decreases, expected returns (and thus the definition of "inefficiency") are normalizing, moving from 30-50% towards traditional market returns in the teens for quantitative funds.
• Actionable Insight: The hunt for alpha is pushing into more complex DeFi interactions and requires sophisticated tools. AI can be pivotal in detecting fleeting cross-chain or DeFi-specific arbitrage opportunities.

Current Market State: Rotations and Liquidity Drains

• Josh Lim highlighted ongoing rotation trades between L1s (Layer 1 blockchains), which are foundational blockchain networks like Bitcoin or Ethereum.
• A key current theme is capital flowing into public market vehicles (e.g., Circle IPO, various private deals in public stocks) used to fund corporate treasury purchases of crypto.
• On-chain, events like the Plasma TVL (Total Value Locked) deal, where users commit stablecoins for future tokens (effectively a call option on Plasma tokens), act as significant liquidity drains. Plasma is a chain intended to support Tether transfers.
  • Josh explained the Plasma deal: "you will receive at the end basically a call option...to buy into the plasma tokens...at a $500 million valuation."
• The fundraising around Pump.fun is another example, reallocating capital from other assets. This contrasts with the previous cycle where access to early deals (like ICOs - Initial Coin Offerings, a fundraising method for new cryptocurrencies) offered more obvious convexity. Now, public deals are more efficient and accessible.
• Investor Watchpoint: These large-scale capital reallocations ("liquidity drains") into new ventures or vehicles can temporarily depress prices in other market segments. Understanding these flows is key to anticipating short-term market movements.

Impact of Liquidity Drains and the Rise of Public Vehicles

• Shailang discussed how public market vehicles, like those acquiring tokens for treasuries (e.g., a potential Fetch AI vehicle), are similar to past ICO dynamics, where early entry (e.g., at NAV for treasury vehicles) is sought for expected premiums.
  • NAV (Net Asset Value) represents a fund's per share/unit value.
• While these are different capital pools, they can support crypto valuations and potentially trigger an "alt season" for tokens deemed fundamentally valuable by traditional public money.
• Josh emphasized that the primary goal for token teams should be building products with utility and durability, rather than just financial engineering. However, creating public treasury companies has become a new "game."
• Strategic Consideration: The trend of token projects seeking public market listings or creating treasury vehicles suggests a move towards more traditional financial structures and regulatory scrutiny. This could favor projects with strong fundamentals and transparent operations.

Risks in Discounted Treasury Deals and Public Structures

• Shailang identified counterparty/credit risk in deals involving locked tokens, especially if not smart-contract enforced. The risk varies depending on whether tokens are sourced from foundations or individual whales.
• For funds doing these deals delta-neutrally (buying discounted locked tokens and hedging with perps), there's a risk of liquidation on the short leg if the token appreciates significantly, requiring more collateral.
• Comparing to Three Arrows Capital's (3AC) GBTC trade, Josh noted current public company structures (like MicroStrategy) have less leverage and more robust corporate governance (shareholder rights, potential for share buybacks or takeovers if trading at a discount to NAV).
• The hosts discussed Morpho's "one token" approach, highlighting investor preference for the legal framework and shareholder rights offered by public companies over the uncertainties of token-only structures.
• Shailang posited that classifying many tokens as securities might not be negative, as it could provide clear rules and unlock large pools of traditional capital.
• Investor Alert: While public vehicles offer a familiar structure, risks include over-leveraging by less experienced teams, investment in subpar assets, and potential for NAV discounts if market sentiment wanes.

The Outlook for Corporate Treasury Vehicles (Spacs, Pipes)

• Josh believes we are in the "early to mid innings" for these deals. He anticipates a handful of credible teams will lead large deals, with a "chosen one" vehicle often emerging for each major asset.
  • Spacs (Special Purpose Acquisition Companies) are shell corporations listed on a stock exchange with the purpose of acquiring a private company, thus making it public without going through the traditional IPO process. Pipes (Private Investment in Public Equity) involve selling publicly traded common shares or preferred stock/convertible securities to private investors.
• There might be around four or five more big ones for new assets and perhaps 50 smaller ones.
• Downside risks include "fatigue for these public equity deals" and crypto flatlining, causing vehicles to trade at a discount to NAV. However, precedents like GBTC and MicroStrategy trading at discounts and then recovering suggest investors are conditioned to view these as levered beta plays.
• The host predicted blow-ups could occur from over-leveraged Bitcoin vehicles run by less skilled teams or vehicles based on subpar assets (outside top 20-30). However, fraud is less likely, and mechanisms like share buybacks or acquisitions (e.g., by entities like MicroStrategy) could mitigate severe collapses.
• Actionable Insight: Investors should be selective, focusing on vehicles led by experienced teams with strong marketing and financial engineering, backing fundamentally sound assets. The global nature (e.g., Brazilian Bitcoin vehicle) indicates broader adoption.

The Deribit Acquisition and Derivatives Market Consolidation

• Josh Lim, whose firm Arbalos was acquired by Falcon X, sees the Deribit (a major crypto options exchange) acquisition by Coinbase as part of a broader consolidation trend in prime brokerage and derivatives.
• He noted a "winner take all phenomenon" where liquidity and collateral concentrate on dominant venues like Deribit for crypto-native participants or CME for traditional institutions.
  • CME (Chicago Mercantile Exchange) is a global derivatives marketplace.
• Despite Deribit's dominance in crypto-native options (estimated 80% market share), new venues are emerging, innovating in instruments, risk management, and collateral efficiency.
• Josh believes it's "very hard for the retail angle in options to break out because perps are so dominant" for retail leverage.
• Deribit, while perceived as institutional, facilitates significant risk transfer among large crypto-native dealing institutions, often via block trades matched by platforms like Paradigm (a technology company, not the VC).
• Market Outlook: Shailang expects IBIT (Bitcoin ETF) options volume to eventually surpass Deribit's Bitcoin options volume, indicating a shift towards regulated, traditional finance venues for crypto derivatives.

ETF Impact on Basis Trades and Volatility

• Shailang explained that traditional funds are engaging in the ETF basis trade: buying a Bitcoin ETF (like IBIT), posting it as collateral, and shorting CME Bitcoin futures to collect the yield from the futures roll-down, often with significant leverage (4-7x).
  • The basis trade in this context involves profiting from the difference between the spot price of an asset (accessed via ETF) and its futures price.
• Josh elaborated that as more capital chases this yield, the basis (the premium of futures over spot) naturally compresses. This trend is likely in its early innings.
• The willingness of TradFi prime brokers to offer margin against ETF shares further supplies cash to crypto and reduces leverage costs, compressing forward basis.
• This impacts options markets: long-term implied volatility for Bitcoin and ETH is near historic lows (mid-40s for 6-month BTC vol). Josh attributes this to "a lot of capital now looking to deploy market neutral into crypto and trying to extract yield. And as the basis compresses they're also looking at things like selling options." This is done via structured products, similar to equity markets.
• Investor Strategy: The compression of basis and long-dated volatility due to institutional yield-seeking strategies creates a challenging environment for traditional vol sellers but may offer opportunities for sophisticated relative value trades or strategies that benefit from sudden volatility spikes.

Hyperliquid: A Rising Star in On-Chain Derivatives

• Both speakers praised Hyperliquid for its user experience and technical execution, noting its emergence as a "clear winner" among on-chain perp platforms this cycle.
• Shailang attributed its success to strong technology (low latency, efficient matching engine) and effective internal market-making, which provided good liquidity from the outset. He stated this was done "in a more transparent fashion" than past centralized exchange practices.
• Josh added that increased on-chain activity (e.g., hedging impermanent loss) drives users to on-chain venues. Hyperliquid also successfully used an exchange token (HYPE) to incentivize users and build community, similar to BNB or FTT.
• They believe Hyperliquid can sustain its growth and compete with larger centralized perp platforms, partly due to easier onboarding and some regulatory arbitrage.
• Platform to Watch: Hyperliquid's success signals a growing appetite for performant and transparent on-chain derivatives. Researchers might explore its data for insights into on-chain trading behavior and liquidity dynamics.

Trade Ideas: Durable Value and Speculative Plays

• Durable Value - On-Chain Credit: Josh highlighted lending protocols with strong user bases paying fees, which accrue value to tokens (e.g., Aave for ETH, Camino for Solana, Syrup for Maple Finance). Wildcat was mentioned for uncollateralized on-chain lending.
  • Investor Focus: Look for protocols with clear revenue models, token buyback/distribution mechanisms, and sticky user bases.
• Relative Value - SOL vs. ETH: A complex trade. ETH benefits from institutional inflows and foundation efforts. Solana has seen memecoin activity (Pump.fun) and perp speculation. Josh leaned slightly towards Solana having "room to run" after recent pullbacks.
• Relative Value - Circle vs. Coinbase: Shailang suggested the current valuation ratio between Circle and Coinbase might be unsustainable and could normalize, presenting a potential relative value trade.
• Public Listings Play: The hosts agreed that new public listings (e.g., Bullish, Gemini) might see initial speculative pumps as investors chase the success of prior listings like Circle, regardless of underlying valuations. Josh: "it would take a lot to knock us off this trend."
• AI Theme Proxy - Worldcoin (WLD): Josh mentioned Worldcoin as a "picks and shovels play for AI," with identity verification becoming crucial. While supply is a headwind, delivering on its product roadmap could reignite its narrative.
  • Crypto AI Angle: Worldcoin is a direct example of a crypto project with an AI-related narrative (identity in an AI world). Its market performance could be a bellwether for sentiment in this niche.
• Memecoins & Pump.fun ICO: Shailang expressed bullishness on the upcoming Pump.fun ICO, with his firm planning to participate. Josh views memecoins as a levered way to get exposure to the underlying L1 gas token.
• Consensus Trades Working: An observation was made that obvious, consensus trades (Sui, Hype, Solana) have performed well this cycle, suggesting a market rewarding conviction in strong narratives.
• Actionable Takeaway: While "consensus trades" have worked, diversification and active management remain key. For AI-focused investors, proxy plays like Worldcoin or infrastructure supporting AI (e.g., decentralized compute, data markets) could be areas of interest, alongside the broader market themes discussed.

Conclusion

The crypto derivatives market is rapidly maturing, driven by institutional capital and innovative on-chain platforms, demanding sophisticated risk management and value assessment. Investors and researchers must track the convergence of TradFi structures with crypto-native assets and the evolving dynamics of liquidity and volatility.