Turning typical incentive schemes on their head has allowed Binance to lead the bitcoin derivatives market.
A changing of the guard in crypto exchanges now has Binance Futures leading the pack thanks to its rapid rise as a venue for trading bitcoin derivatives.
This has been attributed in other media as a result of technological glitches among rivals and a market reputation for Binance’s own technology as fast and reliable (although this hasn’t been 100% true). But the real reason is probably Binance Futures’s pricing model.
The change in fortunes was made stark in the wake of the March 13 market crash that tanked all asset classes, including bitcoin.
Change of guard
Before March 13, Hong Kong-operated BitMEX was the clear leader in volumes. It got its start with an aggressive digital marketing strategy that touted 100x leverage, which attracted the most speculative end of the unregulated market.
Other unregulated exchanges such as Huobi and OKEx followed suit, adding derivatives to their original spot markets (whereas BitMEX has been a pure derivatives exchange from the start).
Traditional futures markets such as CME also introduced bitcoin futures and options, but on conservative terms that appeal to institutions looking for regulatory clarity. They do not cater to the unregulated world of investors who want the high-octane experience of a BitMEX, and who comprise the greatest source of cryptocurrency trading liquidity.
An April 21 report by data provider Coin Metrics showed that in the month following the crash, BitMEX lost open interest and volume for bitcoin futures. It was eclipsed by Binance Futures, which reached $2.8 billion daily turnover versus $2.5 billion for Huobi and $2.1 billion for BitMEX. This is despite Binance being a relative newcomer to derivatives.
Crypto derivatives now account for 2-3x the volume of the spot market; in general, derivative markets set the tone for liquidity and price discovery in traditional markets such as equities and foreign exchange, where volumes may be 10x or 100x spot markets.
The goal for exchanges in crypto is to be the reference source for the rest of the market. That confers leadership in an industry where “flow begets flow”.
What’s behind the shift
Some of BitMEX’s problems have been suggested by crypto media outlets to stem from its systems going down during peak trading moments; it has also suffered from denial-of-service attacks launched by hackers.
These reports may miss a bigger underlying factor that explain why Binance Futures has emerged on top: how it incentivizes people to trade on its exchange.
Aaron Gong, vice president of Binance Futures in Singapore, says most crypto venues operate what is called a maker-taker fee structure. This model originated in the late 1990s with the first electronic pools that sought to win liquidity from established stock markets.
In the traditional model, exchanges filled orders first for recognized customer accounts (say a bulge-bracket firm trading on behalf of a pension fund). Exchanges would make money by charging market makers instead, making them pay for order flow from big brokers.
Electronic competitors favored market makers and high-churn fund managers, by giving them transaction rebates to bring liquidity to their venue, while charging the customers who “take” liquidity out of the market. Rewarding liquidity providers made sense in electronic markets where spreads are very tight, a world in which high-frequency traders generate most of the volume. (The practice has come under scrutiny in the U.S. where it is not clear high-frequency funds return the rebates they receive to their end investors.)
Maker-taker became the playbook for any challenger venue to win liquidity. This became so prevalent that traditional stock exchanges eventually adopted maker-taker pricing as well.
Most crypto exchanges have followed suit, but in a marketplace with fundamentally different types of participants. Cryptoworld is awash with market makers, high-frequency players, statistical arbitrage funds, and other volume traders. It lacks long-only, fundamentals-based or value-based investors that make up the bulk of the equities market.
“The problem with rewarding makers is that everyone wants to be one,” said Gong. “If you reward makers, orders don’t get filled. But if you have enough takers, it becomes easier to make markets on our exchange.”
Binance Futures only launched in 2019 with futures and added its first options contract in March 2020. It has done so with a fee structure that is cheaper for “takers” than other exchanges. It still pays makers for its quarterly futures contract but charges a small fee for its perpetual futures contract. Takers still pay more but only usually only about 2 basis points, or 0.02%.
BitMEX, on the other hand, charges takers 7.5 bps for perpetual contracts, while paying makers a 2.5bp rebate, according to its website.
Gong says this is what is attracting liquidity to Binance Futures. “Now price discovery is happening on our exchange, and other exchanges are following our price for bitcoin. “Our fee structure has made us the leader.”
Is this sustainable? Binance Futures is de facto subsidizing or heavily discounting both sides of trades. It’s a strategy that will work so long as the exchange continues to attract volumes. Being the market leader is critical to doing so. Speed is essential too, to see off rivals that try to buy liquidity.
Market leadership has also required finding a balance between retail investors and institutions.
Initially Binance Futures positioned itself as a more native-crypto counter to CME, offering only 20x leverage, but with smaller minimum contract sizes (just BTC1) and lower margin requirements than CME’s 37% (plus 10% initial margin). Gong says today about 60% of the venue’s flow is via APIs, meaning via integrations with financial entities.
But its userbase wanted the kind of drama on offer at venues like BitMEX. “The maximum leverage you can get on bitcoin futures at CME is two to three times,” said Gong, who used to work at CME before joining Binance Futures. “We [Binance] offered 20x, but users wanted more, so we now offer 125x.”
Even so, Binance Futures’s pricing model will require huge turnover. Crypto-derivative volumes are still less than 3x the spot market, far below the volumes derivatives enjoy in traditional asset classes. Futures markets bring liquidity and stability to assets; if the spot crypto market can be manipulated by “whales”, it is the development of futures that will extinguish such advantages. Market participants are confident the crypto derivatives scene will experience plenty of growth.