Welcome to a new episode of The Big Picture! This week we were pleased to have on Neil Patel and Nick Trileski from DRW.

Join us as we explore the world of CME crypto derivatives, uncovering key insights, trends, and opportunities. From counterparty risk to onshore/offshore options, miners' strategies, institutional adoption, and macro developments, we'll navigate through the intricacies of this dynamic market. Stay tuned for a thought-provoking discussion on CME crypto derivatives that will broaden your perspective and deepen your understanding of the evolving landscape. 

Chapters:
0:00 - Intro
2:55 - CME Crypto Derivatives and Counterparty Risk
6:00 - How are Clients Looking at CME
9:15 - Puts and Calls Onshore and Offshore 
11:25 - Miners Using CME and Basis Plays
15:30 - FTX and Institutional Adoption
18:10 - Macro Developments
25:40 - One Metric to Follow Closely
27:40 - Short to Medium-Term Outlook
30:38 - Price Action and Banking Crisis
33:40 - Macro Regime, Pricing in Another Rate Hike


Don't miss out on free alpha!
https://pdgm.co/45QI1Cc

Join Paradigm Now and Trade: 
https://pdgm.co/42vCv4Z


Join us on social:
Twitter: https://pdgm.co/43NQdS5
LinkedIn: https://pdgm.co/42rze70
Telegram:  https://pdgm.co/45LTDGF
Blog: https://pdgm.co/45HDt17


About Paradigm: 
Paradigm is a zero-fee, liquidity network for crypto derivatives traders across CeFi and DeFi. The platform provides traders with unified access to multi-asset, multi-protocol liquidity on demand without compromising on price, size, cost and immediacy. The firm's mission is to create a platform where traders can trade anything, with anyone and settle it anywhere.


Disclaimer:
All opinions and actions expressed and undertaken by the guest and host are individual opinions and actions only and do not reflect the opinions and actions of Paradigm. Paradigm does not guarantee the accuracy, applicability, reliability, integrity, performance or appropriateness of the content of this video, nor shall Paradigm be liable for any loss or damage that may be caused directly or indirectly by your use of these contents.

Paradigm is not your broker, intermediary, agent, or advisor and has no fiduciary relationship or obligation to you in connection with any trades or other decisions or activities effected by you. No communication or information provided to you by Paradigm is intended as, or shall be considered or construed as, investment advice, financial advice, trading advice, or any other sort of advice.

Hi, I'm David Raquel, Director of Sales at Paradigm.

is reverting, so the obvious trade is always the expensive 1.

This whole peak inflation, peak rates narrative, peak Fed, which we've been talking about.

the crypto option markets are definitely showing some signs of life.

My name is Joe Crui at Paradigm in the weeds around everything crypto vol markets.

Joined here by my macro all star co host David Brickel as well as Neil Patel and Nick Trilesky who run the Crypto Derivatives Desk at DRW.

This is going to be a really exciting conversation around something that we really haven't discussed on this channel before, and that is the CME crypto derivative offering.

But before we begin, please hit that like and subscribe button really helps us as we can continue to build this brand and this channel to become the go to source for insights around crypto derivatives.

But before we begin, Nick and Neil, if you guys can just give a quick background for our viewers, how you guys ended up at DRW and then ended up pivoting to pioneering this crypto derivative space.

I'm 1 of many DRW lifers, been with the firm since 2006, got my start in rates, stayed on that desk for 14 years.

And then when COVID hit, CME launched the Bitcoin futures and options, and we decided to get involved into the vol space, being that we already had the large OTC spot desk, so it was a natural fit.

It was a lot of growing pains, as you can imagine, it was very slow to start.

You have the CME OI chart, and you can see, as recently as Q4 of last year, the open interest was only 400 million and it really started to kind of uptick.

Q1 of this year, as we saw a lot of people looking to onshore and we saw a lot of people prefer the safety of a regulated and compliant exchange.

So we saw the CMEOI hit about 2000000000 in Q1 and early Q2.

But yeah, we've been in the crypto space for about 3 years now, and Nick and I are running the CME and bilateral trading desk.

I started at DRW straight out of college.

Was also on the rates desk, so did overnight trading, covering London hours and did market making rates.

Yeah, with the pandemic, after CME launched their product, we started the crypto options market making desk.

You know, this space has been growing a lot and been focused on that ever since.

So yeah, this is going to be a pretty informative conversation for our viewers around CME crypto derivatives.

And to be honest, selfishly, myself and David as well, like as naturally on Paradigm, our focus has kind of been around like other venues.

So, so really grateful to have you guys here.

And, you know, I think the start kind of, Neil, as you alluded to, you know, in 2023, we saw this significant surge in CME BTC futures and open interest, which I think logically makes a lot of sense in a post FTX world where you're naturally going to see this capital flight to quality to trade against exchanges that aren't necessarily financial black boxes or, you know, have something else to lose with, you know, other product offerings of, you know, going down in their crypto business.

So looking at this chart, you know, volumes in December were extremely low in the immediate aftermath of FTX.

And of course, you had the seasonality effect as well, you know, due to the holidays.

But as people came back to put money to work into the new year, especially due to this rally, you know, the volumes and opening interest immediately covered.

So I guess Can you like speak a little bit more to this sort of flight to quality that you guys have seen in the crypto derivative space?

Not only to CME, but I mean also into the bilateral business.

Obviously DRW has been around for a long time, has a stalwart balance sheet, has a very solid reputation.

So how are users, you know, into 2023 really starting to think harder about managing their counterparty risk and kind of what is your pitch around that?

So 1 of the main considerations to take into account with CME is it is completely agnostic of crypto.

A lot of the offshore exchanges wouldn't exist if Bitcoin hit 0, whereas CME wouldn't bat an eye.

So if you really need to hedge downside exposure puts or short deltas, CME is the safest place to do it.

And it is the venue of choice during any sort of crypto bear market.

We saw front month basis flip from positive 10% to negative 10% during the FTX crisis as CME was the only safe place to actually put on short delta plays.

So that was a catalyst for a lot of people preferring the CME.

It's also just a regulated compliant exchange and they also recently lowered their margin, which helped kind of bring on some of the counterparties that thought the margin was a little bit too high.

It's down to about 24%, so it's still higher than some of the offshore venues, but people are gladly willing to pay that, you know, extra 4, 10% margin to have the safety of the CME.

And, you know, other venues, we really don't see, you know, too much put buying.

And I guess that might make sense, right?

You know, you buy a 5 delta, 10 delta put.

Well, how confident can you be that you are going to get paid on that?

And David, I'm going to bring you into the conversation here.

You are our boots on the ground, so to speak, with prospective paradigm customers.

And I'm curious to hear how you have seen your prospecting conversations evolve.

I would imagine the FTX aftermath, a lot of questions around CME as counterparty risk came into greater focus.

And David, now that we're well into Q2, would you say that interest has continued to be sustained?

I mean, to Neil's point, I think post FTX, everyone was looking and thinking deeply about counterparty risk.

And obviously CME is a place to kind of trade safely.

The big drawback has been around margin, which in many cases was prohibitive.

And then also the tech connectivity as well, you know, when people are set up on other venues, not always easy to pivot.

Yeah, I think definitely, you know, we're still in a world where counterparty risk is pretty key to people.

So looking at either other venues like CME or even around other other kind of ways of managing that counterparty risk.

I definitely feel If you look at some of the sort of larger institutions and particularly those from TradFi moving into the space, CME is definitely something that they're kind of keen on and looking at.

And it kind of, they've got the economies of scale and scope as well, that kind of integrates quite nicely into their current business models and they get the kind of some of the cross-margining benefits from that as well.

So I mean, and actually I was interested to ask from you, Neil, like over this year, have you seen the kind of makeup of the sort of client base that sort of trading with you guys via CME change much at all?

Yeah so some of the crypto native funds that were originally trading offshore have had internal dialogue where they needed to trade on a regulated and compliant exchange that offer, that does some sort of KYC AML compliance.

So we've seen US-based crypto funds essentially prefer that venue and some of them make the switch over.

A lot of people were unaware of the type of liquidity on CME and the liquidity has really improved over the last 6 to 12 months.

You know, You can see 1 year out options 2 to 3 balls wide for a good size.

So similar to what other venues are offering.

And then, like I mentioned earlier, the downside buyer, and we're not talking about 25 Delta puts, we're talking about like, you know, end of the world puts 10k puts 15K puts.

If you want to buy those, the CME is probably the only venue where you can feel comfortable buying those.

Usually the ball surface is about 2 to 3 balls higher on CME relative to other venues, But on the put wing, you could see 10 to 20 vol premium on some of those low delta puts because it really is the only place to safely hedge downside risk.

Yeah, that's interesting, especially you have, I guess, this disparity in the vol pricing on the downside between, you know, because this is the venue that you go to if you need tail risk.

I would imagine that also presents, you know, an opportunity for underwriters as well, where, you know, potentially you guys, you know, have a position where you can, you know, you guys can facilitate those and pretty competitively, kind of just looking at it from a perspective like, okay, if we're down there, I don't mind getting long down there.

For put sellers, it's definitely the best place to go because of that premium.

We think on offshore venues, the put skew doesn't kind of reflect reality because the demand isn't there to kind of put it into place.

So we don't see that the demand is going to change.

It's going to be on CME and that premium, I would say on average it's probably about 5 to 10 balls for that 5 delta put area.

And alternatively, Oh yeah, no, it's fine.

Alternatively, on the top side, so for calls, you do see most of the supply enter the market on offshore venues because of the margining reasons that you talked about before.

So when call overwriters need to sell calls, they generally go to offshore venues because they can actually margin in native currency.

And that's just something that the CME doesn't like offer as a as a benefit because you have to margin in dollars.

And it's expensive for firms that have, you know, quantities of ETH or BTC to borrow dollars to sell calls on top of that.

So we expect that to kind of change over the next coming years because recently there was a CFTC declaration that CBOE Digital was granted margin on BTC and ETH futures.

So margin in terms of posting underlying coin with a custodian to sell BTC and ETH futures.

So eventually, Hopefully that flows into options and we can see some of the call over writing flow.

And in terms of, you know, the main audience for that, my, my impression would be, it would be perhaps, you know, the onshore miners who, you know, look at sort of yield enhancement strategies.

But can we talk a little bit more about, I guess, miners in general, and I guess this existing community of CME derivative users, not just the ones that have kind of, you know, capitulated a little bit and moved some risk off of other exchanges onto CME.

But have you guys been seeing miners, for example, realizing they need to get their act together and actually sell forwards to hedge their exposure if they want to reduce the cost of capital of their businesses?

Or I would also expect maybe some traditional macro hedge funds coming to the CME, either for the lever delta exposure or some of the basis plays that you guys are talking about.

But curious to hear about that existing customer base.

So for miners, we haven't seen too many miners arriving to CME.

And, you know, it does make sense, especially in these kind of conditions when hash rate continues to increase.

So it really pushes the pressure on margins as the price is kind of low.

So that's something that like we have been continuing to expect, but haven't seen a lot of, especially in the options space.

In the future space, it's possible, especially if they just go through a broker to hedge futures against their production.

But then we saw much more of the latter where it's like macro hedge funds or hedge funds in general.

Maybe some of them are dipping their toes into being crypto hedge funds have been arriving on the CME and, you know, putting on either highly levered beta plays or just like trying to trade macro risk around BTC and ETH.

And at the same time we've also seen some of the vol premium selling as well.

There have been like new participants that have been selling vol premium and BTC and ETH on the CME similar to like how other asset classes, how it's done in other asset classes where they just come in and sell strangles.

And to add to that, for miners and underwriters, margining, it all comes down to margining.

And if they can't margin in coins, most of them are dollar light, so CME might not make sense for them.

So that's why we see the vol surface significantly lower on exchanges where you can margin in coin or on bilateral where you can margin in coin versus the CME because most of the natural vol sellers need to be able to post coins instead of dollars.

So you would say that most of the onshore miners are trading bilaterally because of this.

They definitely have a preference towards bilateral versus CME.

So, elephant in the room, news flow last couple days, which we don't really need to dive into here, but like in light of kind of the recent developments that we've seen with other onshore exchanges, like what do you guys see?

Do you guys foresee institutions kind of taking another step back to evaluate their options?

And when do we see this, you know, it's the million dollar question, you know, this next wave of traditional institutional adoption?

Well, the beauty of the CME is they don't touch any coins.

The ref, you know, they have the reference rate, the futures are financially settled, the options settle into the futures.

So they are a little bit safer than other venues.

Coinbase lawsuit yesterday, very unfortunate for the industry.

You know, Coinbase has been arguably the most compliant exchange in crypto by far.

And to see them target that exchange is unfortunate and bad for the space.

And we continue to see a lot of just crypto native firms decide to essentially be based offshore, but we don't think it will have a significant effect on the CME in the short term.

I think it's interesting you say that, Neil, and so, Joe, going back to earlier, the question around conversations with clients.

I think 1 of the things that's really struck me since, particularly since FTX and in terms of institutional adoption is, I kind of think people understand that what happened around FTX was a failure of a third party and a bad actor within the space.

I think people kind of get the value proposition for Bitcoin and crypto generally.

And it's all now about, it is about counterparty risk and understanding exactly the nature of those risks and where they are.

So I think what's, when people keep talking to me about, and conversations we have around what's got to be the effect of SEC, Coinbase, I don't think it's this, oh shit, that's the end of crypto then.

I think again, it just drives the, right, okay, what's the solution?

And that's 1 of the things that's actually brought me a lot of optimism around this space, in that the actual push has been, okay, well, where do we trade?

People kind of get the value proposition.

We just need to put the right infrastructure and the right, I guess, regulatory frameworks within which to trade and be comfortable with trading.

And I think that's coming over the years as more firms develop custody solutions and more well-known firms like Fidelity build out their custodian solutions, partner up with exchanges, hook up margin.

As this infrastructure and tradify gets built, it'll enable more trusted venues to kind of move value and allow hedging, allow trading in general.

So I think that's something that we're looking forward to and looking to support and hoping that the industry prevails until then.

Definitely feels like, especially with the range bound price action that we've seen.

I mean, at least we've had some vol the past couple of days, but it could be a little bit more of a slow burn until we kind of see this breakout of the range and hopefully to the upside.

And David, I know you have some thoughts on this, given macro developments of the past couple of days or so.

I mean, yeah, it's funny because I've been quite bearish sort of crypto and risk, I guess, broadly over the last few weeks, anticipating this liquidity drain with the debt ceiling lift.

We've been talking about that for a while now on this show.

And it feels now like the world and its dogs talking about this liquidity drain.

Yeah, So I've been talking for a while about this liquidity drain and that we expect once the debt ceiling gets lifted.

And that was making me pretty sort of bearish, I guess, for crypto in the short term, given we know particularly Bitcoin's a liquidity junkie.

It feels now that it's quite a common narrative out there.

I'm surprised Uber drivers haven't been talking about this liquidity drain because everyone's kind of talking about it.

But the irony is, there's 2 aspects to that, I guess.

In terms of, I think there's a mechanical aspect.

I do think liquidity and how it sort of funnels its way through the financial system, you know, mechanically can sort of drag us lower if we suck that out.

But also there's quite a reflexive aspect as well, and I think particularly as it pertains to crypto.

And I'm kind of thinking now, if that is such a common story, maybe the impact of that reflexivity is kind of diminished.

And I certainly feel that's why Bitcoin hasn't joined in the tech party that we've seen over the last few weeks because if you're looking at Nasdaq you're kind of thinking Bitcoin should be ramping up and yet we haven't joined in that and I think it's in anticipation of this liquidity drain.

So there's part of me that's thinking that maybe we see a sort of buy the rumor, sell the fact type redux in terms of how that's going to pan out.

This chart we've got up here you know net dollar liquidity I think this is a 1 to watch.

As you can see, actually, the liquidity has actually been climbing over the last sort of month or so.

And that's been a function of the quantitative tightening being offset by the TGA drawdown.

Now, obviously, the big worry now is that...

Hey, David, can I just stop you for a second?

Yeah, so looking at that chart and liquidity, so dollar liquidity has actually been improving over the last few weeks as the TGA drawdown has been offsetting the quantitative tightening.

Now the worry is that green line in the bottom channel absolutely collapses as they rebuild the TGA.

So I mean we've already had like 170 billion issued this week in bills that's kind of been digested okay and the potential, the more that issuance is via bills, the more digestible that is and potentially is offset by the reverse repo that's parked at the Fed.

So it's going to be key for me to keep an eye on that chart there to see does that green line, does the dollar liquidity absolutely collapse in which case that's going to weigh quite heavily on Bitcoin.

But there are offsets and from a global liquidity perspective, you know, there's offsets and 1 of those I'm looking at is China.

China seems to be struggling now with a slowdown.

Obviously the currency is under a lot of pressure right now.

And interestingly, they're not intervening to slow that currency depreciation.

So it kind of tells me that China is quite worried about this slowdown.

We had trade data today which was pretty awful, declining exports, declining imports.

So China feels like they want the currency weaker to export their way out and likely are priming the liquidity pump, PBOC putting some pressure on banks to cut lending rates.

So we might well have, for all this fear about liquidity drain, pretty big offsets, be it from the US itself, if it's all bill issuance and the RRP actually funds some of this, and then also the potential for China to come in.

And then the other chart I was looking at earlier and we were discussing is the MOVE index.

So when I think as well about things that are going to drive liquidity, which is quite a broad thing to try and measure, The move index, so this is the index of bond volatility.

Now this is pretty important in terms of, you know, the more volatile bonds and treasuries are, the more difficult it is to take leverage or what have you.

So bond volatility coming lower is actually pretty good for actually greasing the sort of wheels of the system I'm an allow and leverage and which also allow liquidity.

So so I'm looking at this and This for me sort of looks pretty good for risk actually So if you see the move index coming lower, it tends to all go pretty well for risk.

The VIX as we've seen is what, on a 13 handle or something now?

I mean, partly it feels like there's a lack, just this kind of general apathy in markets, even though Nasdaq's been sort of pumping away.

But look, the sort of broad risk environment in this liquidity drain looks pretty good.

Now again, just mechanically does it start to weigh over the coming weeks?

I'm just wondering if given how anticipated it is, it becomes a bit of a damp squib and given these offsets, that actually we could be setting ourselves up now for a ramp to the upside.

And then in light of the issues we've seen this week with the SEC and around Coinbase and Binance, you know, you kind of really feel that we should have sold off more heavily and we haven't.

And we've been sort of in this range for Bitcoin and ETH for some time now.

And the flush out that we saw, particularly in the Binance news, was, you know, from what we're used to historically, was pretty weak, I thought.

And I think that's partly reflective of the lack of leverage in the system.

I think position in Germany is pretty light.

I think as well, given some of the issues with offshore exchanges, it's a lot more difficult to short these markets now.

So when I think of past liquidation periods, It's come because there's A, been a lot of leverage in the system that's been absolutely flushed out and B, you've had false liquidations with bankruptcies and what have you, and people that just have to sell their Bitcoin as they're kind of coming out of business.

So in the absence of that, it's not obvious to me what actually sort of drives us materially lower.

And I actually think it looks quite constructive.

I mean, like even on this, I'm just looking at this, the top part of this chart and it's like, damn, it looks like a pretty nasty head and shoulders pattern.

And 1 metric that I kind of follow closely is the 200 week moving average, which is around like

You kind of see this range here, here where we kind of tested that 3 or 4 separate times where it was just like, damn, if we kind of break below The neckline was kind of right at this 200 week moving average.

And if we broke lower, well, we could fill the gap all the way back down to

But the fact that, I mean, even yesterday, you know, we, I mean, we're down to 2, 500 or so, and then we just kind of really bounce through it again.

It kind of seems like we're in a place in this market where like, I mean, how much bad news have, has crypto had, you know, over the past few months yet.

And it seems like every new piece of news flow that is negative for the space that comes in is just having a more muted reaction.

So for me, that's a pretty strong bullish signal there.

But Nick, Neil, curious to kind of hear what you guys think around the more short to medium term trajectory.

Are we going to stay range bound or is there a possibility

So Just as you go to answer that as well, and perhaps to tie in with that, what I'd be interested in is because over the last couple of days, we've not seen a material rush to pull on downside in light of those news.

Now it could be the fact, as we mentioned earlier, in terms of the reasons why people might not do that on offshore exchanges.

So just interested as well, whether you actually saw a significant pickup in downside interest over the last couple of days?

Yeah, so I think, well, to start, you're mentioning that, like we, you know, given how much Nasdaq is up and how, how rates are doing, you know, we kind of expected if you saw someone do like a model where you know, they just use like Nasdaq gold and rates to kind of predict where Bitcoin should be as like a like a 4 factor model.

So like, That would have indicated that Bitcoin should have been higher, but right now it's firmly below $30K.

I'm not going to really say any opinions on that, but that's definitely part of the reason that has to do with that is obviously all the regulatory overhead that has been coming out this year.

That combined with like supply from, you know, everyone keeps talking about the Gox supply or the announced US Marshal Service supply as well.

There is not a lot of leverage that we see in the system.

There's a lot of call overriding going on.

It's just like a natural tendency of risk markets.

I mean, Nasdaq vol was around like 33 at the beginning of the year.

Nasdaq is now up 30% and the implied vol there is like 18 right now.

Similar topic with Bitcoin and ETH, they're both up like 50, 60% on the year.

And their implied vol is like at all time lows, lower than it was at any point during the bull market.

That's just kind of the nature of risk markets and naturally Bitcoin and Ether are still risk assets.

So when the assets go up that much, that leads to a lot of people who are long to sell calls to overwrite it and then the natural risk is to the downside.

So We have seen some people take stabs at this implied Vol, you know, here and there, but it's still pretty muted because I think people have been kind of demoralized by how tight this range has been.

See all Paradigm transcripts on Youtube

TBP | Digging into CME Crypto Derivatives with DRW. - Ep 26