Hedging cryptocurrencies with futures: A look at common use cases

Cryptocurrencies have delivered strong returns relative to traditional assets on both an absolute and a risk-adjusted basis over the past decade, with bitcoin generating an annualized return of 47.88% and a Sharpe ratio of 2.08, compared to 10.26% and 0.84 for the S&P 500, according to data from Portfolios Lab as of August 9, 2023. But the common tradeoff has been exposure to high volatility. For many investors, managing that volatility can be challenging, and that’s led to increasing interest in hedging that risk.

While there is a cost to hedging any investment, crypto or otherwise, the costs of not hedging can be significantly higher. History is rife with examples of institutions – from Long Term Capital Management to Lehman Brothers or First Republic – that have collapsed, largely as a result of their failure to properly hedge their exposure to different financial risks.

Holders of cryptocurrencies may want to hedge for various reasons. Venture capital firms (VCs) might want to hedge the risks of tokens they own that are currently locked; participants in proof-of-stake (PoS) protocols may wish to hedge potential downside price moves while staking; and miners may want to insulate themselves from future price volatility.

It’s possible to hedge crypto holdings using liquid and regulated futures, but doing so requires a keen understanding of which vehicles and strategies to use, how different cryptocurrencies are correlated, and how to manage costs and mitigate risks. Choosing the appropriate hedging strategy depends on the particular circumstances and assets. Below, we look at some of the most common use cases and provide investors with guidelines to help them construct effective hedges for each.

Scenario 1: Protecting staked positions

As ethereum (ETH) and other PoS cryptocurrencies have garnered greater market share, many holders have opted to stake their holdings. When users want to withdraw or unlock their staked tokens, a process known as unbonding, they need to initiate a request to release the locked funds from the staking contract. However, most PoS networks impose a lockup period, and, in the case of ETH, the exit queue was several weeks long immediately after withdrawals were enabled in April 2023. While the wait time has since normalized, it is still variable.

If holders want to insulate themselves from price declines while waiting to complete the unbonding process, or if they want to hedge against depreciation risks while actively staking their assets, they can sell futures against their holdings. For ETH holders this is relatively straightforward, as there are liquid ETH futures contracts available. 

But liquid and regulated derivatives may not be available for holders of other commonly staked tokens, such as Polkadot (DOT) and Cardano (ADA). In these cases, holders can construct cross hedges using (other) positively correlated assets. For example, a synthetic hedge can be created by selling an appropriate amount of either bitcoin (BTC) or ETH futures as a proxy. 

To determine which futures contract to use, holders could identify the cryptocurrency with the highest positive correlation to their staked asset. For example, as seen in the table below, DOT and ADA both exhibit slightly stronger correlations with ETH than with BTC, so ETH futures may provide a more precise hedge. 

Next, holders may calculate the hedge ratio, which is defined as: (Standard Deviation of Spot Asset / Standard Deviation of Futures Contract) * Correlation Coefficient. For example, as of August 7, 2023, DOT had a standard deviation of 2.74 and ETH had a standard deviation of 2.13, according to Macroaxis data, while the 30-day correlation coefficient between the two was 0.83, as seen in the table below. So the hedge ratio between the two was: (2.74/2.13) * 0.76 = .1.07. So, each dollar of DOT exposure in this hypothetical example could be hedged with $1.07 of ETH futures. 

Correlations among BTC, ETH, ADA, and DOT

Source: Coinbase, August 2023.

Of course, correlations can and do change over time, sometimes quite suddenly. So, when constructing hedges such as these, where the asset used to hedge is different from the one held, it’s crucial to continuously monitor the performance of the assets and the correlation between them and to adjust the hedge ratio if necessary.

It is also worth noting that hedges can not protect against certain risks that are unique to crypto assets, notably protocol risk, which is the risk associated with the underlying technology or protocol on which a cryptocurrency operates. For example, if a significant security vulnerability were discovered in a token’s underlying protocol, the price of the token – and its correlation with BTC and ETH – could drop meaningfully.

Scenario 2: Hedging assets that are locked up

Many token holders, notably VC firms, are subject to lockup periods that can last several years, during which tokens cannot be liquidated. Tokens with significant market caps and a high percentage of locked assets include Arbitrum (ARB), Avalanche (AVAX), and Sui (SUI).

As with many staked tokens, liquid and regulated derivatives are not available for these locked tokens, but it is possible to construct a hedge with BTC or ETH futures. The table below shows the 30-day correlation coefficients between ARB, AVA, SUI, BTC, and ETH. Again, we see relatively high correlations to ETH and slightly lower correlations to BTC.

Correlations among BTC, ETH, ARB, AVAX, and SUI

Source: Coinbase, August 2023.

Scenario 3: Hedging for bitcoin miners

Bitcoin miners depend on selling their BTC for more than it costs them to mine it, so significant price declines can seriously impair profitability. This dynamic would seem to make hedging a natural part of the mining business, as it is for miners of traditional commodities like gold. 

However, many miners didn’t hedge their exposure throughout bitcoin’s long bull market. But the bear market of 2022 drove home the potential benefits of hedging, and more miners are now hedging with derivatives.

To do so, miners can sell futures contracts with a notional value equivalent to the value of their BTC holdings or sell “forward production” and lock in a price at which their mined BTC can be sold. Alternatively, miners could hedge the portion of their mined BTC that is needed to pay for fixed operational expenses (e.g., estimated energy costs) and leave the balance of their BTC production unhedged to retain market exposure.  

By selling futures, miners don’t have to pay an upfront cost (beyond minor transaction costs outlined below), as they would if they were purchasing put options because futures are settled at expiry. If the miner sold BTC futures at $25,000 and the price was trading at $26,000 at expiry, then they would owe $1,000 per coin. They would sell their spot BTC and pay the cost, pocketing the $25,000 per coin. If the price went down to $20,000 per coin at expiry, the futures contract would essentially pay the $5,000 difference – again, allowing them to realize a price of $25,000 per coin. 

Miners need to maintain enough cash margin to support the futures position throughout the lifecycle. If the price of BTC were to increase significantly, for example, they might need to post additional (variation) margin. These margin requirements are designed to protect both parties involved in the futures contract and ensure that the gains are able to be paid by the losing party.

Managing costs and risks

No matter the reason for constructing a hedge or the assets being hedged, managing both the costs and risks of all futures positions is imperative. Fees on futures contracts for the same assets from different exchanges can vary significantly, so institutions looking to hedge should weigh the costs carefully. Different exchanges also offer different size contracts (in notional USD), with smaller contract sizes allowing for more precise hedging. See the table below.

Size of BTC and ETH futures contracts at different exchanges

Sources: Coinbase Derivatives Exchange, CME. August 2023.

But fees and contract size aren’t the only consideration. Institutions should consider whether and how products are regulated and client assets are safeguarded. Exchanges registered with and overseen by regulatory agencies like the U.S. Commodity Futures Trading Commission (CFTC), such as Coinbase Derivatives Exchange, can often offer an added layer of trust and robust security protocols that institutions find valuable.