Understanding Crypto Derivatives

Whether you are an aficionado or a novice in the field of markets, chances are the term ‘crypto derivatives’ has come up multiple times. Upon first glance, it is difficult to pinpoint what exactly the ‘derivatives’ term means in relation to finances. How could a word that essentially means “imitative” and “unoriginal” possibly have any connections to the markets?

The development of the cryptocurrency industry has had a hand in this term becoming common in the markets field. The cryptocurrency market is effectively blossoming into an extensive and diverse ecosystem. One that consists of coin and token types whose numbers exceed over 2,000. Each focuses primarily on a specific type of application and use case. Moreover, their construction is possible by utilizing innovative blockchain technology.

Admittedly, the infrastructure that supports the world of cryptocurrency is still in a stage of infancy. Be that as it may, there are a wide variety of developments that could change that. By garnering exposure, they will increase awareness of cryptocurrencies as a whole. One particular advancement is the introduction of this article’s focal point, which is cryptocurrency derivatives. This creation is essentially a new line of financial products. Probably the most common form of cryptocurrency derivatives is Bitcoin futures, which are receiving a mixed reception from the community.

So, we know that ‘derivatives’ are the outcome of cryptocurrency’s continual development, but what are they exactly? This article will provide that answer and so much more.

What is it?

The standard ‘derivative’ is a financial contract between two or more parties. Its foundation draws from the impending price of an underlying asset. Its name comes from the fact that it derives its value from an underlying asset. In the case of this article, that asset is cryptocurrencies. To elaborate, it is an agreement pertaining to buying or selling a particular asset, whether it be stocks or cryptocurrencies. Moreover, buying or selling the asset at a prearranged price and a specific time in the future.

Derivatives do not possess any inherent or direct value by themselves. In fact, the value of a derivative contract draws primarily from the probable movements in future prices of the underlying cryptocurrency.

There are three main forms of derivatives: swaps, futures, and options.

  1. Swaps: This is an arrangement between two participating parties. In it, they agree to exchange a string of cash flows in the future. These typically draw from interest-bearing instruments, which include loans, bonds, or notes as the underlying asset. Arguably the most common of the swap forms are ‘interest swaps’. These involve the exchange of two different streams. Specifically, a future stream of fixed interest rate payments for a stream of floating-rate payments between two counterparties.
  2. Futures: This is a financial contract where it is a buyer’s obligation to purchase an asset or a seller to sell an asset, like commodities. They do this at a specific price and a pre-established future price.
  3. Options: This is a financial contract where a buyer has the right – not the obligation – to purchase an asset. Likewise, with options, a seller has the right to sell an asset at a prearranged price by a specific timeline.

The history

Something interesting to note is that derivatives are among the oldest forms of financial contracts that exist on the market. One can easily trace the history behind this concept to antiquity. Back in medieval times, derivatives were a tool for facilitating trades between merchants who would trade all across Europe. Not only that, but they were also participants in the occasional fair, which were early types of Middle Age markets.

The evolution of derivatives has continuously gone on for centuries. Eventually, it would go on to become one of the most popular tools in the field of finances. Today, the general understanding of a derivative is that it’s a security acquiring its value from an underlying asset. Alternatively, from an underlying benchmark. The signing of the contract can be done between two or more parties. These parties are ones that wish to buy or sell an asset for a specific price in the future. The determination of the contract’s value will be because of any fluctuations in the price of the benchmark the value derives from.

The underlying assets utilized in derivatives are often currencies or cryptocurrencies. Other assets include commodities, stocks, bonds, market indices, and interest rates. Derivatives are tradeable either on exchanges or customer-to-customer (C2C) systems. The latter option is fairly different when it comes to regulation and the trading method. Most of the time, however, active traders employ both methods.

Reasons for trading crypto derivatives

Drawing from the definition of derivatives, it’s apparent that they are complex instruments of finance. Advanced and technical investors alike frequently utilize them. There is an array of reasons as to why derivatives are as popular as they are, which include the following.

1 – Volatility protection

The principal reason for the derivative’s existence is for both individuals and corporations to reduce their risk exposure. Moreover, to better protect themselves from any fluctuations in the underlying asset’s price. To further explain the use of derivatives to negate risks, let’s use an identifiable scenario.

Imagine that you are getting a subscription for cable TV to watch some of your favorite channels. As a service buyer, you are entering into a fixed agreement with the cable company. This will effectively allow you to get a specific number of channels at a monthly fee for a 1-year period. This is comparable to a futures contract, wherein you specify the price that you will pay. Additionally, the exact product and/or services that you are going to receive within the specified 1-year period.

By doing this, you secure the monthly pricing of cable TV channels for a full year. You understand that you will have to pay a fixed price no matter what. This is regardless of if the cable TV price rises throughout the year.

This is essentially how derivatives work. However, instead of cable, a rice farmer will try to secure the next season’s produce sales. The price of rice changes regularly, depending on market conditions. So, the farmer would be adamant about fixing the price of the next year’s harvest for protection from the volatility of daily prices. Businesses also use derivatives as a way to cut down on risk exposure.

A bakery purchasing wheat flour from a farmer would use derivative contracts. They would ‘lock-in’ the wheat flour price for the year. This guarantees that the bakery can estimate its budget for the business year. Moreover, protect itself from changes to the wheat prices. These derivative contracts between a buyer and seller are tradeable in the derivatives market.

2 – Hedging

Investors are able to use derivatives as a way to preserve their investment portfolio. This technique has the alternate name of ‘hedging’, which involves taking measures to counteract potential losses. Derivatives function as a crucial method of risk management for institutions and investors alike. The concept behind hedging is identical to having ownership of an insurance policy specifically for your portfolio.

crypto derivatives

Let’s imagine that you are bullish on Apple (AAPL) and you own a substantial amount of AAPL stocks. Be that as it may, there are a lot of risks that you are holding onto. Should the American economy go through a systemic shock or bad news, then AAPL prices would consequently plummet. Moreover, it will diminish your investment capital. You can utilize derivatives – as options contracts – to decrease your overall investment risk. By using ‘put options’, you can profit from your options contract. This is because their value will increase when prices of the underlying asset (i.e. AAPL stocks) collapses.

Therefore, if you own AAPL stocks and are anxious about the unforeseen circumstances, you can purchase derivatives. This will provide protection for your investments and effectively offset any potential losses that could come your way. Even though the main value of your AAPL investments drops, your put option derivatives’s value increase will outweigh the loss.

Hedging is a technique that could save you from potential obstacles and worries that you may encounter. By having an insurance policy that uses derivatives, it ensures the management of your risks. Furthermore, it will placate any concerns you may have.

3 – Speculation

Traders will often use derivatives in order to hypothesize future cryptocurrency prices. The primary objective is profiting from the price changes of the underlying cryptocurrency. For example, a trader may try to profit from a predicted drop in the cryptocurrency prices by ‘shorting’ the coin. ‘Shorting’ (alternatively ‘short-selling’) is indicative of betting against the general price of a security. Speculation often receives negative reception because it includes a higher level of volatility to the marketplace as a whole.

In a traditional sense, there is one way to potentially profit from cryptocurrencies or any securities. That is to purchase a coin or share at a low price and then later sell it at a higher price. However, this particular method can really only be done within a bull market. Alternatively, whenever the market is trending upwards. Shorting is more of a way to profit from a bear market or whenever the market is in a downward trend.

The simplest way to ‘short’ is to borrow a security from a third party and then sell it in the market. This is largely due to your expectations of falling prices. You can re-enter the market as soon as prices fall and reclaim the same amount of securities you sold. Thus, it resolves your account with the third parties. So, you will earn a profit from selling the securities and buying them back at comparatively lower prices.

Another easy shorting method is to use a derivatives contract, seeing as it’s a lot cheaper and ‘capital-efficient’. If anyone thinks that a cryptocurrency’s price may experience a downtrend or is unsustainable, they could sell derivative contracts in the open market. This way, those who think otherwise will be able to buy it.

Spot market: what’s the difference?

In the world of cryptocurrency, there are two types of markets: the spot market and the crypto derivatives market. Both have their own unique characteristics that allow them to stand on their own and be distinct from each other.

The spot market (alternatively the ‘cash’ market) refers to the immediate exchange and settlement of financial assets, like stocks and cryptocurrencies. This means that cryptocurrency ownership undergoes an immediate transfer between market participants (from the seller to buyer) following transaction execution. Whenever you go to an exchange to buy a cryptocurrency, you are automatically engaging in the spot market. This is because the transaction takes place on the “spot” and you will immediately own the coins that you purchase.

Conversely, the derivatives market is the place where participants trade contracts rather than the asset itself. These contracts are in possession of great value, which ties directly to the underlying asset. For that reason, derivatives are technically financial instruments as opposed to an asset. Moreover, while the spot market enforces immediate execution, the derivative market executes transactions at a specific time in the future.

The controversy

As innovative as derivatives are, there are some who do not share the sentiments of the concept’s admirers. Not everyone is a fan; this includes several popular investors like Warren Buffett. Buffett describes his disdain for them as the following:

In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

There have been several instances that prove Buffett’s initial statement to be correct or, at the very least, justifiable. Experts are beginning to blame derivative instruments (collateralized debt obligations, credit default swaps, etc.) for the financial crisis in 2008. Joe Sammut from Swiss Management Center University argues in his paper, Derivative Instruments and the Financial Crisis 2007-2008: Role and Responsibility, that:

“…business in CDOs would not have been so gargantuan had their purchasers not have been able to hedge their positions through CDSs.”

Regardless of their potential danger, derivatives are able to take many forms. As a result, it can be hard for regulators to preserve the supervision of the market for derivatives.

Derivatives did play a role in the 2008 financial crisis, but that does not mean that they are inherently bad. In fact, Buffett has softened up to them since his previous statements. In 2011, he states to the Financial Crisis Inquiry Commission:

I don’t think they’re evil per se…there’s nothing wrong with having a futures contract or something of the sort.”

Buffett now says, according to the New York Times, that the main issue with derivatives has to do with overexposure. This overexposure is largely thanks to banks and ignorant investors. He is of the belief that derivatives can add value to companies, including Berkshire Hathaway. However, this is only if leaders at those companies exercise restraint and hold a “limited amount.” Sentiment on crypto derivatives from seasoned traditional traders is lukewarm thus far.

Where to trade crypto derivatives

By now, you might be curious as to where you can trade them. Well, the answer to that is relatively extensive. Crypto derivatives of all sorts are tradeable on both traditional exchanges and monitored crypto exchanges

In accordance with traditional exchanges, CME Group currently supplies Bitcoin futures. This is primarily due to CBOE stopping the additions of new contracts back in March. In December 2018, Nasdaq was considering the launch of Bitcoin futures in the first half of this year. There is a common belief that cryptocurrencies will garner more mainstream and institutional adoption. Thus, it is highly possible for more traditional players to start trading crypto derivatives in the near future.

Institutional exchanges are providing crypto derivatives contracts as well. In October 2017, LedgerX, an institutional crypto derivatives provider, began trading regulated swaps and options contracts. This was not too long after receiving approval from the U.S. Commodity Futures Trading Commission (CFTC). Bakkt, another institutional crypto platform, would postpone the launch of its Bitcoin futures trading several times before settling on July for product testing.

Some of the leading crypto exchanges actively participate in crypto derivatives trading. OKEx, a platform from Malta, offers futures as well as enduring swaps trading. This is a contract that has no expiration, with 100x leverage and it delivers via a scaling engine. It also supports a wide variety of popular crypto assets like Bitcoin, Ether, and EOS. An additional one that is listed is USDK, which is a newly launched stablecoin.

A word of caution

All trading strategies that correlate to price fluctuations indicate a specific level of risk. This is especially true when you combine it with the lack of pertinent regulation for the crypto derivatives sector. 

Probably the biggest risk that traders face concerning crypto derivatives is volatility. Prices are susceptible to rises and drops at erratic speeds. Moreover, the losses are vulnerable to excessive amplification every time someone trades on margin.

Overall, the crypto derivatives market is incredibly complex. It can potentially be very difficult to figure out for users who lack the proper experience. Mistakes at the hands of rookies can be very costly and the general unpredictability increases the chances of something going awry. So, it’s crucial that you fully understand the features that a trading platform provides and follow the tutorials. Above all else, you should have a reliable strategy in place when you start the process.

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