Crypto Derivatives: What are Crypto Derivatives and How do They Work

Beginner’s Guide / 29.03.2020

In recent years, the crypto space has witnessed incredible growth into a diverse ecosystem consisting of over 5, 000 coins and tokens, with each token focusing on a particular use case built on blockchain technology. And with the diversification of the crypto ecosystem, there has been increased launch of financial products aimed at increasing mainstream adoption. 

One such crypto-financial product that has gathered pace among crypto enthusiasts in recent years is the cryptocurrency derivatives. A notable cryptocurrency derivative in the crypto space is Bitcoin futures with an average daily volume of 5, 053 contracts and with a cumulative value of approximately $177 million. 

This guide will analyze crypto derivatives looking in detail on how it can help a market grow. 

What are Crypto Derivatives?

In the financial world, a derivative simply means a financial contract between two or more parties that derives its value from an underlying asset, i.e., cryptocurrencies. In the crypto context, derivatives refer to the financial contracts between two or more parties who agree to sell or buy a particular cryptocurrency at a fixed price and a specified time in the future. 

Financial derivatives have evolved for centuries to become one of the most popular financial tools. In fact, derivatives are one of the oldest forms of a financial contract in the market and were used to facilitate trades among merchants. They are, therefore, a time-tested trading tool that has proven to be effective in rescuing a financial market after a crisis. For instance, the Milken Institute Research reported that financial derivatives expanded US GDP by about $3.7 billion each quarter over the 2003-2012 period resulting in massive economic growth. 

In the crypto space, crypto derivatives are crucial for institutions as they present a critical risk management mechanism conferring protection against crypto volatility, which can cause a potential loss among blue-chip investors and corporations. Additionally, crypto derivatives allow traders to offset their potential losses via ‘put options’ and hedging-quite crucial for institutional traders. 

Types of Crypto of Derivatives

There are three main forms of derivatives

  • Swaps – A swap is an arrangement between two parties to exchange a series of cash flows in the future. Swaps are usually built on interest-bearing instruments such as loans, bonds, or notes as the underlying asset. The most common form of swaps is interest swaps, which involves the exchange of a future stream of fixed interest rate payments for a stream of floating-rate payments between two different counterparties. 
  • Futures – refer to a financial contract where a buyer is obliged to buy an asset or a seller to sell an asset, e.g., commodities at a fixed price and a predetermined future price.
  • Options – Options refer to a financial contract where a buyer has the right rather than the obligation to purchase an asset or a seller to sell an asset at a predetermined price by a specific timeline.   

The crypto derivatives sector is still growing. Thus there are limited derivatives types currently available in the market. The most common cryptocurrency derivatives are Bitcoin futures and options. Almost all crypto derivatives are based on Bitcoin since it controls over 50% of the entire cryptocurrency market capitalization.

Why Crypto Derivatives are Used

As a crypto trader, there are only two reasons to use these financial instruments. They are:

1. To hedge your bitcoin holdings against future volatility

If you already own bitcoin or other cryptocurrencies, you can use futures or options to offset volatility in the “spot” or cash market. If you are holding bitcoin because you believe the long-term value will increase, you are considered “long” in the spot market. That is, you have made a purchase in the spot market and hope to sell at some point in the future at a profit.

To hedge using futures, for example, you would take a “short” position by purchasing a contract that obligates you to sell bitcoin at a specific price on a predetermined date in the future, also known as the delivery date. Keep in mind however, that futures contracts are standardized. For instance, on the Chicago Mercantile Exchange, contracts require you to buy or sell five bitcoins at a time. If you do not have that many bitcoin, then futures may not be in your, well, future.

Nevertheless, here’s how futures can protect you: If prices on the spot market decline, as you had feared, the value of your futures contract would increase in value because you have the right to sell bitcoin at the higher contracted price. However, if the value of bitcoin continues to rise, your short futures contract would be worth less, but you would be able to profit more in the spot market. Bitcoin contracts are “cash settled,” which means you do not exchange actual bitcoin, but pay our receive dollars at settlement. In most cases, however, traders “unwind” their positions by buying equal offsetting positions.

2. To speculate on future price movements

Speculating the price of cryptocurrencies is another way of making profits in the crypto space, or lose money really quickly. Speculating by its very nature is highly risky, and when you speculate in futures you could end up losing more than you originally invest.

Speculators look to profit on short-term price movements in the market, and they are helped by leverage. When you purchase a futures contract, you do not have to pay the full value of the holdings. You place a deposit, known as the “initial margin” through your broker. You can choose to take either long or short positions depending on the direction you believe prices will move. If the markets move in your direction and your positions increase in value, your margin account would be credited when the exchange marks the contract to market at the end of the day. However, if the market moves against you, funds will be deducted from your margin account. If your margin account dips below the required maintenance amount, you will receive a margin call, which means you must refill your account back to the maintenance margin amount or your position will be closed. The maintenance margin for CME bitcoin contracts is 70 percent, which means you control 5 bitcoin at only 70 percent of the cost. This leverage can boost your returns, but it can also amplify losses.

Where Can I Trade Crypto Derivatives

There are several avenues you can trade crypto derivatives. These include:

  • LedgerX – LedgerX is a pioneering regulated institutional exchange that launched Bitcoin derivatives taking the form of swaps and options. The platform is currently the only federally regulated cryptocurrency exchange and clearinghouse in the US allowed to list and clear physically held Bitcoin derivatives. LedgerX also owns the LedgerX PIT platform, which can gain exposure to digital currencies with a trusted platform while still mitigating risk. However, only accredited investors and institutional players can trade on LedgerX’s trading platform.  
  • Bitcoin futures – Bitcoin futures are arguably the most renowned crypto exchange platform allowing the trade of crypto derivatives. The platform was first introduced by Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) in December 2017. CME is the world’s leading derivatives exchange, handling over 20% of the total derivatives trading volume globally, while CBOE no longer offers Bitcoin Futures.
  • Bakkt Futures – Launched in the fourth quarter of 2019, Bakkt Futures is a cryptocurrency future exchange backed by Intercontinental Exchange(ICE), which is the 3rd largest exchange group in the world. The platform currently offers Bitcoin derivatives in the form of options, futures, and custody products. The Bakkt Bitcoin Cash Settled Monthly Futures is reconciled against the prices of Bakkt’s physically delivered bitcoin contracts.    

The Bottom Line

Trading bitcoin futures requires a lot of capital, and know-how. These are complex markets and not for novice bitcoin traders. You should always limit your investments to products you know and fully understand. Brokers may also require you to meet certain capital requirements before allowing you to trade. Most participants in futures markets are hedge funds and other institutional traders. The main benefit that futures markets offer over the spot market is that they are fully supervised and regulated.

For instance, the exchanges listed above are regulated in the United States by the Commodity Futures Trading Commission and you can trade on them using registered futures commission merchants or brokers. There are also a number of scams out there, especially binary option scams, and get rich quick schemes that you should try to avoid.

Resources:

Commodity Futures Trading Commission | Futures Fundamentals | National Futures Association

avatar
Wayne is a Blockchain enthusiast and expert in crypto trading. Currently, he covers trendy issues on digital currencies.