The Future of Cryptocurrency Derivatives in the Crypto Space
The cryptocurrency space continues to grow to a diverse ecosystem with over 2000 cryptocurrencies and a world of financial possibilities. Blockchain technology provides the supporting infrastructure, and with its astounding features, the industry will be in for greater developments. Of all cryptocurrency-based services and functionalities, a significant proportion of users are taking an interest in crypto trading. According to statistics on bitcoin trading volumes, the coin has hit an all-time high in January 2021 after surpassing $11 billion.
It’s a clear sign of how much bigger cryptocurrency trading will get soon. The industry is still faced with high risks, specifically due to the volatile nature of cryptocurrencies. Advanced or technical investors are adopting the use of derivatives.
Cryptocurrency derivatives are among the risk management strategies in the crypto industry whose current and future trends are worth noting.
Understanding Cryptocurrency Derivatives
A derivative is a financial agreement involving two or more parties, deriving its value from an underlying asset. The asset can be exchange stocks or other valuables, but in cryptocurrency derivatives, the underlying asset is usually a crypto coin. The agreement involves selling or buying the asset in the future at a predetermined price.
Usually, derivatives exist in three major forms, which include Futures, Swaps, and Options. However, the market is still young, and only Bitcoin futures and options are common in the crypto space. The cryptocurrency derivatives being more profound in Bitcoin is understandable, as the coin remains the most traded and the one controlling more than half of the cryptocurrency market capitalization.
Futures are derivatives where a seller should sell an asset or a buyer to purchase an asset at a fixed price at a predetermined future time. For options, the buyer or seller usually has a right as opposed to an obligation to purchase or sell the asset at a fixed price within a predefined time frame.
Are Crypto Derivatives the Future of Crypto Trading?
Although cryptocurrency derivatives are complex trading and financial instruments, their market has been heating up over the last couple of months. Pankaj Balani, a cryptocurrency derivatives exchange’s CEO, noted in late 2020 that cryptocurrency derivatives markets were in the middle of an explosion. Pankaj noted that derivatives had been growing at a phenomenal rate over the past two years, and the growth would only continue.
Looking back to 2018, when cryptocurrency derivatives were kicking off, the daily trade volume on derivative exchanges was way below a billion, while the spot market trade volumes were way above. However, moving forward after the launch of cryptocurrency derivatives, there is parity between the two trading volumes. Following up with the trend, the derivatives market could hit up to 5 times that of the spot market.
Pankaj is an expert in derivatives, having served as Elara Capital’s head of derivatives strategy. Speaking to Finance Magnates, he compares the derivatives market to foreign exchange and equity markets to show the variations in market capitalizations. Equity markets hold between 65 trillion to 70 trillion of market capitalization outstanding globally, while the derivatives on top of it are worth 800 trillion. From these figures, the derivatives market is about seven times the size of the underlying spot market.
As noted earlier, the cryptocurrency derivatives market is currently dominated by Bitcoin derivatives of Bitcoin Option and Bitcoin Futures. The shift to Bitcoin derivatives started in 2018 after the 2017 bull-run. Investors were seeking a way to short Bitcoin since it was getting lower. The investors have now learned the derivatives market effectively and can use it to their advantage. Therefore, as the market continues to grow, more traders will continue to explore leveraged trading.
Further, the success in Bitcoin derivatives will attract users to invest in other altcoins. In 2020, the shift towards altcoin futures already started to grow steadily, following the stagnation of Bitcoin prices from May to July. There had been increased trades in altcoin futures, specifically on Binance, with Ethereum futures hitting an unprecedented weekly trade volume. In total, about $712 billion of crypto derivatives products were traded in August 2020, which was a 53% increase from the previous month. Therefore, altcoins are cryptocurrency derivative pockets that will soon explode and record significant growth in the coming years.
Although the cryptocurrency derivatives market is gaining momentum in the cryptocurrency space, it still faces its share of challenges. For instance, the Financial Conduct Authority issued a ban last year on selling crypto derivatives to retail consumers. The regulator argues that crypto derivatives are ill-suited for individual investors and have no reliable basis for valuation. Further, the level of understanding of crypto-assets and derivatives is still low, and so personal investors could suffer sudden losses if they invest in them.
On the other hand, trading in cryptocurrency derivatives protects investors from price volatility and is one of the two main reasons for their use. Investors reduce their risk exposures and remain protected from fluctuations in the price of the underlying asset. Additionally, derivatives serve as insurance policies through hedging. Investors can use them to protect their investment portfolios and offset potential losses.