Before we delve into cryptocurrency derivatives, we need to first understand what derivatives are. In layman terms, derivatives are financial instruments, and the values are derived from the underlying assets. Derivatives usually assume a form of contract between two parties, centered on the assets they are based on and priced according to the fluctuations in those two opposing assets.
Before Bitcoin and other cryptocurrency derivatives came into play, derivatives have been around for a long time. Precious metals such as gold and silver have been offered as derivatives options since 1974 and 1933 respectively.
Now that we are familiar with derivatives, let us come to cryptocurrency derivatives. They are an upcoming line of financial products. At the moment the most common among them is bitcoin futures, which have received mixed reactions from the community. Despite the mixed reactions, there is no denying the popularity of bitcoin futures. The average daily volume in the third quarter was equal to 5,053 contracts worth $177 million approximately.
Bitcoin futures, as a concept, is fairly new as it came into existence during the bull run in 2017. It was first introduced by the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE). The CME is one of the world’s largest derivatives exchange that handles over 20% of the total amount of derivatives trading all across the world.
Any new technology comes with its share of resistance. The same happened with cryptocurrency derivatives when it was first introduced. The Securities and Exchange Commission (SEC) strongly opposed it, whereas, surprisingly the U.S. Commodity Futures Trading Commission (CFTC) was all for it. While the resistance was in full force, the CME wrote a letter to the SEC requesting them to allow bitcoin futures trading.
Chris Concannon, the President of CME wrote a letter stating that the market was ready to support Exchange Traded Funds (ETF). While he did not push the agenda directly, he implied that (with the help of data collected) the market could soon support ETFs.
There are three main forms of derivatives namely, swaps, options, and futures. Let us go through each of these terms in detail:
- Swaps: A swap is an arrangement between two parties wherein they agree to exchange cash flows in the future, based on interest-bearing instruments such as bonds, notes, and loans on the asset (which in this case is, cryptocurrency).
- Options: A financial contract where a buyer has the right (not obliged) to purchase an asset or a seller takes the call to sell his asset at a pre-determined price within a specific time period.
- Futures: A financial contract where a buyer has the obligation to purchase an asset or a seller has to sell an asset at a fixed price as well as a pre-determined future price.
Advantages of cryptocurrency derivatives:
As many in this industry would know, cryptocurrencies involve a high amount of risk. The cryptocurrency derivatives market allows players with risk-management experiences, to enter the market and make substantial profits. Apart from that, there is protection from volatility, and cryptocurrency derivatives’ traders don’t stand to face a huge loss.
Another reason why crypto derivatives are a reliable option is that it allows for more liquidity as compared to the underlying asset. Speculation is comparatively easier on derivatives as traders can bet on future prices of assets and easier to make large speculative plays due to an ability to leverage on their positions.
- Hedging and better risk management
- Low Transaction costs
- Exposure: Traders can bet against an asset’s performance without owning it
- Leverage: Traders can enter positions that are larger than their account balance
Futures vs Margin Trading:
Cryptocurrency Futures are always superior to margin trading because futures provide:
More leverage: Future contracts allow much higher leverage than the maximum leverage allowed in Margin trading. On CoinDCX, Cryptocurrency futures can be leveraged to as high as 15x whereas margin trading is capped to 5x.
More liquidity: Margin trading market is a borrowing market which is hard to build, and as a result, have lower liquidity. Future markets are more liquid than spot markets since they are free of this limitation and are easy to develop.
No Cost of Interest: The futures contract will either trade at a premium or discount. There are no costs of interest involved in holding the futures. In the case of margin trading, CoinDCX offers interest-free margin trading for the first 24 hours and charges 0.05% per day thereafter.
One of the most well-known platforms for cryptocurrency derivatives is Bakkt which is backed by Intercontinental Exchange (ICE). Earlier this month, the platform launched two new products, namely Bakkt Bitcoin (USD) Monthly Options and Bakkt Bitcoin (USD) Cash Settled Futures. The first one is based on the benchmark Bakkt bitcoin (USD) monthly futures contract and settles into the underlying futures contract two days before the expiry on ICE Futures US Price Discovery. The latter allows traders in Asia and abroad, a convenient way to gain or hedge exposure to Bitcoin.
Conclusion: Cryptocurrency-related derivatives can be a good jumping-off point for traders who are new to the industry and are not very familiar with the volatility of this space. Once they have dipped their toes in the water, they could move to the original assets such as Bitcoin and Ethereum.