Cryptocurrency Derivatives Guide

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What are cryptocurrency derivatives

This guide to cryptocurrency derivatives offers a general look at interesting points related to the main topic of what cryptocurrency derivatives are.

The cryptocurrency market has grown into a diverse ecosystem of more than 2,000 coins and tokens, and each of the projects is focused on a specific use case using revolutionary blockchain technology.

Although the infrastructure supporting the cryptocurrency world is still at an early stage of development, there are developments that require more experience and knowledge about cryptocurrencies.
One of these achievements is the emergence of cryptocurrency derivatives, which are a completely new line of financial products.
The most common form of cryptocurrency derivatives at the moment is Bitcoin futures, the reaction to which was mixed among the community.

The popularity of Bitcoin futures becomes apparent when you look at the average daily trading volume, which in the third quarter of 2017 showed an increase of more than 40%.
In monetary terms, the average daily volume of trading in Bitcoin futures amounted to 5,053 contracts with a total value of approximately $ 177 million.
These data look pretty impressive, especially considering that the cryptocurrency market has been in recession since the beginning of 2018, and coin and token prices generally fell by more than 85%!

A large trading volume is an indicator of high liquidity, which is always a plus for market participants. It reflects a growing and healthy market.

What are cryptocurrency derivatives

Before moving on, let’s try to understand the essence of cryptocurrency derivatives.
A derivative is simply a financial contract between two or more parties, the value of which occurs (Eng. ‘Derive‘, therefore ‘derivative‘) from the value of the underlying asset, in this case cryptocurrency.
More specifically, this is an agreement to buy or sell a specific asset – whether it is stocks or cryptocurrencies – at a predetermined price and at a certain time in the future.

Derivatives themselves do not have their own or direct value; The value of the derivative contract is purely based on the expected future price movements of the underlying cryptocurrency.
In the financial world, there are three common types of derivatives.

The three main forms of derivatives are

  1. Swaps. A swap is an agreement between two parties about the exchange of future series of cash flows. As the underlying asset, interest-bearing instruments such as loans, bonds or mortgages are usually used. The most common form of swaps are interest rate swaps, which involve exchanging a future fixed-rate payment stream for a floating-rate payment stream between two different counterparties.
  2. Futures. A financial contract whereby a buyer agrees to purchase an asset and a seller agrees to sell an asset (for example, a product) at a fixed and predetermined future price.
  3. Options. A financial contract in accordance with which the buyer receives the right (and not the obligation) to acquire the asset, and the seller receives the right to sell the asset at a predetermined price at a certain time.

Due to the youth of the cryptocurrency derivatives market, only a few such derivative products are currently available to the public.

The most common cryptocurrency derivatives are futures and options on Bitcoin, due to the fact that it is Bitcoin that accounts for more than 50% of the total capitalization of the cryptocurrency market, and this makes it the largest and most traded coin.

Reasons to trade derivatives

Derivatives are very complex financial instruments that are used by advanced or technically savvy investors.

There are three main reasons for using derivatives:

 1. Protection against volatility
The main reason for the existence of derivatives is that individuals and legal entities want to reduce their exposure to risk and protect themselves from fluctuations in the price of the underlying asset.

As the price of rice fluctuates daily depending on market conditions, the rice producer is trying to profitably set a fixed price for the next year’s crop to protect against the volatility of daily price fluctuations.
Businesses also use derivative financial instruments to reduce their exposure to risk.

A bakery that wants to buy wheat flour from a farmer uses a derivative contract to “fix” the price of wheat flour for the whole year.
This will allow the bakery to forecast its budget for the whole year and protect itself from fluctuations in wheat prices.
It is these derivatives contracts between the buyer and the seller that can be traded on the derivatives market.

2. Hedging (insurance)
Investors can also use derivatives to protect their investment portfolio.
This is also called a “hedge” and involves taking measures to compensate for potential losses.
Derivatives are an important risk management technique used by financial institutions and investors.
The concept of hedging is similar to buying an insurance policy for your portfolio.

Hedging can save you from potential headaches or worries that you may encounter on your investment path.
Having an insurance policy in the form of derivatives provides good risk management and, more importantly, allows you to sleep well!

3. Speculation
Traders often use derivatives to speculate on cryptocurrency prices with the main goal of making a profit from changing the price of the underlying cryptocurrency.
For example, a trader may try to profit from the expected fall in cryptocurrency prices by opening a short position on a coin.
Shorting (or short selling) is a bet against the value of a security.
People often look at speculation negatively, as they increase the level of volatility in the common market.An easier way is to use derivative financial instruments, as it is much cheaper and more efficient in terms of capital.
If someone thinks that the price of cryptocurrency is unstable or will soon move into a downtrend, he can sell derivative contracts on the open market to those who think that the market will grow.

Spot and Derivatives Market

In the world of cryptocurrencies, there are two types of markets: the spot market and the derivatives market. Both have their own unique characteristics.

The spot market involves the immediate exchange of financial assets – such as stocks and cryptocurrencies – and the calculation of them.
This means that ownership of cryptocurrencies is transferred between market participants (from seller to buyer) immediately after the transaction.
When you go to the exchange to buy any cryptocurrency, you participate in the spot market, as the transaction occurs instantly, and you immediately become the owners of the coins you bought.
In the derivatives market, participants trade in contracts, rather than the asset itself. These contracts have a value that is directly tied to the underlying asset.
Thus, derivatives are financial instruments rather than assets.

Where to trade cryptocurrency derivatives

LedgerX was the first regulated institutional exchange to introduce Bitcoin derivatives in the form of swaps and options.
But only accredited investors and institutional players can trade on the LedgerX platform.

Bitcoin futures were first introduced by the Chicago Mercantile Exchange (CME) and the Chicago Options Exchange (CBOE) in December 2017.
The Chicago Mercantile Exchange (CME) is the world’s largest derivatives exchange and processes more than 20% of the total derivatives trade worldwide.
Retail investors who trade CME Bitcoin futures can do this through providers or brokers.

As for derivatives offered by purely cryptocurrency exchanges, here the main players at present are Bitmex, OKEX, BaseFEX and CryptoFacilities.
It is important to note that derivatives offered by purely cryptocurrency exchanges are currently not regulated in any jurisdiction.
This increases the risks associated with these derivatives.

Bakkt is the new cryptocurrency futures exchange supported by the Intercontinental Exchange (ICE), the third largest exchange group in the world after CME and the Hong Kong Exchange.

Bakkt is not only owned by the parent company of the New York Stock Exchange (NYSE), but is also supported by heavyweights such as Microsoft, Starbucks and Pantera Capital.
Bakkt plans to start trading Bitcoin futures by January 2019.
Another major player aimed at entering the derivatives space is Nasdaq, the second largest stock exchange in the world. Nasdaq plans to release its Bitcoin futures in the first quarter of 2019.

Warning

Despite the fact that derivatives were one of the main factors that contributed to the development of the global financial crisis in 2007, they are still a very important tool for managing investment risks.
When major traditional exchanges – CBOE and CME – launched Bitcoin futures at the end of 2017, the market reacted very violently.

It is easy to understand that the derivatives market is necessary for the dynamic development of the financial ecosystem, and, perhaps, is the bridge that is necessary to increase the level of knowledge about cryptocurrencies in the mass market.
However, caution should be exercised when dealing with derivatives, especially considering their complexity.
In the next article, we will delve deeper into the technical details of how derivatives actually work, as well as the consequences of using these complex financial products.

 

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