Derivatives in Crypto, Explained

What is a derivative?

A derivative is a financial contract between two or more parties based on the future price of an underlying asset. 

Financial derivatives are discussed a lot when it comes to the crypto industry, especially concerning futures contracts for Bitcoin or altcoins. It is worth noting that the derivative is one of the oldest forms of a financial contract that exists on the market. The history of this type of deal can be traced to antiquity: In medieval times, derivatives were used to facilitate trades among merchants who traded all over Europe and participated in periodical fairs, an early form of markets in the Middle Ages.

Derivatives have evolved for centuries to become one of the most popular financial tools. Nowadays, a derivative is understood as a security that derives its value from an underlying asset or benchmark. The contract can be signed between two or more parties that want to buy or sell a particular asset for a specific price in the future. The value of the contract will therefore be determined by changes or fluctuations in the price of the benchmark it derives its value from.

Normally, the underlying assets used in derivatives are currencies (or cryptocurrencies), commodities, bonds, stocks, market indexes and interest rates. Derivatives can either be traded on exchanges or customer-to-customer (C2C), which is quite different in terms of regulation and manner of trading. Normally, however, active traders use both methods.

Why would a trader use derivatives?

Derivatives are generally used to hedge risk or to speculate on the price of the underlying asset in case it changes. 

Derivatives are used in many areas but mainly for hedging purposes, namely when investors want to protect themselves from price fluctuations. In this case, signing a contract to buy an asset for a fixed price would help mitigate related risks. Another way to take advantage of derivative trading is speculation, when traders are trying to predict how the asset’s price might change over time. That is the reason why high-profile American investor Warren Buffet once called derivatives “financial weapons of mass destruction,” sharing a commonly held view that they were to blame for the 2007-2008 global financial crisis.

There are many ways in which derivatives can be applied in real life. For instance, prior to the aforementioned crisis, major United States holding company Berkshire Hathaway started selling put options on four equity indexes, including the S&P 500 and FTSE 100. A put option is a form of derivative that gives the owner the right, but not the obligation, to sell an underlying asset to the seller of the put at a specified price by a predetermined date. In this case, Berkshire Hathaway offered investors the chance to purchase an option premium and therefore buy the ability to sell their stocks at an agreed-upon price and date. When the date finally came, they could earn money by selling a stock whose price had visibly decreased. However, if the price has been rising through that period of time, the company received the option premium. In this particular case, Berkshire Hathaway took the risk and earned around $4.8 billion as a result. 

Another interesting example of using derivatives comes from the airline business. As airlines are heavily dependent on jet fuel, the price of which continually sees ups and downs, it is very useful for the business to implement appropriate derivative hedging strategies. The world's largest low-cost carrier, Southwest Airlines, which operates in the U.S., is a well-known example of success in this area. Because of its well-designed hedging program, the airline managed to lock crude oil prices at a very low rate and has therefore been paying between 25% and 40% less for its jet fuel than its competitors for years. 

Some use cases are nowhere near traditional finance systems. For example, there is a whole segment of weather derivatives aimed to protect farmers, commodity providers and others from weather-related losses, such as frost or hurricanes.

What are the common forms of derivatives?

There are four major types of derivatives: futures, forwards, swaps and options. 

Futures and forwards are similar types of contracts with only slight differences. Thus, futures oblige the buyer (or buyers) to purchase the asset at a previously agreed-upon price on a specific date in the future. These futures are traded on exchanges, and the contracts, therefore, are similar and standardized. As for forwards, this type of contract is more flexible and customizable for the needs of both traders. As forwards are normally traded on over-the-counter (OTC) exchanges, counterparty risks should always be taken into account. 

Options grant the buyer the right to purchase or sell the underlying asset at a certain price. However, according to the terms of the contract, the trader is not necessarily obliged to buy the asset, which is a key difference between options and futures.

Swaps are derivative contracts that are often used between two parties to exchange one type of cash flow for another. The most popular types of swaps are related to interest rates, commodities and currencies. Normally, swaps imply the exchange of a fixed cash flow for a floating cash flow. That is, a trader can choose an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

How are derivatives used in crypto trading?

Cryptocurrencies are increasingly gaining popularity, and there are more traders who want to benefit from price fluctuations. 

Bitcoin’s rate has had a wild ride over the past two years — surging to its all-time high around $19,800 and then losing one-third of its value in just a few days, continuing to drop throughout 2018 to as low as $3,200. However, in April 2019, things started to change again, and the current price of Bitcoin — over $12,171, as of press time — is far from pessimistic. 

Bitcoin futures trading was launched by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) during the peak of the crypto bull market in December 2017. The move was a huge milestone for the whole crypto industry, as a futures contract allows investors to hedge positions and reduce the risk of the unknown, which is quite relevant for cryptocurrencies. In other words, trading Bitcoin and altcoin futures enables major traders to mitigate their risks by signing a contract that settles directly to an underlying auction price of a particular cryptocurrency. 

Moreover, there are, obviously, many traders who want to benefit from those drastic changes by trading derivative contracts for Bitcoin and major altcoins. To make a profit from a sudden change in the underlying asset’s price, the trader can buy a cryptocurrency at a low price and sell it at a higher price later. However, this strategy is only relevant during a bull market and is quite risky, as are all other attempts to speculate on the price of the underlying asset.

Another strategy is called shorting, which is a way to profit even from a crypto bear market or a market that is currently experiencing a downtrend. To short, the traders usually borrow the assets from a third party — whether it be an exchange or broker — and sell them on the market when they expect the price to decrease. As the coin's price goes down, the trader purchases the same amount of assets back for a lower price and profits from the price movement, while the exchange or the broker gets paid a commission.

Where can I trade crypto derivatives?

Crypto derivatives of different kinds can be traded officially both on traditional exchanges and regulated crypto exchanges. 

As per traditional exchanges, Bitcoin futures are currently offered by CME Group, as CBOE stopped adding new contracts in March. Meanwhile, in December 2018, Nasdaq stated it was considering launching Bitcoin futures in the first half of 2019. As cryptocurrencies are expected to gain more mainstream and institutional adoption, it is highly likely that more traditional players will trade crypto derivatives soon. 

Institutional exchanges are also offering these types of contracts. Institutional crypto derivatives provider LedgerX started trading regulated swaps and options contracts in October 2017, shortly after receiving approval from the U.S. Commodity Futures Trading Commission (CFTC). Another institutional crypto platform, Bakkt, delayed the launch of its Bitcoin futures trading several times but has finally scheduled the testing of the product for July 2019.

Major crypto exchanges are also actively involved in crypto derivatives trading. Malta-based OKEx offers futures and perpetual swaps trading, which is a contract with no expiration, with 100x leverage, and delivers them through an optimized and scaling engine. A range of popular crypto assets such as Bitcoin, Ether and EOS are supported — and USDK, a newly launched stablecoin, is also listed.

Are there any downsides of trading crypto derivatives?

All trading strategies related to price fluctuations imply a certain level of risk, especially combined with the lack of relevant regulation for the crypto derivatives sector. 

When it comes to crypto derivatives, the biggest risk that traders face is volatility. Prices can rise and fall at speeds that make your head spin, and losses can be amplified substantially whenever someone is trading on margin.

To better help mitigate these risks, a tiered maintenance margin ratio system has been adopted by OKEx to avoid the liquidation of large positions, events that can have a huge impact on market liquidity. During a recent "flash crash," when Bitcoin suddenly plunged from $7,800 to $6,100 in just five minutes, OKEx’s risk management system managed to stabilize the quarterly contract price from a fierce fluctuation — at about $7,000 — while other crypto exchanges offering derivatives experienced a nosedive, as shown in the graph involving other market players such as BitMEX derivatives prices.

This market is a complex beast, and it can be difficult to navigate for inexperienced users. Rookie mistakes can be extremely costly, and the unpredictability of crypto derivatives greatly amplifies the likelihood of something going wrong. As a result, it’s important to fully understand the features that a trading platform can offer, follow the tutorials and make sure you have a solid strategy in place.

It’s also worth paying close attention to regulation. Regulators in different countries are cautious about crypto futures and other types of such contracts — as well as with cryptocurrencies themselves. The U.S. Securities and Exchange Commission (SEC) is closely monitoring the area and has already filed charges against an international dealer, who was illegally offering Bitcoin-funded, security-based swaps in the country. At the same time, the European Economic Area has not yet elaborated clear guidelines on how to treat crypto derivatives and how they should be regulated.

The article was co-authored by Connor Blenkinsop.

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