Just a decade ago, speculating on cryptocurrency prices meant figuring out a way to buy Bitcoin (BTC) and add it to your blockchain wallet. This was a feat that was worthy of bragging rights: In 2010, there were few exchanges, low liquidity and barely any infrastructure, meaning that crypto was less a financial instrument and more a digital novelty.
Larger centralized exchanges unlocked the idea that Bitcoin and other cryptocurrencies have relative value and made it possible to speculate on their value versus fiat currency. Since then, a slow proliferation of a variety of crypto derivatives has transpired. This has given traders many new ways to mobilize their capital in the young ecosystem.
The newness of cryptocurrency and its unique decentralized characteristics mean that new financial instruments and their terms are introduced gradually to the ecosystem, and with effects that are hard to predict. It’s actually an excellent experiment in how money markets mature and change when ideas considered old by the fiat market are initiated.
There are many instruments for enterprise Bitcoin traders that now exist, raising important fundamental questions while giving us a glimpse of where the crypto market as a whole may end up.
Theoretical side to derivatives
A derivative is a financial instrument that can be used by traders to speculate in different ways on the underlying asset. It is literally “derived” from something else. In the case of Bitcoin — a scarce asset that can only be minted by mining blocks to support the blockchain — the notion that one can go long on Bitcoin without directly purchasing or mining has significant implications.
Not only is much of Bitcoin’s value derived from scarcity due to its mining difficulty but to own BTC means you’d have control over its associated private key. If derivative traders are trading Bitcoin they don’t own, exposure is possible without buying physical BTC. In this case, is the fundamental value of blockchain being mortgaged for the promise of easier speculation?
However, some of the most mature market places, such as equity markets, maintain their integrity despite an enormous and more diverse derivatives market. In fact, the proliferation and maturity of derivatives may even be what’s holding back crypto from achieving the status and market capitalization it deserves. The CEO and founder of a BTC options and futures exchange, Deribit John Jansen, told Cointelegraph:
"In the past, traders have been afraid of the impact of incumbent markets launching BTC derivatives. While I can understand where the fear is coming from, I don't agree with it. I truly believe in the benefits of derivatives for the entire ecosystem and that they are essential for institutional adoption. With liquidity on the rise, more 'adoption doors' are finally opening."
What form does adoption take for derivatives?
There are many emerging cryptocurrency derivatives, some launched by well-known financial firms in the fiat money market and some new ones with new value-added blockchain elements. These come in many shapes and sizes and allow various strategies to be pursued in the crypto market. For example, the first derivative milestone for Bitcoin was the launch of futures contracts on the Chicago Board Options Exchange in late 2017.
The XBT instrument, as well as the other futures offering from CME, are cash-settled contracts that use BTC prices from other sources. This means they’re effectively separate from the blockchain and Bitcoin itself, and so supply of BTC remains untouched regardless of demand for XBT futures.
Bakkt is a new exchange venture from Intercontinental Exchange — or, ICE — that recently launched to offer physically settled Bitcoin futures in traditional markets. What this means is that the first brick in the path to institutional investment in BTC has been laid. The pension funds and venture capital firms already investing in the underlying asset can hedge their positions — and instead of realizing gains or losses in cash, the result of their positions simply affects a Bitcoin balance. This means these are the first futures to stimulate the supply and demand equation inherent in Bitcoin’s price momentum.
Options are a newer type of instrument yet to be deployed by big exchanges like CME, but they’re planned for the first quarter of 2020, pending regulatory review. Seed CX has recently announced its intention to take it a step further, with physically settled swap contracts on BTC futures, adding leverage into the picture.
This will give people who buy futures contracts a way to buy or sell them at specifically executed price points and on margin, expanding the ways in which individuals and institutions manage their capital when crypto is involved.
The future of decentralized derivatives
Half the battle for new derivatives and crypto instruments has been tied to figuring out how to loop in the traditional fiat economy, and it’s a testament to this struggle that it took Bakkt until 2019 to create the first derivative to link these two worlds. However, now that there are enough infrastructure and custody solutions available, as well as transparency about tax liability, institutions have begun dabbling in crypto in larger numbers.
Soon, new derivative instruments allowing exchanges to settle in physical BTC will be available to the wider public using special products like exchange-traded notes (ETNs). The CEO of asset management firm Iconic Holding, Patrick Lowry, told Cointelegraph:
“An ETN will be the first genuine exchange traded product with crypto as the underlying that we will see in regulated marketplaces. It’s the perfect investment product to facilitate the adoption of crypto as an asset class with institutions as it tracks the performance of Bitcoin or another crypto one-to-one, provides superior liquidity relative to the exchange traded certificates available today, and provides many institutional managers an International Securities Identification Number (ISIN) so they may legally diversify their portfolio into crypto.”
A maturing market and a mysterious future
As liquidity due to derivatives increases, economists have estimated that crypto markets will be less volatile, providing a more enticing lure for funds that wish to expose their capital to inclusive growth strategies.
At the end of the day, derivatives are meant to control risk as much as they’re good at encouraging speculation, and their comfortability and fast growth in crypto is a characteristic that undoubtedly resembles development. It’s easy to say that incumbent fiat ideas have changed crypto.
Now, as new derivatives like the upcoming OKEx margin futures for Tether (USDT) encroach on similar instruments in the forex market, questions arise about how the small upstart market will affect the old, established one. If we know anything for certain, however, it’s that with crypto, we must learn as we go.