The crypto derivatives market has exploded over the past couple of years, ever since the CME (Chicago Mercantile Exchange) and CBOE (Chicago Boards Options Exchange) launched Bitcoin Futures in 2017.
According to recent reports by CoinMarketCap, Binance recorded a massive crypto derivatives volume of $42 billion. CME reported that in April 2021, Bitcoin Futures alone reached a total market volume of $28 billion. Ever since the birth of crypto derivatives, there has been a mounting interest among traders. They want to know what crypto derivatives really are, and how they can benefit them.
So, let’s talk about what crypto derivatives are, their benefits, and the different variations in the market.
Before we explain what crypto derivatives really are, let’s quickly review derivatives trading in general.
Derivatives are an age-old financial tool used by traders and merchants. Derivatives are used as a form of security against an underlying asset that has financial value (a fixed price). Derivatives were used as contracts between two parties who wanted to trade, buy or sell a product based on its future price. The value of the underlying asset served as a benchmark based upon which the future price was determined. The future price depended on market fluctuations and changes based on this benchmark. Derivatives can be anything like a bond, stock, interest rates, and in this case, cryptocurrencies.
A crypto derivative is a financial contract based on an underlying asset whose price is fixed, and facilitates cryptocurrency trading in a way that attempts to even out the existing volatility of the market. On the day of the trade, both the crypto traders have to honor the price (both buying and selling) that was decided on the day the contract was signed. Crypto derivatives trading can be done on DeFi (decentralized finance), CeFi (central finance), and C2C (customer-to-customer) markets.
- Manage risks One of the hardest challenges of crypto trading is the volatility of the market. Derivatives allow crypto traders to hedge against investment risks that help to downsize the risks of the market. Derivatives also predict the price variation and future risks of a crypto asset. Hence, if a trader believes that the price of Bitcoin will go up in the near future, he will invest more and in the same way, if he predicts that the price will go down, he will try to sell and maximize his profits.
- Liquidity Crypto derivatives tend to attract professional and institutional traders who contribute to the liquidity of the crypto market. Increased liquidity means there are more buyers and sellers in the market and more transactions can take place.
- A few years ago, big investors would shy away from trading crypto assets due to the fluctuation in prices. But derivatives can cushion that risk and attract more institutional traders like banks, government crypto assets, etc. Bitcoin, Ethereum, and Ripple are some of the most popular cryptocurrencies and are traded with high trade volumes. Derivatives can allow other cryptocurrencies to enter the market and contribute to the liquidity and bring equilibrium in the market. The participation of more players in the market also shifts or distributes the risk to others.
- Reduce trading costs Crypto derivatives are trading tools that reduce the cost of overall transactions. The cost of spot trading in crypto market exchanges is much higher compared to crypto derivatives.
- Leverage the market Derivatives trading increases price stability and cushions the traders against sudden price shocks. Price predictions and prior knowledge of the market increase the efficiency of the market and help traders to speculate the market price and make proper investment decisions against the adversity of the market. Leveraging the market also allows traders to take advantage of price volatility that may be risky in the long term.
- Futures — These are derivative contracts between parties with a pre-determined market price and trading date irrespective of the price of the crypto asset on that particular settlement date. They are the least risky derivatives and have a limited lifespan. However, the contract will expire after the settlement date so both parties have to keep track of the contract.
- Perpetual swaps — Unlike futures, swaps do not have an expiration date and are more flexible. The traders can hold the assets for an indefinite period of time and there is no settlement date. However, in some cases, traders have to maintain a minimum amount of crypto in their accounts
- Options — Bitcoin and Ethereum are popular options to trade in the crypto market. Options give both the buyer and the seller the choice not to buy or sell any underlying asset on that particular date. Traders can trade options on any future date or price.
- Forwards — These derivatives are more flexible than the Futures contracts, however, they are traded in OTC (over-the-counter) platforms and hence are riskier.
- Leveraged tokens — These derivatives have leveraged exposure to market risks, liquidity, and margin. The token price depends on the existing supply and demand and the market price of the derivative.
Crypto derivatives are instruments to manage risks against the volatile nature of crypto assets. In the past, we have witnessed severe price fluctuations that make crypto exchanges a highly vulnerable trading platform, which is why many institutional and small investors hesitate to venture into the market in spite of the high-profit margins. Derivatives trading allows traders to hedge the underlying crypto assets and mitigate risks through future predictions and betting of crypto market prices.