What are Crypto Derivatives?

The significance of derivatives in crypto trading and crypto derivative trading benefits.

 

The decentralized finance market has boomed over the past couple of years. The rising popularity of crypto trading has paved the way for the entrance of new DeFi solutions and technologies like stablecoins, NFTs, etc., and the latest addition being the crypto derivatives.


The crypto derivatives market has exploded since the launch of Bitcoin Futures by CME (Chicago Mercantile Exchange) in December 2017. Since then the market has grown exponentially. Many new traders have come forward to leverage its benefits.


But what are crypto derivatives, and how did they gain so much popularity in such a short time? To know about crypto derivatives, we must first understand what derivatives are.


Understanding Derivatives

In simple words, a derivative is a financial contract between two or more traders, the value of which is based upon an underlying asset. The asset here can be currencies, bonds, commodities, stocks, securities, or cryptocurrencies. A derivative is a financial tool that is used for hedging purposes or to limit the risks of financial assets. This mainly happens when two trading parties are trying to speculate or gamble on the price of an asset over a period of time.


Significance of Derivatives in Crypto Trading

Cryptocurrency trading is like a roller-coaster ride. The volatility of the market is one of the main reasons why many new entrants hesitate to invest in the market. We all know about the unprecedented surge in bitcoin price in 2017, followed by subsequent crashes in the value of bitcoins in early 2018. The value of bitcoins dropped by over 65% from January to February 2018. This was devastating for traders who were forced to sell their assets to squeeze in whatever returns they were getting.


Seasoned traders try to benefit from these price fluctuations and make massive profits in the crypto spot markets. However, investors can only make profits in a spot market when the value of cryptocurrencies goes up, or else they can incur huge losses if the prices suddenly go down. Another significant characteristic of derivatives trading is that investors do not need to hold on to the actual assets or own an asset and can simply trade the contracts based on price fluctuations in the market.


Similarly, crypto derivatives trading allows investors to bet on the price of cryptocurrencies on any given date. These speculations are bound by a contract. On that particular date, the traders are obliged to buy or sell the cryptocurrencies at the same price that they have agreed upon previously irrespective of the present market value of the cryptocurrencies.

Derivatives are extremely profitable for trading volatile assets like cryptocurrencies. They are also risk-management tools that lessen the risks of crypto trading and safeguards traders from incurring massive losses due to the continuous price fluctuations of cryptocurrencies.


The Five Types of Crypto Derivatives

  • Future: They are the most popular derivatives. Here two parties can buy or sell crypto assets at a previously agreed price on a specified date.

  • Perpetual Contracts: They are more like futures but the contracts are not bound by a specified time or expiration date.

  • Options: They are derivative contracts that allow traders to buy or sell cryptos at a predetermined price, but the only difference is that there is an option for settlement at future dates.

  • Forwards: Forward derivatives are customizable contracts between two parties that can be settled on a predetermined price on a future date.

  • Swaps: Just like crypto swaps, traders can swap derivatives on a crypto exchange to earn profits.

Crypto Derivative Market Overview

Derivatives have brought in new opportunities through hedging and speculation of cryptocurrencies that mitigates the risks of crypto volatility. CME’s debut in 2017 raised a total trading volume of $2.3 million on the first day which was an eye-opener for many mainstream investors, banks, and large companies to invest in cryptocurrencies.


With more and more derivative exchanges coming in, the future seems quite promising. There has been a consistent rise in trade volumes in popular exchanges like OKEx, BitMEX, ByBit, Binance, etc. The latest data from CryptoCompare on June 2021, it shows a marked increase in the trade volume of derivatives around $3.2 trillion compared to $2.7 trillion in spot trading volumes.


The volatility of the market witnessed a shift of the traders towards derivatives. The total volume of spot trading decreased by 42.7%, and total derivatives volume showed a decrease of 40.7%. According to the latest reports, the crypto derivative market share is 53.8% which is a 4% hike since May.


Crypto Derivative Trading Benefits

Spot crypto trading may be simple and straightforward, but it is risky. Crypto derivatives, on the other hand, offer a number of benefits:

  • Hedging – One of the prime reasons for derivatives is risk management. It protects individuals or corporations from incurring heavy losses in the future.

  • Market volatility – Derivatives are used to protect traders from the price fluctuations of cryptocurrencies. A contract is executed between the two parties based on pre-determined prices of the cryptocurrencies. This eliminates the risks of volatility.

  • Speculation – Speculating and betting on the price of cryptocurrencies is an important part of derivative trading. Traders can speculate future prices and benefit from the price fluctuations.

  • Liquidity – Derivative trading can overcome the limitations of spot trading and improve the overall liquidity of the crypto market.

  • Leverage trading – Maximize profits and get better returns compared to spot trading. At the same time, leverage trading is extremely risky in digital currencies. Hence, you should excercise maximum precaution while investing with leverage in cryptocurrencies.

  • Hold - No need to hold cryptocurrencies for trading.


Final Thoughts

The crypto derivatives market has grown ten folds in recent years, and the profit margin is quite high compared to crypto spot markets. LedgerX was one of the first exchange platforms for trading bitcoin derivatives, but it was accessible mostly to accredited investors. Since the inception of Bitcoin futures by CME and CBOE (Chicago Board Options Exchange), two of the leading exchanges in 2017, there is a huge scope for the derivatives market. The CME market witnessed a staggering growth of 38% of around $6.6 billion between April and May 2019. However, experts believe that the market is still young, and there are risks of bitcoin price manipulation in the crypto space. While traders mainly prefer derivatives for risk mitigation, but there are still risks for price fluctuations and short-term losses. The crypto exchanges should be monitored and regulated properly to minimize these risks and maximize profits for investors.

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