The crypto market has seen massive growth over the past few years. Digital currencies have become a major economic disruptor, operating both as a medium of exchange and an asset for investment. As the cryptocurrency space continues to grow, so do the range of products offered in the ecosystem. Derivatives in crypto are one such product that has shown massive growth, recently having grown more than four times the size of the spot market in volume.
Below we break down the basics you need to know about crypto derivatives.
What are derivatives?
Derivatives are part of any mature financial system. They are called derivatives because they derive their value from underlying financial assets like bonds, stocks, commodities, interest rates, fiat currencies and cryptocurrencies.
Crypto derivatives work similarly to those of the traditional financial markets. It invokes a buyer and seller entering a contract to sell an underlying asset at a predetermined time and price. Derivatives don’t have any inherent values, instead, they rely on the underlying assets’ value. For example, a Bitcoin derivative obtains its value from the value of Bitcoin. Derivative trades do not own or hold the underlying asset.
There are various types of crypto derivatives. Some commonly used derivatives include futures, options, and perpetual futures.
Futures are one of the most popular types of crypto derivatives and are often used by institutional investors. Traders frequently look to futures data to predict market sentiment and future price movements.
Futures are an agreement between two parties to sell an asset at a specific date in the future at an agreed amount. While some exchanges might provide different contract details, they all operate on the same premise.
Futures work through the betting of possible price changes in the future. If the price of Bitcoin was $50,000 you could either sell futures contracts (to mitigate against a futures decline in price) or buy futures contracts (to gain a profit from a price increase). If a buyer buys a futures contract worth one Bitcoin, if the price rises to $60,000 at the contract close date, they would realise a $10,000 profit. Whereas, if the price dropped to $40,000 at the contract close date, they would incur a $10,000 loss (not including the fees to buy the contract). In future, the parties are obligated to fulfil the terms of the traded contract. The example above is a simple example, as many futures contracts are leveraged, the gains and losses are generally more substantial.
Options are a derivative contract that allows the trader to buy or sell a given commodity at a given price on a specific futures date. However, unlike the futures or forwards, options allow the buyer the liberty to not buy the asset.
Options can either be call options or put options. Call options allow the trader to buy an underlying asset at a given date, while the put option allows the trader to sell the underlying asset at a specific date. There’s also the American or the European options. The American options can be sold anytime even before the expiry date, while for European options, the trade must wait until the agreed date.
Options include fees to buy the contract. For example, an option might cost $1,000 to enter. Therefore, regardless of the outcome of your trade, you have to pay the $1,000. If we follow the example of the futures, if Bitcoin was $50,000 and you entered a call option with a strike price of $50,000 closing in a month, and in a month the price of Bitcoin was $40,000, you would not incur a $10,000 dollar loss. In this case, you exercise your right to not fulfil the contract, however, you would still incur the loss of paying the premium to buy the contract. Options are also most often leveraged, accentuating gains.
Perpetual future is a type of derivative that is extremely popular among day traders. It is most prolific in crypto, with the traditional finance equivalent being contracted for difference (CFD). Unlike options and futures, perpetual swaps do not have an expiry date. You can keep the positions for as long as you wish, but you would regularly be charged fees for holding your position called the funding rate.
Given the ever-changing price of the underlying asset, there can be a massive difference between the value of the index price and the price of perpetual futures contracts. Therefore, if the perpetual contract price was higher than the index, the longs would pay funding rate fees to cover the difference. The same if the perpetual futures contract prices were below the index price, the shorts would pay the funding rate fees to cover the difference.
Reasons to Use Crypto Derivatives
While there are various crypto exchanges offering spot price assets, you might be wondering why some traders opt for derivatives. Some of the reasons to use derivatives include;
Derivatives have been used by farmers to help cushion market price fluctuations. Given the seasonality of farming, there is always the possibility of farmers getting low returns at some point. However, with the derivatives, the farmers are assured of a given price for their products whenever they are ready.
The same logic applies to the crypto world. Given the volatile nature of cryptocurrencies, you are never sure of future values. This might be detrimental if you depend on crypto for your income. For example, crypto miners always want to ensure they get the best prices. Without an assured future value, it makes it difficult for them to budget and project future profits. Derivatives like futures (not perpetual futures) ensure miners are able to project their revenue no matter the market movement.
Crypto derivatives support speculation in various ways. The main reason it is so popular among day traders is due to the use of leverage. Most crypto derivatives exchanges allow traders to open larger positions than their deposits within a given ratio. The leverage increases the possible winning margins, at the same time it comes with the risk of higher losses, such as losing your entire account balance if the trade goes south.
Derivatives in DeFi
All expanding markets at some point develop a derivative market that might grow bigger than the underlying market. In the last few years, decentralised finance (DeFi) has been on an upward trend. Like any other financial setup, it also has a corresponding derivatives market.
The crypto community is excited about DeFi derivatives due to their decentralised nature. Unlike traditional finances, anyone can use DeFi in a permissionless and open way. This opens up the market for more creativity.
Some of the top DeFi derivative platforms at the moment include;
Synthetix is the most popular protocol among the derivatives in DeFi. It allows the creation of synthetic assets that track the value of underlying assets such as fiat currencies, commodities and cryptocurrencies.
Synthetix operates on a debt model such that in order to issue an asset, the trader gives collateral in the form of SNX tokens. The system is already overcollaterised at around 500%. Therefore, for every $50 worth of SNX tokens given as collateral, a trader can only get $10 worth of the synthetic assets.
UMA is also a protocol that supports the creation of synthetic assets. However, unlike Synthetix, it is not highly collateralised. Instead, it relies on liquidators who look for highly collateralised positions then liquidates them for incentives.
Launched in 2020, Opyn is a DeFi project that allows for trading ETH downside and upside. It also offers protection against ETH volatility, flash crashes and other price movements.
The project has also launched a second version that comes with European, cash-settled options. This option auto confirms upon maturity. Once a trader has taken a position they don’t have to do anything else.
Crypto derivatives FAQs
How big is the crypto derivatives market?
The crypto derivatives market is huge, has exploded in recent years. A recent study established that the market can trade more than $100 billion on a given day. This is bigger than the daily trading limits at the New York Stock Exchange.
The daily derivative market trading surpasses that of the crypto market by more than five times.
Do crypto derivatives impact the value of cryptos?
Yes, studies have established that crypto derivatives have an impact on crypto values. The value of crypto comes from the market dynamics of demand and supply. As the derivatives of the underlying asset become popular it raises credibility, hence better valuations.