It was only a matter of time before derivative products becomes commonplace in the cryptocurrency industry, given the inclination of the market towards delving into highly volatile and risky financial assets. Granted, there has been an increase in the popularity of derivatives as a highly-leveraged tool to speculate and significantly capitalize on price movements. As with the majority of the cryptocurrency market, cryptocurrency derivatives are unregulated and require a deep understanding of complex financing processes. It is therefore not surprising that trading volumes on the Chicago Mercantile Exchange (CME), one of the biggest traditional exchanges that offers bitcoin futures, is nowhere near the volumes generated from unregulated cryptocurrency exchanges.

Introduction to Derivatives

Simply put, derivatives are financial contracts that derive value from an underlying asset. The derivative contract is an agreement made by a party to buy or sell a particular asset at a predetermined price and a specified future date. The most common underlying asset used for derivatives are commodities (such as precious metals, oil or harvest) and currencies (US dollars being the most prominent). The derivatives contract does not possess any inherent value; rather, its value is derived – albeit speculatively – from the expected future price movements of the underlying asset.

Derivatives in the Cryptocurrency Market – Three General Categories

Swaps

Swap arrangements allow parties to exchange a series of future cash flows, which is usually predicated on interest-bearing financial assets such as loans and receivables. The most common form of swaps are interest swaps, where a party with a fixed-interest rate payment exchanges their future cash flows with a party that has assumed a variable-interest paying scheme. An example of a cryptocurrency-focused swap is the Bitcoin perpetual swap offered by BitMEX.

Futures

An arrangement where the buyer/seller has an obligation to buy/sell an asset at a predetermined price and date in the future. This is perhaps the most common form of cryptocurrency derivatives, with multiple exchanges offering Bitcoin and Ethereum futures.

Options

An arrangement where the buyer/seller owns the right to buy/sell an asset at a predetermined price and date in the future. Options are relatively more complex than futures owing to more specific variables that affects the contract price. Bitcoin and Ethereum options are available for trading in a limited number of exchanges.

Risk Profile

Before proceeding from here, it is imperative to understand the risk profile of derivatives vis-à-vis other financial instruments.

In terms of the risk-reward spectrum, derivatives – with the most common instruments being options and futures – represents one of the riskiest financial instruments in the markets. Derivatives are complex and highly sophisticated financial instruments that are often utilized by professionals. It is extremely hard to quantify the real value of any derivatives contract, since there are multiple factors that influence the actual price of the underlying assets. This was apparent in the 2007 global financial crisis, where even the banks that structured mortgage-backed derivatives did not understand the true value of the underlying assets they were repackaging and selling to the public.

The risk profile of cryptocurrency derivatives is even higher, given that the majority of cryptocurrency derivative exchanges are unregulated, meaning that no legal recourse or consumer protection mandates exist that could protect users in the case of any possible mishap (e.g. hacks, manipulation, default, moral hazards). Regulated exchanges are also required to adhere to standard risk management practices, with the most prominent mechanism being the use of central clearinghouse to mitigate against counterparty risks. Unregulated exchanges usually tend to sidestep these integral mechanisms.

It is therefore wise for users to only engage in cryptocurrency derivatives trading if they possess an holistic understanding of what derivatives are, in addition to what their purpose is.

Cryptocurrency Derivative Classification

In the cryptocurrency world, derivatives generally fall into four specific classifications based on their degree or regulation as well as their mode of settlement:

In cash settlement, no actual delivery of the underlying asset happens, rather there is a transfer of cash positions upon the expiration or exercise of the derivatives contract. Cash settlement is a more convenient way of transacting and settling futures contracts, since it does not require sellers to assume full possession of the underlying assets. Cash settlement occurs on the basis of spot price (prevailing market prices). Physical settlement, on the other hand, requires the delivery of the underlying asset to take place once the derivatives contract is exercised or expires.

Regulated cryptocurrency derivatives exchanges are pursuant to both forms of settlement equally, with CME and CryptoFacilities providing cash settlement while Bakkt and LedgerX inclining towards physical settlement of Bitcoin. However, a particular pattern emerges for unregulated exchanges, where all four of the biggest cryptocurrency derivative exchanges (BitFlyer, BitMEX, Huobi and OKEx) offer cash settlement. Cash settlement is the preferred settlement method due to its convenience factor and cost-efficiency, since there are no transaction costs related to the actual or physical delivery of the underlying asset. More importantly, it is much easier to hedge credit risks given that the required deposits from both counterparties in their margin account eliminates the risk that a party is unable to pay the offsetting monetary cash positions. However, a major disadvantage of cash settlement is its vulnerability towards market manipulation by either of the corresponding parties, which was exemplified by the manipulation of the Libor rates by financial institutions through collusion. In the context of the cryptocurrency market, it is much easier to manipulate data inputs since cash settlement is predicated on spot prices of cryptocurrency exchanges; an entity or a group of powerful entities can manipulate the cryptocurrency prices on exchanges (spot prices) which then benefit their derivative positions.

Physical settlement has gained popularity in being the preferred mode of settlement, especially since most cryptocurrency exchanges are not regulated. The risk of prices converging from the prevailing market price and the price of the derivatives contract at settlement is greatly reduced with physical settlement. This provides greater transparency, as well as the propensity for a fairer equilibrium price since the physical visibility of the underlying asset can be easily seen.

Reasons for Using Cryptocurrency Derivatives

Although derivatives are often seen as a high-risk financial instrument, there are various reasons to leverage derivatives as part of one’s portfolio.

Hedging Risk

The core reason for the creation of derivatives in the first place is to hedge the risks pertaining to the uncertain value of an asset in the future. For example, if you hold a huge amount of Bitcoins, there is tremendous risks on your end in the form of price volatility. Bitcoin can plunge in prices anytime in the future, which will then result in massive losses for investors. Derivatives can be used to allow investors to have an offsetting position to protect their Bitcoin holdings if things go bad. In this scenario, an investor could just enter into a derivative contract with a buyer to sell away his Bitcoin at current prices in the future, meaning that if Bitcoin prices fall significantly, the investor can exercise the derivative contracts and sell his Bitcoin at the pre-agreed price rather than the prevailing market price in the future. This is a popular risk management tool used by financial institutions and entities with huge positions, who require an insurance policy in the event of market turmoil.

Speculation

Given the highly-leveraged nature of derivatives, it has become a popular tool for speculation. Traders can bet on the price movements of cryptocurrencies by creating and trading derivatives, the main objective being purely to profit from the changes in the price of the underlying asset. An example is the act of shorting a coin with the expectation that the price of the coin will tumbledown in the future. Traders will then acquire short positions by borrowing Bitcoin in large amounts and selling them in the open market. If in the near future the trader is correct and Bitcoin’s prices fall in value, he can then purchase Bitcoins at a much lower price than when he initially sold, thereby bagging a profit from both transactions. Leveraging derivatives to short a coin has become common for traders in the cryptocurrency space, given the convenience that derivative contracts possess.

Conclusion

Derivatives are seen as a double-edged sword in the financial sphere; both as extremely risky due to their complexity and their highly-leveraged nature, but also serving as a vital tool for market participants to manage their risks and protect their positions. The fact that a major traditional exchange, in the form of CME, has entered the race in providing cryptocurrency derivatives shows the increasing public adoption and awareness of cryptocurrencies being a credible asset class, although caution is also always required and advised.

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