The blockchain industry is replacing or revolutionising several existing systems. Meanwhile, it is boosting operating efficiency, extending optionality, and lowering costs. This is most apparent in the financial services industry. The interest in blockchain-enabled decentralised finance (DeFi) solutions has skyrocketed in recent years. The blockchain industry is increasingly overlapping with mainstream investor interest. Consequently, a broader range of financial products are beginning to use this technology. Similarly, the derivative market is not untouched by the emergence of blockchain.
As a result, the ongoing adoption of blockchain also influences the global derivatives market. According to estimates, the derivatives industry is worth more than $1 quadrillion USD.
What are financial derivatives?
Derivatives are financial contracts whose value depends on an underlying asset, collection of assets, or benchmark. A derivative is a contract entered into between two or more parties that can be traded on an exchange or over-the-counter (OTC). One can use these contracts to trade a variety of assets. However, it comes with its own set of risks. Cryptocurrency Derivatives prices depend on the movements of the underlying asset.
They are widely used to get access to certain markets. Traders use this instrument to mitigate risk. The investor does not own the underlying asset but instead wagers on the direction of price movement through a contract with a counter-party or exchange.
What are the different types of derivative instruments?
Options, swaps, futures, and forward contracts are all examples of derivative instruments.
1. Futures
A futures contract is an agreement between two parties to acquire and deliver an item at an agreed-upon price at a future date. Futures are standardised contracts that are traded on a market. Traders use futures contracts to hedge their risk or speculate on the price of an underlying asset. The parties have to fulfil the promise of acquiring or selling the underlying asset.
2. Forwards
Forward contracts are comparable to futures contracts but do not trade on an exchange. These contracts are only available for trading over-the-counter. When they construct a forward contract, the buyer and seller can tailor the terms, size, and settlement method. Forward contracts, being OTC goods, have a higher level of counterparty risk for both parties.
3. Swaps
Swaps are another prevalent sort of derivative that exchanges one type of cash flow for another. For example, a trader may use an interest rate swap to go from a variable interest rate loan to a fixed interest rate loan, or vice versa.
4. Options
An options contract is an agreement between two parties to purchase or sell an asset at a fixed future date and price. The primary distinction between options and futures is that the buyer of an option is not required to exercise their commitment to purchase or sell. As with futures, it is merely an opportunity and not a requirement.
What are Cryptocurrency Derivatives?
The cryptocurrency sector is still in its early stages, and most crypto investors have mostly participated in spot trading. Spot trading is the direct buying and selling of an asset at a mutually agreed-upon price throughout the last decade. However, as investor interest in the market has increased, new cryptocurrency-based derivatives have emerged. It allows traders to access a greater range of potential investment strategies.
The first crypto derivatives hit the market in 2011. However, they were limited to futures contracts based on the price of bitcoin. Several years later, exchanges began providing a larger range of derivatives. Investors can hedge against projected market moves and enjoy future price volatility. Hence, the crypto derivatives trading industry had grown to new highs by 2020. According to Tokeninsight’s Cryptocurrency Derivatives Exchange Industry Report, the cryptocurrency derivatives market’s trading volume for the third quarter of 2020 was $2.7 trillion. This represents a 25.1% increase over the previous quarter and a 159.4% increase over the third quarter of last year. It indicates the extraordinary growth in crypto-derivatives over the last several years.
With a rising number of institutional investors attempting to hedge their holdings in large-cap cryptos like BTC, many analysts expect that the crypto derivatives trading volume lead over crypto spot trading may grow even greater.
The increasing number of crypto-based derivatives is an exciting development that highlights the industry’s steady maturing. However, these financial instruments often continue to function within the traditional framework established by legacy financial institutions. As a result, one of the most interesting synergies between blockchain technology and the global derivatives market is blockchain’s ability to revolutionise the way the traditional derivatives market functions.
What are the benefits of utilising derivatives?
1. Derivative contracts are risk management instruments. Hence, they contribute to lower market transaction costs. As a result, the cost of transactions in derivative trading is lower when compared to other securities such as spot trading.
2. The value of a derivative contract depends on the price of the underlying crypto coin or token. Derivatives are thus used to manage the risks associated with shifting underlying asset values. Mr A, for example, buys a derivative contract whose value moves in the opposite direction to the value of the crypto-coin or token he owns. He’ll be able to offset losses in the underlying crypto coin or token with derivative gains.
3. Derivative trading implies arbitrage. It is crucial for ensuring that the market achieves equilibrium and that the prices of the underlying assets are correct.
4. Derivative contracts determine the price of an underlying asset.
5. Derivatives enable investors, businesses, and other parties to transfer risk to third parties.
What are the disadvantages of derivatives?
1. High risk: Due to the rapid change in the value of the underlying crypto coins and tokens, derivative contracts are very volatile. As a result, traders risk losing a large sum of money.
2. Speculative: Derivative contracts are popular speculative instruments. Speculative investments can result in huge losses due to the high risk involved and the unpredictability of their value fluctuations.
Where to trade crypto derivatives?
Different types of crypto derivatives are traded officially on both traditional markets and authorised crypto exchanges.
CME Group presently offers Bitcoin futures on traditional exchanges. Meanwhile, NASDAQ announced in December 2018 that it was exploring issuing Bitcoin futures in the first half of 2019. As cryptocurrencies gain popular and institutional acceptance, more traditional players may start trading crypto derivatives soon.
These contracts are also available on institutional exchanges. LedgerX, an institutional crypto derivatives provider, began trading regulated swaps and options contracts in October 2017. Bakkt, another institutional crypto platform, has repeatedly postponed the debut of its Bitcoin futures trading but has now planned testing for July 2019.
Major cryptocurrency exchanges are also involving themselves in crypto derivatives trading. OKEx, situated in Malta, provides futures and perpetual swaps trading. Perpetual swap trading is a contract with no expiration and 100x leverage using an efficient and growing engine. OKEx supports popular cryptocurrencies such as Bitcoin, Ether, and EOS. It also supports USDK, a recently created stablecoin.
The future of derivative trading
The global financial derivatives market is critical in providing market liquidity, increasing investment options, and expanding the number of alternatives for investors to hedge their positions. Financial institutions offering derivatives stand to benefit from increased market transparency and efficiency in a way that benefits both institutional and retail investors by leveraging blockchain technology to develop new financial instruments and migrate existing products to decentralised, globally accessible platforms.
As the infrastructure supporting this linked network of decentralised finance platforms matures, the blockchain space and the conventional financial services sector are ready to merge into a more egalitarian, feature-rich financial environment.
Also read: Metaverse, Cryptocurrency and NFTs
