With the crypto market over a decade old and slowly but steadily maturing, it makes sense that financial instruments from the traditional markets entering the crypto space. One of these instruments are derivatives, that come in four separate types, futures, forwards, swaps and options. Over the course of this piece we will look into these instruments in relation to the crypto space.
A derivative is a financial product that, via a tradable security or a contract, derives its value from an underlying asset or benchmark. Key to a derivative is the binding agreement to purchase or sell a given asset at some future pre-determined and specified time. The derivative itself is of little inherent value, instead it is the future value of the underlying asset that is of value to a derivative.
In the case of crypto, the value derived from a derivative, would be subject to the underlying asset, such as Bitcoin, Ethereum or Ripple etc. Having been in use since 600 B.C. in ancient Greece and rejuvenated by the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBT) in the 1970’s and 1980’s. It was only until December 2017 that the Bitcoin futures trading was initiated by the CME and the CBT’s Options Exchange.
Via derivatives, traders can speculate “today” about the future price of an underlying asset without having to buy the asset “today”; thus, decreasing the time spent exposing themselves to the vibrancy of the marketplace. Additionally, derivatives lend themselves as vital tools for the management of risk, able to lock-in “hedge” prices and prevent traders from incurring losses due to market price volatility.
The four main types of derivatives including: futures, forwards, swaps and options.
Types of Derivatives
Futures contracts occur between a buyer and a seller, where both parties are obligated to buy or sell a given asset, Bitcoin, at a pre-agreed time in the future, regardless of the market price. Thus, both the seller and buyer agree to lock in the price of Bitcoin for a transaction at a contract-specified time in the future.
A Forwards contract is very similar to that of a Futures, except that the Forwards contract is traded OTC, decreasing the risk born during futures trading. Generally, Forwards contracts are more flexible and can be tailored to the needs of both trading parties involved.
In the crypto market, swaps are known as “perpetual swaps”, similar to Futures but without a set expiration date. Since no expiration or settlement date exists, neither parties is required to buy or sell a crypto. They can maintain an open position as long as their account holds enough crypto to cover the open position. Key to the perpetual swap’s is their funding rate, used to ensure that price convergence occurs with a degree of regularity and acts as a fee between the two trading parties. If the funding rate is positive, then the market is bullish and the perpetual swap contract price exceeds the spot price. A negative fund rate indicates the opposite occurrence.
Options are similar to a Futures contract, however with Options, the buyer or seller has the right, not the obligation, to buy or sell an asset at a pre-determined time and price. There are two forms of option contracts, call options and put options. The call options refer to the rights of the buyer, wishing to purchase an underlying asset and put options refer to the rights of the seller wishing to sell an underlying asset at a given time and price.
Why use derivatives?
The use of derivatives is growing within the crypto space, with the trading volume of crypto derivatives equating to $2.159 trillion in Q2 of 2020. These numbers indicate a 165% increase from the volume traded during Q2 in 2019. With the growth of crypto derivatives evidently growing, what are some of the reasons that investors use derivatives in the first place?
As noted above, one of the main reasons for using derivatives is to protect traders from market volatility. The crypto market is filled with extreme volatility, hence derivatives are used to reduce individual or company exposure to rapid crypto price fluctuations.
The second reason for using derivatives stems from their usability as a hedging tool. Derivatives can be used to hedge, undertake an investment in order to offset market risks of an asset, in order to reduce their losses.
Lastly, derivatives can be used as a speculation tool, where traders use derivatives to speculate on the price of a given crypto. The aim of speculating is to profit from the volatility of the crypto asset. That said, speculation may be a key driver in the volatility of the crypto market.