Crypto Derivatives – What are they & How are they used?

Introduction

Derivative instruments are a complex, but popular tool that is used for a number of different reasons, including hedging against risk exposure and gaining access to additional markets or assets. Derivative Instruments are now being used in the Crypto and Web3 space.

In this article, we will dive into the meaning of derivatives and what their uses in the Web3/Crypto space are.

You will learn:

• Some basic terms and definitions
• How derivatives are used within crypto markets
• Some pro’s and con’s

Basic terminology

1. Derivative instrument: a financial instrument whose value is dependent on an underlying financial asset, predefined variable or commodity.
2. Over-the-counter (OTC): a decentralized market where market participants are able to trade commodities, stocks, currencies or other instruments without a broker or central exchange.
3. Exchange-traded derivatives: a financial contract that is traded and listed on regulated and public exchanges.
4. Futures: a contract that is made for financial assets (mainly for shares or commodities) that are bought at an agreed price, but are only paid for and delivered later.
5. Options: derivative contract that gives the contract holder the right but not the obligation to sell or buy the underlying asset at a specific price (strike price) by a certain date (expiration date).
6. Perpetual swaps: agreement to non-optionally buy or sell an asset at an unspecified point in the future.

What are derivative instruments?

In more detail: a derivative instrument refers to a financial contract whose value is linked to that of an underlying asset. Some of the advantages of investing in derivatives include: hedging against risk, increasing the efficiency of the financial markets, giving access to otherwise unavailable assets and markets and when determining the price of an underlying asset. There are four common types of derivative instruments, namely: Futures contracts, forward contracts, option contracts and swaps. 

Most derivative instruments are traded over-the-counter (OTC), or on some sort of exchange. Swaps on the other hand are traded privately and therefore do not go through an exchange or other intermediary. Exchange traded derivatives (ETD) are traded through specialized derivative exchanges or other exchanges. 

How are derivatives used in Crypto?

Crypto derivatives, like normal derivatives, derive their value from some underlying asset, in this case, their value is derived from a cryptocurrency (for example, Bitcoin or Ethereum). The most popular crypto derivatives are: Crypto futures, Crypto options and perpetual contracts.

A cryptocurrency derivative has many advantages, one of which is that it allows the derivative holder to trade contracts that follow the price of a crypto (Bitcoin) without ever having to own any crypto assets.

Specific types of crypto derivatives:

Crypto futures

A contract agreement between two parties to purchase and sell a crypto asset on a specified date at a given price. Neither party involved in the transaction is required to actually hold the underlying asset, instead the contract is settled in USD or another fiat currency. 

Crypto options

Follow the price of the underlying crypto, these option contracts do not necessarily need to be settled at their expiration dates.

Perpetual swaps/contracts

Perpetual contracts are a crypto derivative that does not have a specific expiration or settlement date. Under certain conditions, perpetual crypto derivative traders are able to keep their positions open for as long as they want. One of the conditions is that this derivative requires a margin (minimum) amount. Traders use a funding rate in order to aid in tethering the perpetual contracts price to the price of the chosen cryptocurrency. 

Examples of cryptocurrencies that support derivative trading:

1. Binance
2. Huobi
3. Bridges Exchange
4. BitMEX

Pro’s and Con’s of using derivative instruments in Crypto trading

Pro’s

1. Derivatives in the already volatile crypto market can serve as a tool for mitigating risk exposure to the underlying asset.
2. Allow traders access to a market that is otherwise unavailable.
3. The derivatives market can generate insights into the market’s movements.
4. Crypto derivatives can also open up sophisticated trading strategies.
5. Traders can gain access to the cryptocurrency market by way of derivatives, without actually holding any crypto.

Con’s

1. Derivatives offer risk mitigation in the long term, however, short term fluctuations could still lead to large losses.
2. It is extremely complex to value crypto derivatives.
3. Transactions that are OTC do not always follow compliance procedures, thus, this could be risky for traders.

Conclusion

Cryptocurrency derivatives are a useful tool when it comes to traders seeking access to exposure in the crypto market, without holding any crypto assets. The popularity of these derivative instruments is growing, however, as with all risky investments, it is important to remain cautious when it comes to trading cryptocurrency derivatives.

Cointelegraph has made a beginners guide to help understand crypto derivatives, you can investigate the concept further there.

TLDR

• Derivative instruments are used for hedging against risk exposure and gaining access to additional markets or assets.
• Crypto derivatives derive their value from some underlying asset, for example their value is derived from a cryptocurrency (for example, Bitcoin or Ethereum). 
• The most popular crypto derivatives are: Crypto futures, Crypto options and perpetual contracts.
• A cryptocurrency derivative has many advantages, one of which is that it allows the derivative holder to trade contracts that follow the price of a crypto (Bitcoin) without ever having to own any crypto assets.