What are Crypto Derivatives and Why do They Matter

The crypto market has flourished into an ecosystem comprising over 2,000 coins and tokens – each pivoting around a specific use-case backed by disruptive blockchain technology. Although the infrastructure supporting the cryptocurrency ecosystem is in its nascent stage, different developments promote increased exposure and awareness of cryptocurrencies. One of these developments is cryptocurrency derivatives – the most common example of which is Bitcoin Futures.

The burgeoning popularity of Bitcoin Futures is evident from the incredible stats cited by CME Group – the world’s leading and most diverse derivatives marketplace. As updated by CME Group, the average daily volume for Bitcoin futures grew 40 percent in Q3. Furthermore, as told by Tim McCourt, the Managing Director of CME Group, out of the 40 percent of Bitcoin futures trading on CME that were outside the U.S., 21 percent came from Asia.

Greater trading volume means good liquidity – the most sought-after thing for market participants. This exhibits a growing derivatives marketplace, which is why many businesses planning for crypto exchange development are considering offering the option of derivatives trading to their potential exchange users.

What are crypto derivatives?

A derivative is a financial contract, between two parties, which derives its value from an asset – in this case, cryptocurrencies. It is an agreement to buy or sell a specific cryptocurrency at a predetermined price and a specified time in the future.

Derivatives do not have a direct value; their value is based on the anticipated future price movements of the underlying crypto asset.

Types of crypto derivatives

Cryptocurrency derivatives are of three types, including the following:

• Swaps

A swap is an agreement between two parties to exchange a series of cash flow in the future, generally based on interest-bearing instruments like loans or bonds as the underlying assets. The most common type of swap is the interest swap that comprises the exchange of fixed interest rate payments for a stream of floating-rate payments between two parties.

• Futures

Futures is a financial contract where a buyer has an obligation to buy an asset or a seller has an obligation to sell an asset at a fixed and predetermined future price.

• Options

Like a futures contract, options is a financial contract but here a buyer has the right, and no obligation, to buy an asset or a seller has the right to sell an asset at a fixed and predetermined future price.

As the crypto derivatives market is in its infancy, there are not many derivates projects on the market, however, the number of these projects is increasing and businesses seeking cryptocurrency exchange development services are considering integrating derivatives trading into their exchange platforms.

Reasons why traders opt for derivatives trading

There are three main reasons why traders choose derivatives trading and why exchange owners should offer derivatives trading to gain a competitive edge.

• Protection from volatility

The fundamental reason why individuals and corporations choose derivatives trading is to reduce their risk exposure and safeguard themselves against any fluctuations in the price of the underlying asset. Let us gain a better understanding of it through a real-life example.

Imagine that you have decided to get a mobile cellular subscription at a monthly fixed price for one year. As a buyer of the service, you will enter an agreement with the mobile company. This is akin to a futures contract where you define the exact price that you will be paying for the exact services that you will be getting for a year. By entering into this agreement, you have locked in a fixed price. Even if the price of mobile cellular increases during the year, you will continue to pay the fixed price, thereby reducing your risk of paying higher monthly prices.

• Hedging

Investors use derivatives to safeguard their investment portfolios. This is known as hedging, which involves taking the required measures to offset prospective losses. Derivates are an ideal risk management technique for institutions as well as investors.

For example, if you invest in the stocks of a company, you also hold a significant amount of risk, especially if the economy of that country, where the company is located, suffers a systemic shock. This can have a negative impact on the price of the stocks that you have purchased. This is when derivates can reduce your overall investment risk. You can leverage the put options to benefit from the contract to protect your investments from any unforeseen circumstances and offset the potential losses.

• Speculation

Investors often use derivatives to anticipate the future price of cryptocurrencies to benefit from the fluctuations in the price of the underlying crypto asset. For example, an investor might look to benefit from a predicted drop in the price of an underlying cryptocurrency by shortening the currency. Shortening, also referred to as short selling, involves betting against the price of a security. Speculation is usually seen negatively as it leads to higher volatility.

Take away

Derivatives play a significant role in managing investment risks. As the market is witnessing an increasing number of derivatives projects, derivatives seem to have a promising future. They can not only lead to a dynamic financial ecosystem but also increase the awareness of cryptocurrencies.

If you are planning to build a derivatives trading platform, Antier can help. We leverage our rich experience and deep domain knowledge to offer business-oriented cryptocurrency exchange development services to help businesses tap into the flourishing crypto world.

A free consultation is available to discuss your business needs, no obligation, just a friendly chat to work out if we can help.