A derivative is a financial contract between two or more parties based on the future price of an underlying asset.
Usually, this type of financial contracts comes up when the discussion of futures contracts for bitcoins and various altcoins begins. And this is logical, because a derivative is, in fact, one of the oldest forms of financial contracts currently existing on the markets. They began to be used by medieval merchants who traveled throughout Europe and regularly participated in periodical fairs (an early form of market development).
Over the past centuries, derivatives have been refined a lot, which allowed them to become one of the simplest and most common financial instruments. Now this term also means various securities that receive their value depending on the price of the underlying asset or benchmark. The contract is between parties who plan to sell or acquire a certain asset at a certain price in the future. And the value of the contract itself will be determined by changes or fluctuations in the price of the standard with which it is associated.
Usually, an underlying asset which is used to calculate derivatives is currencies (or cryptocurrencies), commodities, bonds, stocks, market indices or interest rates. They can be traded either on specialized exchanges or directly between two clients (C2C). And there are significant differences between these two options both in the way of trading and in regulation. However, majority of traders use both the first option and the second, depending on the market situation.
Why do traders need it?
Because derivatives can be used both to hedge risks and to speculate on changes in the price of the underlying asset.
But more often, nevertheless, it is for hedging, that meands, to protect against serious price fluctuations. A clearly spelled out contract, according to which the transaction must be carried out on the conditions strictly set now, is an excellent protection against any changes. As for speculation, it is when traders try to predict the change in the price of an underlying asset over time and make it more profitable to buy or sell in the future. This is quite risky - not just that the famous financier Warren Buffett once called derivatives "financial weapons of mass destruction", because he considered them to be reason of the global financial crisis of 2007-2008.
There are many ways to use this financial instrument in real life. For example, before the start of the crisis, the largest American holding company Berkshire Hathaway began selling put options on the four largest stock indices, including the S&P 500 and FTSE 100.
What is a put option? It is a form of derivative where the new owner is given the right, but not the obligation, to sell a specific underlying asset to the option seller at a specific price by a predetermined date. That means, numerous investors had the opportunity to choose at what price to sell their shares in the future at the exact current moment. And if the price of the shares had fallen by that time, then the investors would have won, since they would have been glad to sell them at the old, predetermined price. But if this value rose, then the company would receive a net premium for the unused option, because no one would want to sell shares for less than the actual market price. Berkshire Hathaway took a significant risk, but it was justified, so the move brought the company $ 4.8 billion in profit.
There is another interesting example of the use of derivatives related to the aviation business. Airlines are highly dependent on fuel, the cost of which fluctuates depending on oil prices and a number of other factors. Therefore, to avoid the negative impact of these fluctuations, hedging derivatives are used. There is a well-known example of Southwest Airlines, the largest low-cost airline in the United States, which was able to effectively use this financial instrument. They managed to lock down the price of jet fuel at a time when oil prices were unusually low, so the company now pays 25-40 percent less to refuel than its competitors.
There are also examples of the use of similar financial instruments that are not associated with traditional financial systems. For example, there is a whole segment of so-called “weather derivatives” that protect farmers and suppliers of raw materials from financial losses associated with extreme weather such as frost, hurricanes and floods.
What are the main types?
There are 4 main types - futures, forwards, swaps and options.
Futures and forwards are somewhat similar to each other. They oblige the buyer (or buyers) to purchase the asset in the future at an agreed price by a specified date. The difference is that futures are traded mostly on exchanges, so they are standardized and somewhat simplified. Forwards, in this regard, are more flexible, since they give traders the ability to customize conditions to cover their needs. Therefore, they are traded mostly on over-the-counter platforms, so it is worth additionally considering the risks associated with counterparties.
Options give their owner the right to buy or sell the underlying asset in the future at the current price. But only a right, not an obligation, which distinguishes them from futures.
Swaps are a type of derivative that allows two parties to exchange similar financial flows with each other. Most often, we are talking about interest rates and exchange rates. Usually there is an exchange of a fixed cash flow for a "floating" one. That means a trader can use an interest rate swap to switch from a loan with a variable interest rate to a fixed one, or vice versa.
What does all this have to do with cryptoeconomics?
The most direct thing is that more and more traders want to speculate on fluctuations in cryptocurrency rates, and derivatives are the easiest way to do it.
This is not surprising - in recent years, the bitcoin price has reached an all-time high - $ 19,800 per 1 BTC, and then - in just a few days it has lost almost a third of its value and continued to fall throughout 2018 to the level of $ 3,200. However, the situation soon changed, so that in 2019 bitcoin rose again to a decent level - about 12 thousand dollars per coin. At the moment (July 2020), the price has dropped significantly due to the general downtrend in the financial markets, but has already pulled back to the level of $ 10,400.
In December 2017, right at the height of the bullish cryptocurrency market, the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) launched bitcoin futures trading. This was a turning point for crypto investors, as they had the opportunity to hedge the risks inextricably linked to cryptocurrency trading. Now large traders could join this trade by concluding contracts, the cost of which could be agreed in advance.
In addition, many smaller traders were able to speculate on fluctuations in bitcoin rates and the most popular altcoins. That means, right now they are buying crypto at a market and relatively low price, and in the future they undertake to sell at a higher price that does not depend on the state of affairs in the market. However, this is relevant only during a bullish trend, and in general it is a rather risky procedure, like all other attempts to speculate on the price of the underlying asset.
An alternative option is the "shorting" strategy, which can be used in both a bear market and a market experiencing a prolonged downtrend. According to this strategy, traders borrow assets from a third party (exchange or broker) and sell them on the market at a convenient moment, if the price is expected to decline. And when the value falls to a certain level, the trader buys the same amount of assets that he borrowed and returns them to the intermediary. Traders benefit from price fluctuations; intermediaries receive a commission for their services anyway.
Where does crypto derivatives trade?
Either on traditional exchanges or on cryptocurrency but regulated ones. And, of course, on some OTC platforms.
Currently, CME Group operates from traditional exchanges with bitcoin futures, and the Chicago Options Exchange, on the contrary, has stopped it. The world famous Nasdaq exchange also works with these derivatives. And in connection with the growing interest in crypto from traditional large investors, we can count on other large platforms to join crypto futures trading.
Even now, however, some institutional exchanges offer similar types of financial contracts. So, for example, the institutional provider of cryptocurrency assets LedgerX, back in 2017 - immediately after receiving permission from the US Commodity Futures Commission (CFTC) - began trading regulated swaps and options for crypto. Another similar platform, Bakkt, has postponed the launch of such futures trading several times, but still launched them too.
The largest cryptocurrency exchanges are also involved in similar trading. For example, the Maltese crypto exchange OKEx offers trading in futures and perpetual swaps, with 100x leverage, and also using optimized and scalable mechanisms. It can work with bitcoins, ETH, EOS and even some stablecoins like USDK.
What are the disadvantages of this process?
In general, all trading strategies based on price fluctuations involve a certain level of risk. In the situation with crypto derivatives, it is still more dangerous due to the lack of appropriate regulation of cryptocurrencies in general.
Perhaps the biggest risk for traders planning to speculate in cryptocurrency is volatility. Prices fall and fly in so strongly and quickly that they do not even have time to assess the situation. This is especially dangerous for those who trade on margin.
The cryptocurrency market is an extremely complex thing in which it is very difficult for new users to navigate. Mistakes can be very costly, and the unpredictable behavior of crypto derivatives only increases the risk that something will go wrong. The only thing that can save you from this is increased caution, strict adherence to tutorials, an ability to understand the functions provided by the platform, and a reliable strategy.
Official regulation is a separate topic. The fact is that regulators in the majority of countries are extremely wary of both the crypto itself and its futures. In the United States, for example, the Securities and Exchange Commission (SEC) is closely monitoring this segment of the market and has even begun to press charges against some dealers who work with bitcoin-backed swaps on certain securities throughout the country. So you have to trade with caution. In Europe, the situation is a little simpler, as the European Economic Area has not yet developed clear guidelines regarding the regulation of the cryptocurrency market.