What Are the Essential Functions of Derivatives in the Crypto Economy?
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What Are the Essential Functions of Derivatives in the Crypto Economy?

2 years ago

Binance Futures takes a deep dive into how crypto derivatives function in the crypto space.

What Are the Essential Functions of Derivatives in the Crypto Economy?

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You may have heard of the fast-growing crypto-derivatives market, where every major crypto-exchange is battling out to offer the latest derivatives product. Due to its infancy, you may not have a clear idea of what crypto derivatives are and how they are used in the market. And perhaps, you may be wondering, why are derivatives so crucial in the crypto economy? How are they relevant to cryptocurrencies?

This article gives a comprehensive primer to how traders and investors utilize derivatives to maximize their investment profits or reduce risks. It will also outline the various forms of crypto derivatives available in the market today. Lastly, you will also learn why derivatives are so crucial to cryptocurrencies.

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What Are Derivatives?

Derivatives are an essential part of finance: they are highly complex financial instruments that advanced or technical investors use. Investors, corporations and governments use derivatives to protect their exposure to risk and volatility of asset prices. 

A derivative is a financial contract that derives its value from an underlying asset. Traditionally, derivatives are used in markets such as commodities, currencies, stocks or bonds. These contracts can be traded over the counter or through an exchange.

In the crypto industry, the derivatives market is relatively new and small compared to traditional markets, but that doesn’t make it less lucrative. Like stock options or commodity futures contracts, crypto derivatives offer protection against volatility and adverse price movements on cryptocurrencies. A crypto derivative is also a proxy tool for investors to speculate on the future prices of cryptocurrencies.

Forms of Crypto-Derivatives

1. Crypto Futures and Perpetual Swaps

Crypto futures contracts and perpetual swaps are two common forms of derivatives offered by crypto exchanges. Like a traditional futures contract, crypto futures and perpetual swaps derive their value from an underlying crypto asset. 

Crypto futures contracts have a limited lifespan, and they will expire based on their respective calendar cycle. For instance, a BTC quarterly futures contract will expire three months upon the date of issuance. 

On the other hand, as the name suggests, perpetual futures do not have an expiration date. Therefore, traders do not need to keep track of various delivery months, unlike traditional futures contracts. In this case, a trader can hold a position to perpetuity unless he gets liquidated.

Bitcoin futures is the largest futures market in the crypto industry, averaging an estimated $60 billion daily volume in January 2021. One of the largest venues for Bitcoin Futures is Binance, where over $650 billion of Bitcoin contracts exchanged hands in January 2021 alone.

2. Crypto Options 

The two most traded options in the crypto industry are Bitcoin and Ethereum options, mainly cash-settled European or American style options. 
Compared to the entire crypto futures market, the options market is relatively small, with only a limited range of products available at the moment. Options are often used by sophisticated traders who employ complex strategies involving buying or selling multiple option positions.

Options offer downside protection and leveraged returns, but there are also disadvantages like the requirement for upfront premium payment.

3. Leveraged Tokens

Leveraged tokens are an innovative product that allows users to gain leveraged exposure without worrying about liquidation risk and the nitty-gritty of managing a leveraged position. Leveraged tokens have a built-in leverage mechanism that enables users to generate a predetermined multiple on a crypto asset’s daily return. 
For example, a 3x BTCUP token allows users to generate three times the daily return of Bitcoin. If Bitcoin goes up by 5% in a day, the token aims to produce a 15% return (three times) for token holders. On the other hand, a BTCDOWN token allows you to generate leveraged gains when Bitcoin goes down.

Why Are Derivatives Essential in the Crypto Economy?

The functions of derivatives go beyond the applications to your investment portfolio. In fact, derivatives play a crucial role in developing the crypto industry as a recognized asset class. 

Portfolio Diversification

With derivatives, you have more options to diversify across multiple crypto assets and develop advanced trading strategies to generate excess returns. Professional traders can now develop sophisticated trading strategies such as short-selling, arbitrage, pairs trading, etc. The availability and development of these sophisticated strategies will further increase the underlying crypto asset’s market liquidity. 

Increase Liquidity 

Liquidity refers to the ease of transacting orders in a market without affecting the price of an asset. In simple terms, it is a measure of how many buyers and sellers are present and whether transactions can take place easily. A liquid market offers high supply and demand for an asset, making it easier for buyers and sellers to transact in the market. An illiquid market is the opposite, as fewer market participants are willing to transact in the market. 

Market liquidity is vital for several reasons, but primarily because it impacts how quickly traders can open and close positions. A liquid market is generally associated with less risk because there is usually always someone willing to take the other side of a given position. This can attract more traders and investors to the market, which adds to the favorable market conditions. Market liquidity also lowers transaction costs as traders and investors will experience less slippage when transacting orders in the market. 

Risk Management

Derivatives are primarily used to hedge against downside risk and protect a portfolio from high volatility in crypto asset prices. This is a crucial aspect in attracting institutional interest to the crypto industry. Professional traders are always concerned about a portfolio’s overall exposure to tail-risk events. Without a derivatives market, a professional trader who is long a specific cryptocurrency cannot protect his portfolio from unexpected risk. 

Also, derivatives function as predictors of risk. In uncertain market conditions, options prices are often overbought. This reflects risk-averse sentiments as traders rush to protect their portfolios by buying options.

Optimize Price Discovery

Price discovery is the central function of a marketplace. It is the process of finding out the price of a given asset. It depends on a variety of factors, from market structure to liquidity to information flow.

By enabling investors to go long and short, price discovery mechanisms can become more efficient, leading to smoother market adjustments and avoiding adverse price shocks. With optimized price discovery, market participants know that all available information has been assimilated into the asset’s current price, increasing market efficiency and improving price reliability. The result is a global marketplace for the fair, efficient and transparent discovery of market price.

How Can You Use Derivatives in Crypto Trading?

Derivatives are used for two main reasons: hedging and speculation.

You can use derivatives to protect your portfolio of cryptocurrencies from adverse movements in the market. This is otherwise known as hedging, which involves opening new positions that negatively correlate with existing positions. Investors and traders hedge their portfolios as a form of insurance to mitigate potential losses.

When investing for the long-term, Bitcoin may experience occasional bear markets as sentiment changes. In these uncertain periods, your Bitcoin portfolio is unlikely to gain very much, if any at all.

Futures contracts can be useful to protect your investments against downside risk without compromising your cryptocurrency holdings.

With futures, you can hedge a portfolio with only a fraction of its cost. For instance, for a $100,000 portfolio, you can hedge the entire exposure by opening a short position in a 10x perpetual futures contract for just $10,000, or 1/10 of its market value. In this scenario, a 10% gain in this position would have doubled your initial investment.

By hedging, you need not compromise your Bitcoin holdings or liquidate them at an unfavorable price. Therefore, hedging is definitely a better option than merely waiting out for price recovery and doing nothing.

Another reason to use derivatives is to speculate on the future price of cryptocurrencies. 

When you purchase Bitcoin in the spot markets, you make a profit only if prices go up. However, in the bear market, you can’t make money. 

Futures contracts allow you to bet on prices to decline. This is commonly referred to as going short. If your short position goes in favor, you will profit as the price of Bitcoin falls. With futures contracts, you can trade with price momentum and buy or sell at support and resistance levels during periods of high volatility. The idea is to remain agile and flexible to take advantage of market volatility and trade frequently to capitalize on opportunities.

Furthermore, the biggest attraction to derivatives trading is leverage. Leverage allows you to gain significant exposure to the underlying asset with only a fraction of its total cost. 

At top-tier exchanges such as Binance and BitMEX, users can select leverage of up to 125 times their initial margin. For instance, if Bitcoin breaks above a critical resistance level, you can open a 125x leveraged long position in Bitcoin perpetual futures to trade with the momentum. In this scenario, a 1% increase in prices will result in 125% on your investment. With leverage, you can magnify relatively small price movements to potentially create profits that justify your time and effort.

Do bear in mind that leverage is a double-edged sword, and you must use it prudently. With larger volatility, you must exercise discipline to avoid overexposing yourself to any undue risk when trading futures. 

The benefits of an established derivatives market go beyond the uses of an individual’s portfolio. It improves the underlying cryptocurrencies as a complete financial product that caters to demand from both retail and institutional investors. The fast-growing derivatives market will further expand the uses and acceptance of cryptocurrencies. And hopefully, challenge conventional financial products as the go-to venue for investors to grow their wealth over the long term. 

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