A cryptocurrency derivative is a financial tool that tracks the value of an underlying asset. It allows traders to devise a variety of financial setups and benefit from various market occurrences. ^[1]

Overview

A crypto derivative represents a financial agreement involving two or more parties, deriving its value from an underlying asset. Specifically, it involves an arrangement to purchase or sell a specific cryptocurrency asset at a predetermined price and at a specified time in the future. As derivatives do not have inherent or direct value by themselves, the value of a derivative contract is purely based on the expected future price movements of the underlying cryptocurrency. ^[7]

History of derivatives in crypto

The first crypto derivative was Bitcoin futures, which led to the launch of ICBIT in early 2011. ICBIT became the first Bitcoin futures exchange platform, bringing about Bitcoin futures trading in early 2012. Due to this, numerous people were attracted to the platform, making platforms such as IRC channels to provide opportunities for people to create options and engage in futures trading. However, this promising concept did not receive immediate market recognition due to the relatively low adoption of the underlying asset, Bitcoin. ^[8][9]

After 2012, people's interest in Bitcoin grew due to various platforms promoting both retail and institutional adoption of the cryptocurrency. One such platform is 1Broker, a Bitcoin Forex and CFD trading platform. Although it was launched in November 2012, it was later shut down in September 2018. 1Broker enabled users to engage in trading across diverse financial markets using Bitcoin as the settlement currency. The platform bridged the gap between Bitcoin and the traditional market, encouraging people to embrace the cryptocurrency. Following this, Grayscale stepped in to facilitate institutional investment in Bitcoin in 2013. The growing popularity of Bitcoin led to a surge in demand for more intricate financial products tied to it. Experts from traditional financial markets were drawn into the crypto world, with many of them collaborating to design derivative products for this emerging market. ^[8][10]

One major obstacle to the development of Bitcoin futures is the lack of an easy-to-use platform. However, in 2014, a significant milestone was reached with the launch of the derivatives platform BitMEX. BitMEX's simple interface marked a significant advancement, especially when it created a perpetual swap in 2016. The feature became a highly influential innovative product that continues to dominate the crypto derivatives market and is now offered by most major exchanges. ^[8][11]

In 2017, crypto derivatives became more significant. In December of that year, when Bitcoin reached an unprecedented high of approximately $20,000, the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange & Chicago Board of Trade (CME) chose to introduce futures contracts tied to Bitcoin. This decision provided market participants with a regulated platform for trading derivatives. ^[8]

Despite challenges in Bitcoin's price during 2019, it marked a significant period for Bitcoin derivatives. The crypto derivatives market saw a substantial increase in trading volumes, with some exchanges reaching unprecedented levels. As Bitcoin futures continued to grow, the trading volume of Bitcoin derivatives gradually surpassed that of the spot market, mirroring trends observed in the traditional financial market. ^[8]

During this timeframe, numerous well-known Bitcoin futures platforms emerged. Bybit, established in late 2018, concentrated on perpetual swaps and provided people with leverage up to 100:1. In July 2019, Quedex, a crypto derivatives exchange based in Gibraltar, obtained a license from the Gibraltar Financial Services Commission (GFSC) to trade cryptocurrency derivatives. Bakkt, founded by Intercontinental Exchange, the creator of the NYSE, introduced Bitcoin futures in September 2019. It specializes in physically settled Bitcoin futures contracts, primarily catering to institutional investors. ^[8]

In 2020, amid the pandemic, an increasing number of institutional investors, such as MicroStrategy, an AI innovation and BI analytics platform, and Block Inc. (formerly Square Inc.), a financial technology company, exhibited considerable interest in Bitcoin. This heightened attention not only significantly accelerated Bitcoin's mass adoption but also propelled its price above $40k in January 2021. The resulting Bitcoin frenzy led to substantial demand to hedge crypto risks, fueling the growing popularity of the crypto derivatives market. ^[8][12]

How Derivatives Work

Derivatives are financial agreements made between two entities: a buyer and a seller. The nature of these agreements (or contracts) varies based on the type of derivative. In some cases, they obligate a buyer to acquire an asset and a seller to sell an asset. Alternatively, they might stipulate that a specific transaction occurs on a predetermined date and at a predetermined price. While the specifics vary for each type of derivative contract, most of them comprise the following elements: ^[1]

• An underlying asset
• Quantity
• Method of delivery
• Settlement date

Underlying Asset

The underlying asset forms the basis of the derivatives contract. In crypto derivatives, these underlying assets can encompass diverse cryptocurrencies such as Ether (ETH), Solana (SOL), Litecoin (LTC), and others. The price of the derivative contract fluctuates in line with the market price of the underlying asset. ^[1]

Quantity

The quantity represents the volume of the underlying asset exchanged according to the conditions of the derivatives agreement. A derivatives contract might encompass several hundred units of a particular cryptocurrency, like Avalanche (AVAX), Tezos (XTZ), or Cardano (ADA). ^[1]

Method of Delivery

Physically delivered derivatives involve the direct exchange of the underlying asset between parties when the contract is fulfilled. This implies that a seller needs to either own or acquire the underlying asset before entering into the contract to sell it to the buyer upon reaching the settlement date. During settlement, the buyer receives crypto instead of its equivalent value in fiat currency. ^[1]

Settlement Date

The settlement date is the agreed-upon day when both parties are required to execute the contract. After the settlement date has elapsed, the contract terms can be settled either in the form of the underlying asset or its equivalent value in fiat currency. ^[1]

Types

Derivatives include the following types: futures contracts, options, swaps, and forwards. ^[3][4]

Futures

This refers to an arrangement made in advance between a buyer and a seller to exchange an asset at a later date. It involves both parties betting on the future value of a specific asset at a predetermined time in the future. ^[5]

Options

In crypto options trading, individuals can buy or sell a specific cryptocurrency based on a future price target and a predetermined price. Unlike futures, these options provide the buyer with the flexibility to avoid purchasing assets in the future before the expiration date. In addition, the buyer agrees to pay a premium to the seller. Crypto options are categorized based on their exercise type, the currencies involved, and settlement methods. There are two categories of option contracts: the call option and the put option.  ^[4][5]

• Call option: This grants traders and investors the authority to purchase an asset at a predetermined price within a specific period.
• Put option: This grants traders and investors the authority to sell an asset at a designated price within a specific period.

Perpetual Contracts

Perpetual contracts, a popular choice among day traders in the crypto market, share similarities with traditional futures contracts but with a distinct advantage: traders can maintain perpetual futures indefinitely as they never expire, and there is no set end date for these contracts. The only obligation for a trader is to pay a fee, known as a funding rate, to sustain the contract. Sellers pay this funding rate to maintain their positions for as long as the trader desires, provided there is a minimum amount in the account, referred to as margin. ^[5]

Forwards

Forwards and futures share similarities as contract types. However, a forward contract sets itself apart through over-the-counter exchanges instead of centralized ones. This allows buyers and sellers to personalize buying and selling agreements directly between the two parties. While this flexibility exists, the absence of centralization increases the risk associated with trading forwards. ^[4]

Swap

A swap involves two contracts: one for the immediate buying and selling of an underlying asset, and another for the future transaction of the same asset. This represents a more complex form of futures trading. To illustrate, it's comparable to purchasing a specific car model while simultaneously making a deal with a friend to sell the same car at a higher price in the future. ^[15]

Benefits

Derivatives have a vital impact on shaping the cryptocurrency sector as a recognized asset class. They serve key functions such as risk management, enhancing liquidity, refining price discovery, and broadening investment portfolios. ^[6]

Risk Management

Derivatives play a vital role in shielding portfolios from unforeseen risks caused by the fluctuating prices of crypto assets. A robust derivatives market is instrumental in attracting professional traders and institutional investors to the crypto sector by reducing the risks associated with a portfolio's exposure to rare, high-impact events. ^[6]

Enhancing Liquidity

Liquidity describes the ease with which transactions can occur in a market without impacting the asset's price. It signifies the presence of numerous buyers and sellers and determines the smooth facilitation of transactions. Cryptocurrency derivatives enhance market liquidity, impacting how easily traders can enter or exit positions. In a liquid market, the risk is usually lower because there's always someone prepared to assume the opposite side of a position. ^[6]

Refining Price Discovery

The primary role of a marketplace is price discovery, an ongoing process of determining the current value of a specific asset. Prices are influenced by factors such as liquidity, market structure, and information flow. Cryptocurrency derivatives enhance price discovery by allowing investors to go long or short, improving the efficiency of price discovery mechanisms. This smooths market adjustments and helps prevent adverse price shocks. ^[6]

Broadening Investment Portfolios

Derivatives provide traders with greater opportunities to broaden their investment portfolios, enabling diversification across multiple cryptocurrencies and the mastery of advanced trading methods. These include sophisticated strategies like arbitrage, pair trading, and short-selling. Ultimately, employing these advanced trading techniques enhances the market liquidity of the underlying cryptocurrency asset. ^[6]

Use Cases

Derivatives are often used for hedging, speculation, and leverage. ^[3][6]

Hedging

Hedging is a process whereby one's crypto portfolio is protected from adverse market conditions. This practice entails establishing positions that counterbalance or oppose existing ones. Hedging is adopted by individuals aiming to safeguard their portfolios and reduce possible losses. It is beneficial, especially during a bear market, as it offers a superior choice to waiting for price rebounds or selling assets at unfavorable rates. ^[6]

Speculation

Speculation entails predicting future price movements in the crypto market to earn profits. Traders leverage the market's high volatility, potentially gaining substantial profits when accurately forecasting the underlying asset's future price shifts.^[3]

Leverage Trading

Leverage trading allows controlling a substantial asset amount with a relatively small sum, like needing only 10% of a futures contract's total value. On platforms such as Binance, traders can leverage up to 125 times the initial margin. Although leverage amplifies potential profits, it significantly heightens the risk of losses.^[4]

Examples of crypto derivative projects

BitMEX

BitMEX, short for Bitcoin Mercantile Exchange, is a peer-to-peer (P2P) cryptocurrency exchange and professional derivatives trading platform. Founded by Arthur Hayes, Ben Delo, and Samuel Reed with financing from family and friends and owned and operated by HDR Global Trading Limited in 2014, it is registered in the Seychelles under the International Business Companies Act. BitMEX is primarily designed for experienced investors and seasoned traders well-versed in leveraged tokens and margin trading concepts. ^[13][14]

In 2016, the platform launched perpetual futures, which quickly became its most sought-after derivative product. BitMEX provides a variety of futures and other derivatives; however, for newcomers, navigating the exchange's features can be complex. Additionally, BitMEX exclusively facilitates crypto-to-crypto trading and does not allow fiat deposits. ^[13][14]

BitMEX claims to maintain encrypted cryptocurrency funds in cold storage and offers clients multi-signature wallets to ensure a high level of security. The platform's developers emphasize the use of an MPC system to enhance the security of fund deposits and withdrawals, preventing intruder activity. Within the BitMEX platform, users can purchase futures and perpetual contracts for a diverse range of assets, including BTC, ETH, LTC, XRP, SOL, ADA, BCH, BNB, LINK, and DOT. Notably, the derivatives platform offers a broader selection of cryptocurrencies compared to the spot market. ^[13][14]

OKEx

OKEx offers access to crypto-to-crypto trading, encompassing cryptocurrency futures, leveraged spot trading, and perpetual swaps. ^[16]

Timeline for Product Launch

On December 19, 2018, OKEx introduced perpetual swaps, which are non-expiring, cash-settled derivative contracts linked to Bitcoin. These swap contracts start with an initial nominal value of $100 worth of bitcoin, allowing traders to take leveraged positions of up to 1:100. ^[16]

In November 2019, the OKEx team revealed the introduction of futures trading paired with Tether (USDT) as a margin. According to the announcement, test simulations for the futures commenced on November 5, 2019. The contracts were denominated with a face value of 0.0001 BTC, offering leverage options ranging from 0.01 to 100x, and they were settled in USDT. ^[16]

On December 9, 2019, OKEx announced it would introduce put and call options trading on December 27 of the same month. The announcement highlighted that its offering of put option trading would set it apart from other cryptocurrency trading platforms. ^[16]

Crypto Facilities

Crypto Facilities, a subsidiary of Kraken, is the first cryptocurrency company to obtain a Multilateral Trading Facility (MTF) license from the UK’s Financial Conduct Authority (FCA). This authorization enables Crypto Facilities to facilitate trading in cryptocurrency pairs and leveraged contracts, which the platform refers to as "futures." Additionally, the platform offers data and index services to the CME Group, Inc., specifically related to the CME's bitcoin futures contract and its Ether index. ^[17][18]

Kranken acquired Crypto Facilities on February 4, 2019, and rebranded it as "Kraken Futures." A statement released on March 25, 2019, informed users of the Kraken platform that they could now participate in both spot and futures trading. Additionally, Kraken users gained the capability to trade these contracts with leverage of up to 50x, allowing them to capitalize on both bullish and bearish market conditions. ^[18]