The birth of Decentralized Finance (DeFi) and blockchain-based cryptocurrency trading has given the crypto market a makeover and boosted its image in the last couple of years. DeFi exchange platforms have introduced further developments and advanced options to promote cryptocurrency trading like asset tokenization, crypto loans, stablecoin creation and many others.
Since the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) started the Crypto Derivatives trading, (that is) Bitcoin Futures on their platform in late 2017, there has been growing interest associated with it. Bitcoin Futures’ popularity is such that it enjoys a staggering 40-50% growth in average daily volume.
So, what are crypto derivatives? Why has the crypto derivatives trading market grown exponentially since its inception? Why is every exchange allowing its users to trade crypto derivatives?
What Is Crypto Derivatives Trading?
Before we explain the meaning of crypto derivatives trading, let’s first understand what derivatives trading is. According to financial markets and investments, derivatives are contracts that represent a deal to sell or buy a commodity, an asset or any other financial instrument at a predetermined price on a predetermined date in the future, between two parties. A derivative also refers to a contract that derives its value from an underlying entity’s performance, such as an asset, stocks, bonds, or cryptocurrencies. For crypto derivatives trading, both parties agree to a contract that speculates on the prices of cryptocurrencies on a specific date in the future. On the date of execution of the contract, both parties must commit to the sale price and the purchase price of the crypto, regardless of the market price (i.e., whether the price fell or rose) on that date.
Crypto derivatives trading can be done on DeFi, CeFi or client-to-client (C2C) exchanges. Derivatives trading is generally used to hedge against the risk of volatile assets, especially those that have experienced sudden price fluctuations. The purpose of derivatives trading is not to generate profits but to mitigate risk against a volatile asset. For example, if a trader predicts that Bitcoin could see its price rise in the future, he/she may invest in buying Bitcoins or if he/she owns Bitcoins and anticipates a drop in the price of crypto like defi coin in the future, he/she can sell them to avoid losses.
Benefits of Crypto Derivatives Trading
Derivatives trading play a crucial role in financial markets by performing key functions. Traders trust crypto derivatives trading, which is why many exchanges like Drixx have expanded their services for the same. Crypto derivatives trading has many advantages; here are some:
Risk Mitigation Against Volatile Cryptocurrencies
The leading reason traders invest in derivatives trading is to mitigate the risks associated with the volatile nature of the asset, in this case, cryptocurrencies. As we know, Bitcoin is a very volatile crypto that sees strong fluctuations in its prices. Therefore, to reduce the risk associated with their ever-changing market price, traders use Bitcoin derivatives trading.
Derivatives are also important risk management tools for traders. Forwards, futures, options and swaps can be used to lock in prices and prevent unfavorable price movements from causing large losses to the trader. This is known as position hedging and is used by many market participants to protect against and in their favor, unexpected market movements.
Hedging
To reduce the risk of incurring potential losses, traders and investors use derivatives trading. In the stock market, an investor uses the put option on derivatives to offset losses arising from unforeseen situations in the future. Therefore, crypto derivatives trading is the best in terms of risk coverage.
Cryptocurrency Price Speculation
Speculating and forecasting the price of cryptocurrencies is also an advantage of derivatives trading. They allow traders to speculate on future asset prices today without the need to buy the underlying asset itself today. Traders use derivatives to bet on the future price of crypto to profit from price fluctuations. This means that the trader doesn’t need to spend the maximum amount to realize exposure to the market. For example, a trader may buy a March 2021 bitcoin call option with a strike price of $35,000. This means that the trader believes that the bitcoin price will rise above $35,000 by March 2021, aiming to receive the (positive) difference between the actual price and the strike price of $35,000.
According to the crypto derivatives trading industry report of blockchain research firm Tokeninsight in July 2020, the crypto derivatives market transaction volume for the second quarter of 2020 was $2.159 trillion – this was according to the data from 42 exchanges. This represents a 2.57% increase over the previous quarter and a massive 165.56% year-over-year increase from the second quarter of 2019, indicating how strong the growth of crypto derivatives is. It has been astronomical over the past year, and the market continues to grow. In addition, the second week of August saw an open interest in bitcoin futures on the CME (which is regulated by the Commodity Futures Trading Commission) hit an all-time high of $841 million, while volumes on unregulated exchanges like Huobi and Binance are consistently higher.
Currently, Asia has become the global hub for cryptocurrency derivatives. Most of the most traded exchanges are based in this region, particularly Singapore, where cryptocurrencies are more liberal than in most places. Some of the major Asia-based exchanges, such as Binance, OKEx and Huobi already have consistently higher trading volumes in their derivatives markets than in their respective spot markets.
Institutional Investors Are Making the Key Change
While there are multiple factors behind the expansion of crypto derivatives, it’s safe to mention that it’s been driven primarily by institutional investors’ interest since derivatives are complex products that are difficult for the typical retail investor to know . Analysts also attribute the recent growth of crypto derivatives to growing interest in the space by these institutional investors. A growing number of institutional investors are supporting Bitcoin as a possible hedge against inflation. For example, open interest in Bitcoin futures trading on the Chicago Mercantile Exchange surpassed $800 million in September 2020, representing an increase of more than 100% from $365 million in July 2020. This Development is a strong sign of growing institutional demand investors.
Investors interest in crypto derivatives also appears to be increasing thanks to the explosion of decentralized finance (DeFi) running on the Ethereum blockchain. In turn, this has added a huge amount of bullish sentiment to the space this year, especially for Ether, which is the second most valuable cryptocurrency after bitcoin. Indeed, open interest in ether (ETH) futures and options markets hit a new all-time high in August 2020 as the ether spot price climbed to levels not seen in over two years.
Although it is not yet as mature or liquid as the crypto futures market, other crypto derivatives such as swaps and options are also experiencing solid growth. Once again, recent increases in trading volumes imply growing interest from institutions. However, the market is still fairly nascent when it comes to options – CME’s bitcoin options market was recently launched in January 2020. Despite that, open interest in CME managed to reach $440 million in June last year while Deribit reached $1.7 billion in open interest for bitcoin options at the end of July in the same year.
2020 was the most important year for the crypto derivatives market so far, but 2021 may see true growth. The crypto derivatives market is now in demand and is a sign of maturity for assets like Bitcoin and Ether.
