BIO: Cezary Graf is a lawyer based in Warsaw, Poland. He provides cryptocurrency and digital assets services.
The explosive rise of cryptocurrency prices in Q4 2017 seemed to shock everyone on the sidelines, and exceed the expectations of virtually everyone with skin in the game. Alongside the rise in prices came increasing amounts of blockchain activity, exposing the limitations and novelty of the current state of this technology. Lengthy transaction times and heavy fees were looked over in favor of speculation on where the price would go next.
As the correction of 2018 drags into the New Year, the wheat will continue to separate from the chaff, and legitimate projects with competent team members will improve their technologies in preparation for the next wave of activity. While developers are working hard behind the scenes, regulatory advancements are also being made.
Obtaining regulatory approval seems like a 3 steps forward, 2 steps back type of process. Although progress has been painstaking for a lot of crypto-holders to witness, the entire industry is being legitimized, and institutional investors are gaining an increasing amount of both access and incentives as time passes by.
The combination of developmental and regulatory progress has allowed for the opportunity to trade cryptocurrency derivatives. A handful of exchanges that offer derivative products are slowly making their way to the scene; however, a majority of exchanges still don’t offer them. In this article, we’ll look into the current state of cryptocurrency derivatives, and attempt to discern how they’ll impact the market as a whole, moving forward.
What Are Cryptocurrency Derivatives?
To answer this question, first you’ll need to know what a derivative is. By definition, a derivative is “something which is based on another source.” In regards to finances, a derivative’s value is based on an underlying asset, which in this case would be a cryptocurrency. Furthermore, derivatives are agreements to buy or sell an asset at a predetermined price and time.
Derivatives are useful to traders for two main reasons: they can minimize risk, and allow the speculation of an asset’s future price, without physically handling the asset itself. Cryptocurrency derivatives would allow traders to play the market without going through the hassle of handling the token itself.
The three most common types of derivatives are futures, options, and swaps.
- Futures — A futures contract is an agreement between a buyer and seller to make an exchange at a predetermined price and time. Both actors are obligated to fulfill the contract.
- Options — A financial contract that gives the buyer/seller the right to buy/sell an asset at a predetermined price and time. Options are like futures contracts with added leniency. They can help an investor limit potential downside, and even generate recurring income.
- Swaps — Swaps are derivatives that allow two parties to exchange the value, or cash flow, of one asset for another. There are multiple types of swaps, and are typically done over-the-counter by large enterprises and institutions.
Trading derivatives is much more complex than trading the actual asset, and beginners should arm themselves with as much knowledge as possible before participating. While a proper understanding of derivatives will allow a trader to lower their risk exposure, poorly used derivatives can expose you to more risk.
What Do Cryptocurrency Derivatives Look Like?
With the basic definitions and differentiation of derivative contracts, we can start to piece together how they apply to the cryptocurrency market.
- Bitcoin Futures — A contract that allows an actor to place a bet on what they believe the price of Bitcoin will be in the future, without ever needing to own Bitcoin itself. Futures contracts (as well as options and swaps), can be applied to Bitcoin, Ethereum, or any cryptocurrency supported by the exchange being used.
- Bitcoin Options — Investors pay for the right to buy or sell a predetermined amount of Bitcoin on an agreed upon date. Since Bitcoin has an extremely volatile price history, and option pricing is based on implied volatility, Bitcoin options are expensive.
- Bitcoin Perpetual Swaps — A continuous chain of futures contracts, similar to a futures contract without a predetermined expiration date.
Where Can I Trade Crypto Derivatives?
There are currently a small number of exchanges that allow traders to take advantage of derivatives in the cryptocurrency market. Here are some of the major players who are either in the game already or will be soon.
- BitMEX — Crypto trading platform that offers futures, options, and swap products. Also offers up to 100x leverage.
- OKEx — Offers futures and swap contracts with up to 20x leverage.
- Crypto Facilities — CME Group partner offering futures contracts and up to 50x leverage.
Institutional & Traditional Exchanges
- LedgerX — First exchange to offer Bitcoin options and swaps approved by the U.S. Commodity Futures Trading Commission (CFTC).
- CBOE — Chicago Board Options Exchange, first major regulated exchange to launch Bitcoin future contracts in December 2017.
- CME — American financial company offering Bitcoin and Ethereum futures.
Upcoming Institutional Exchanges
- Bakkt — Futures exchange backed by the Intercontinental Exchange (ICE), the same institution that owns the New York Stock Exchange. Bakkt has also partnered with Starbucks and Microsoft, and plans to launch in January 2019 after several delays.
- Nasdaq — Second largest stock exchange in the world, plans to launch Bitcoin futures trading platform in the first quarter of 2019.
Social Trading Platforms
- eToro — Offers Contract-for-Difference (CFD) and allows users to copy the trades of highly skilled traders. CFDs are similar to futures and options, although they have their differences.
Cryptocurrencies seem to have gotten a bad rap in general over the years, which makes for a grindingly slow regulatory process. However, there has proven to be a high enough demand for companies like the ones listed above to keep pushing forward, despite the frequent setbacks.
Cryptocurrency Regulation: Setbacks & Success
It’s no surprise that governments are skeptical about ushering in digital assets, and more power to them. A TechCrunch report released in mid-2018 revealed that more than 1,000 (roughly 80%) of the ICOs that were launched in 2017 were dead before Q3 2018.
This has led the United States Security and Exchange Commission (SEC) to crackdown on bad actors in the ICO space, and even sold fake tokens to serve as a warning to new and experienced investors alike.
The UK Considers Banning CFDs
Another setback currently underway is the United Kingdom’s Financial Conduct Authority’s (FCA) concern with cryptocurrency CFDs, and possibly all crypto-based derivatives. In a speech given in November 2018, Christopher Woodward explained the following:
We’re concerned that retail consumers are being sold complex, volatile and often leveraged derivatives products based on exchange tokens with underlying market integrity issues.
It’s become clear that the U.K. government is taking cryptocurrencies seriously, which seems to be bringing some much-needed regulation to the industry.
For example, the FCA and the Bank of England (BOE) have joined efforts to create the CryptoAssets Task Force, which is responsible for regulating and supporting cryptocurrencies. They recently released a report proposing changes to how digital assets are going to be handled moving forward.
It’s worth noting that CFDs are banned in the United States, and while banning all derivatives in the UK might have adverse effects on crypto prices, banning higher risk derivatives like CFDs could help put cryptocurrencies in the same realm as other institutionally recognized assets.
The simple fact this conversation is being had by multiple financial powerhouses around the world is a testament to the validity of cryptocurrencies. If it were mere speculation, the conversation would’ve died off long before started, the blockchain job market wouldn’t be outpacing every other career field, and the U.S. government wouldn’t be accepting Bitcoin as tax payments.
On top of that, the same companies that own some of the largest stock exchanges in the world are launching regulated cryptocurrency derivative products, which will almost certainly draw more interest — and therefore money — into the space.
How Crypto Derivatives Affect Prices
In the short-term, they lead to a spike in prices. When CBOE launched Bitcoin Futures on December 10, 2017, the price jumped more than 10%. When CME launched their futures contracts about one week later, a similar price jump was recorded.
It’s more difficult to determine the long-term impact derivatives will have on the cryptocurrency market. That being said, derivatives are likely to lead to increased prices and decreased volatility overall for a few reasons.
In general, the more established exchanges regulate and approve crypto derivatives, the more confidence the public will have to invest in them. This also means professional investors will be more likely to offer them to their clients. For these reasons, cryptocurrency would be introduced to a broader range of investors, even if they live in a country that has banned the exchange of Bitcoin altogether.
Increased prices for major cryptocurrencies like Bitcoin could, and historically have, led to increased prices for altcoins across the board. When altcoins see higher prices, the developers behind them are generally given an opportunity to secure more funding, which leads to the release of more innovative projects into the market for years afterward (depending on how well the funding is used).
The current state of cryptocurrency derivatives is promising. Investors have been trading futures contracts for years, and recent regulatory hurdles serve to legitimize the cryptocurrency industry as a whole. Governments and their financial regulatory agencies wouldn’t be as involved with the space as they are today if it weren’t for the interest of massive institutional investors.