Understanding Cryptocurrency Derivative Markets

When most people discuss crypto markets or think about cryptocurrency like Bitcoin, they are referring to the actual asset, security, or coin. This type of market is often also described as the "spot" market or "physical" market, since it involves the exchange or transfer of actual Bitcoin (or crypto). But there is another type of market that is growing in volume and usage: the cryptocurrency derivatives market. What is a derivative you ask and what is the difference? Technically, a derivative is a security that derives or is reliant upon another asset to determine its value. (Full Investopedia definition here). So by definition, a bitcoin (or crypto) derivative's value is determined by the spot price, but it is not the security itself. This distinction is important because the derivative markets typically allow you to make directional bets on the future price of the asset, without actually owning the asset. Most often, these derivatives utilize leverage, and allow a speculator to profit on the direction of price movement for a fraction of what the actual asset may cost.

There are a growing number of cryptocurrency exchanges that allow derivatives trading. Binance, Huobi, ByBit, FTX, and others are some of the largest. (Ranked list on CoinMarketCap here) There are also large financial market exchanges, like the CME (Chicago Mercantile Exchange) that now allow trading on Bitcoin. And other retail brokers like TDs' Thinkorswim have followed suit. All of these derivatives markets described above involve the use of leverage, and therefore can carry a great financial risk of loss. The full contract specifications for the CME can be found here, and the margin required is currently ~$30k USD per contract! (Margin Requirements)

There are other uses for the derivative markets besides speculation. If you are an institutional (or individual!) investor with a large risk exposure, there are limited ways for you to reduce your Value at Risk or overall risk exposure to Bitcoin or other assets besides selling your holdings. In the spot market, you either own the asset and exposure or you do not. The derivatives market allows an individual to hedge his exposure; thereby reducing sensitivity to large directional moves. This may be especially important for market makers or other dealers. Also, due to the fact that you do not actually "own" the asset, the derivatives markets open the opportunity for hedge funds or other funds to partake in risk taking that otherwise may go against their trading mandate. Lastly, the derivative markets also create new trading opportunities with basis trading, which we will discuss in an upcoming article.

Notice: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. Author does not own the any crypto currency discussed. The information and content are subject to change without notice. CryptoDataDownload and its affiliates do not provide investment, tax, legal or accounting advice.