Author: Dorian Kandi & Matías Andrade Source: Coin Metrics Translation: Shan Ouba, Golden Finance
Key points:
Derivatives allow indirect exposure to cryptocurrencies
Derivatives allow investors to hedge downside risk
Derivatives can achieve diversified trading strategies that cannot be achieved through spot trading alone
Derivatives allow investors to exploit market inefficiencies through arbitrage.
Introduction to Derivatives
Derivatives are financial instruments that have become a cornerstone of the financial ecosystem, enabling participants to effectively manage risk and allowing markets to operate more efficiently. The global derivatives market is massive, dwarfing even the global stock and bond markets. Similarly, derivatives in the cryptocurrency market have evolved to provide traders and investors with sophisticated tools that enable a variety of hedging, speculation, and risk management strategies for this growing asset class. The main types of cryptocurrency derivatives are futures, perpetual futures, and options, each of which caters to different needs.
This article delves into the landscape of derivatives in traditional finance and crypto asset markets, examining their types, applications, and underlying data.
What are derivatives?
A derivative is a financial instrument whose value depends on the value of one or more underlying variables. Traditionally, these underlying assets are traded assets such as stocks, bonds, currencies, and commodities such as gold, oil, and wheat. In the case of crypto derivatives, the value of these financial instruments is derived from the price of a cryptocurrency, such as BTC or ETH.
Derivative Types
A futures contract is an agreement to buy or sell an asset at a predetermined price at a specific time in the future. These contracts are standardized and traded on exchanges. Futures allow traders to speculate on the future price of cryptocurrencies or hedge against price fluctuations. Traditional futures have an expiration date, when the contract is settled.
Perpetual futures are similar to standard futures, but have no expiration date. This means that traders can hold their positions indefinitely, subject to maintenance margin requirements. Perpetual futures are typically traded on margin, allow for leverage, and are subject to financing rates, which are periodic payments exchanged between long and short positions. These rates keep the contract price close to the price of the underlying asset.
Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specific price before or at the expiration of the contract. Options can be used for hedging or speculation. For example, call options allow traders to benefit from rising prices while limiting downside risk because they have no obligation to buy the asset if it falls below the strike price.
The first graph illustrates the payoffs of buying and selling call options. A call option gives the holder the right to buy an asset at a specified price (the strike price) by a certain date.
Buying a call option (blue line): If the stock price at expiration is below the strike price, the option expires worthless, resulting in a loss limited to the premium paid. As the stock price rises above the strike price, the gains increase linearly.
Selling a call option (green line): If the stock price remains below the strike price, the seller makes a profit through the premium received. However, if the stock price exceeds the strike price, the seller could face unlimited losses.
The second graph shows the returns from buying and selling put options. Put options give the holder the right to sell an asset at a specific price by a certain date.
Buying a put option (red line): If the stock price is above the strike price at expiration, the option expires worthless and the loss is limited to the premium paid. If the stock price falls below the strike price, the gain increases linearly.
Selling a put option (purple line): If the stock price remains above the strike price, the seller makes a profit through the premium received. Conversely, if the stock price falls below the strike price, the seller's loss increases.
Traders often combine options, futures and spot instruments to adjust their exposure and manage risk effectively. For example, miners can use futures to lock in a sales price and buy options to hedge against adverse price movements.
Forward-looking indicators
By design, derivatives imply forward-looking expectations about future events. The ratio of a futures price to its underlying spot price is called the implied forward rate (also called the "implied yield" or "basis"). This implied yield is useful for comparing returns and expectations on different assets. When the implied yield is positive, it indicates that investors expect the value of the underlying asset to increase over the life of the contract. Conversely, a negative yield indicates that investors expect the asset to decrease in value.
The chart below illustrates this phenomenon. Shown here is the annualized futures basis for a one-month term. Notable peaks and troughs reveal key insights about market expectations, with peaks in implied returns typically occurring just before anticipated events. A notable rise from December 2023 to January 2024 coincided with expectations and launches of a Bitcoin spot ETF. Returns subsequently normalized as the market digested this development. Another peak occurred in April, likely driven by expectations for Bitcoin’s fourth halving event, a cyclical event that typically draws more attention to the asset. Conversely, a notable and sudden decline occurred in late 2022 as events surrounding the rapid collapse of FTX unfolded, with broad implications for the crypto asset industry.
Use Cases for Derivatives in TradFi
Southwest Airlines famously launched its jet fuel hedging program more than 20 years ago in 1994. During the global financial crisis, the airline effectively hedged 70% of its fuel needs at $51 per barrel; while crude oil market prices soared to $130.
Farmers who want to secure prices before harvest can do so by purchasing agricultural derivatives. For example, a corn producer may decide to sell a corn futures contract in May for delivery in December. Due to the volatility of corn market prices, any gains/losses in corn market prices are offset by gains/losses on the futures contract. This allows farmers to manage the risk of falling corn prices throughout the season.
Use Cases for Crypto Derivatives
One of the key use cases for cryptocurrency derivatives is hedging, especially for miners. For example, Bitcoin miners invest heavily in hardware and operating costs, which makes them highly sensitive to the price fluctuations of the cryptocurrency. They are essentially long BTC and short USD because they receive mining rewards in BTC and all fees are paid in USD (assuming they live in the United States). By using futures or options, miners can lock in the selling price of the cryptocurrency they mine, ensuring a predictable income stream and protecting against potential price drops.
In addition to miners, derivatives are also useful for investors and traders in the crypto asset market. Their popularity can be observed in the following chart, which illustrates the share of Bitcoin trading volume in the futures market versus the spot market over time.
While spot trading initially dominated, futures trading now accounts for the majority of market activity - currently 78%. This is mainly due to factors such as the strong infrastructure of centralized exchanges, the tools provided by decentralized exchanges, clearer regulation of futures products, and the strong appeal of leverage. As the market adapts to new investment tools and launches spot Bitcoin ETFs, the ratio between the spot market and the futures market will continue to change.
The rise in open interest levels for Bitcoin futures across exchanges further demonstrates the role of derivatives, especially during the launch of Bitcoin spot ETFs. Futures open interest refers to the value of futures contracts that have not yet been settled or closed, serving as a measure of market activity. BTC open interest reaching $30B may be due to investors potentially buying spot Bitcoin ETFs and hedging their risk through futures contracts. This highlights an important use case for derivatives as they allow investors to manage risk and position themselves strategically in the market.
The settlement mechanism of derivatives is critical. In traditional markets, derivatives can be cash-settled or physically-settled. Cash-settled derivatives are settled in cash based on the difference between the contract price and the market price at the time of settlement. Physically-settled derivatives involve the actual delivery of the asset. Most cryptocurrency derivatives, especially those on venues such as CME, are cash-settled. This means that at settlement, participants exchange the difference in value rather than the actual cryptocurrency.
in conclusion
Derivatives in the cryptocurrency market have become an important tool for managing risk and enhancing trading strategies, reflecting their importance in traditional finance. They enable participants to hedge against price movements, speculate on future prices, and gain leveraged exposure to cryptocurrencies, while typically settling in cash to facilitate an easier trading and settlement process. The development of crypto derivatives has greatly contributed to the maturity of the digital asset ecosystem, providing institutional and retail investors with familiar tools to navigate this new asset class.
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