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Derivatives in Crypto, Explained

From mitigating risks to gaining on price difference: A multifaceted world of financial derivatives and their application in crypto, reviewed.

Are there any downsides of trading crypto derivatives?

All trading strategies related to price fluctuations imply a certain level of risk, especially combined with the lack of relevant regulation for the crypto derivatives sector. 

When it comes to crypto derivatives, the biggest risk that traders face is volatility. Prices can rise and fall at speeds that make your head spin, and losses can be amplified substantially whenever someone is trading on margin.

To better help mitigate these risks, a tiered maintenance margin ratio system has been adopted by OKEx to avoid the liquidation of large positions, events that can have a huge impact on market liquidity. During a recent “flash crash,” when Bitcoin suddenly plunged from $7,800 to $6,100 in just five minutes, OKEx’s risk management system managed to stabilize the quarterly contract price from a fierce fluctuation — at about $7,000 — while other crypto exchanges offering derivatives experienced a nosedive, as shown in the graph involving other market players such as BitMEX derivatives prices.

This market is a complex beast, and it can be difficult to navigate for inexperienced users. Rookie mistakes can be extremely costly, and the unpredictability of crypto derivatives greatly amplifies the likelihood of something going wrong. As a result, it’s important to fully understand the features that a trading platform can offer, follow the tutorials and make sure you have a solid strategy in place.

It’s also worth paying close attention to regulation. Regulators in different countries are cautious about crypto futures and other types of such contracts — as well as with cryptocurrencies themselves. The U.S. Securities and Exchange Commission (SEC) is closely monitoring the area and has already filed charges against an international dealer, who was illegally offering Bitcoin-funded, security-based swaps in the country. At the same time, the European Economic Area has not yet elaborated clear guidelines on how to treat crypto derivatives and how they should be regulated.

The article was co-authored by Connor Blenkinsop.

Where can I trade crypto derivatives?

Crypto derivatives of different kinds can be traded officially both on traditional exchanges and regulated crypto exchanges. 

As per traditional exchanges, Bitcoin futures are currently offered by CME Group, as CBOE stopped adding new contracts in March. Meanwhile, in December 2018, Nasdaq stated it was considering launching Bitcoin futures in the first half of 2019. As cryptocurrencies are expected to gain more mainstream and institutional adoption, it is highly likely that more traditional players will trade crypto derivatives soon. 

Institutional exchanges are also offering these types of contracts. Institutional crypto derivatives provider LedgerX started trading regulated swaps and options contracts in October 2017, shortly after receiving approval from the U.S. Commodity Futures Trading Commission (CFTC). Another institutional crypto platform, Bakkt, delayed the launch of its Bitcoin futures trading several times but has finally scheduled the testing of the product for July 2019.

Major crypto exchanges are also actively involved in crypto derivatives trading. Malta-based OKEx offers futures and perpetual swaps trading, which is a contract with no expiration, with 100x leverage, and delivers them through an optimized and scaling engine. A range of popular crypto assets such as Bitcoin, Ether and EOS are supported — and USDK, a newly launched stablecoin, is also listed.

How are derivatives used in crypto trading?

Cryptocurrencies are increasingly gaining popularity, and there are more traders who want to benefit from price fluctuations. 

Bitcoin’s rate has had a wild ride over the past two years — surging to its all-time high around $19,800 and then losing one-third of its value in just a few days, continuing to drop throughout 2018 to as low as $3,200. However, in April 2019, things started to change again, and the current price of Bitcoin — over $12,171, as of press time — is far from pessimistic. 

Bitcoin futures trading was launched by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) during the peak of the crypto bull market in December 2017. The move was a huge milestone for the whole crypto industry, as a futures contract allows investors to hedge positions and reduce the risk of the unknown, which is quite relevant for cryptocurrencies. In other words, trading Bitcoin and altcoin futures enables major traders to mitigate their risks by signing a contract that settles directly to an underlying auction price of a particular cryptocurrency. 

Moreover, there are, obviously, many traders who want to benefit from those drastic changes by trading derivative contracts for Bitcoin and major altcoins. To make a profit from a sudden change in the underlying asset’s price, the trader can buy a cryptocurrency at a low price and sell it at a higher price later. However, this strategy is only relevant during a bull market and is quite risky, as are all other attempts to speculate on the price of the underlying asset.

Another strategy is called shorting, which is a way to profit even from a crypto bear market or a market that is currently experiencing a downtrend. To short, the traders usually borrow the assets from a third party — whether it be an exchange or broker — and sell them on the market when they expect the price to decrease. As the coin’s price goes down, the trader purchases the same amount of assets back for a lower price and profits from the price movement, while the exchange or the broker gets paid a commission.

What are the common forms of derivatives?

There are four major types of derivatives: futures, forwards, swaps and options. 

Futures and forwards are similar types of contracts with only slight differences. Thus, futures oblige the buyer (or buyers) to purchase the asset at a previously agreed-upon price on a specific date in the future. These futures are traded on exchanges, and the contracts, therefore, are similar and standardized. As for forwards, this type of contract is more flexible and customizable for the needs of both traders. As forwards are normally traded on over-the-counter (OTC) exchanges, counterparty risks should always be taken into account. 

Options grant the buyer the right to purchase or sell the underlying asset at a certain price. However, according to the terms of the contract, the trader is not necessarily obliged to buy the asset, which is a key difference between options and futures.

Swaps are derivative contracts that are often used between two parties to exchange one type of cash flow for another. The most popular types of swaps are related to interest rates, commodities and currencies. Normally, swaps imply the exchange of a fixed cash flow for a floating cash flow. That is, a trader can choose an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Why would a trader use derivatives?

Derivatives are generally used to hedge risk or to speculate on the price of the underlying asset in case it changes. 

Derivatives are used in many areas but mainly for hedging purposes, namely when investors want to protect themselves from price fluctuations. In this case, signing a contract to buy an asset for a fixed price would help mitigate related risks. Another way to take advantage of derivative trading is speculation, when traders are trying to predict how the asset’s price might change over time. That is the reason why high-profile American investor Warren Buffet once called derivatives “financial weapons of mass destruction,” sharing a commonly held view that they were to blame for the 2007-2008 global financial crisis.

There are many ways in which derivatives can be applied in real life. For instance, prior to the aforementioned crisis, major United States holding company Berkshire Hathaway started selling put options on four equity indexes, including the S&P 500 and FTSE 100. A put option is a form of derivative that gives the owner the right, but not the obligation, to sell an underlying asset to the seller of the put at a specified price by a predetermined date. In this case, Berkshire Hathaway offered investors the chance to purchase an option premium and therefore buy the ability to sell their stocks at an agreed-upon price and date. When the date finally came, they could earn money by selling a stock whose price had visibly decreased. However, if the price has been rising through that period of time, the company received the option premium. In this particular case, Berkshire Hathaway took the risk and earned around $4.8 billion as a result. 

Another interesting example of using derivatives comes from the airline business. As airlines are heavily dependent on jet fuel, the price of which continually sees ups and downs, it is very useful for the business to implement appropriate derivative hedging strategies. The world’s largest low-cost carrier, Southwest Airlines, which operates in the U.S., is a well-known example of success in this area. Because of its well-designed hedging program, the airline managed to lock crude oil prices at a very low rate and has therefore been paying between 25% and 40% less for its jet fuel than its competitors for years. 

Some use cases are nowhere near traditional finance systems. For example, there is a whole segment of weather derivatives aimed to protect farmers, commodity providers and others from weather-related losses, such as frost or hurricanes.

What is a derivative?

A derivative is a financial contract between two or more parties based on the future price of an underlying asset. 

Financial derivatives are discussed a lot when it comes to the crypto industry, especially concerning futures contracts for Bitcoin or altcoins. It is worth noting that the derivative is one of the oldest forms of a financial contract that exists on the market. The history of this type of deal can be traced to antiquity: In medieval times, derivatives were used to facilitate trades among merchants who traded all over Europe and participated in periodical fairs, an early form of markets in the Middle Ages.

Derivatives have evolved for centuries to become one of the most popular financial tools. Nowadays, a derivative is understood as a security that derives its value from an underlying asset or benchmark. The contract can be signed between two or more parties that want to buy or sell a particular asset for a specific price in the future. The value of the contract will therefore be determined by changes or fluctuations in the price of the benchmark it derives its value from.

Normally, the underlying assets used in derivatives are currencies (or cryptocurrencies), commodities, bonds, stocks, market indexes and interest rates. Derivatives can either be traded on exchanges or customer-to-customer (C2C), which is quite different in terms of regulation and manner of trading. Normally, however, active traders use both methods.

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Bitfinex CTO Hints at Maximum Leverage for Upcoming Derivatives Trading

Crypto exchange Bitfinex’s chief technology officer, Paolo Ardoino, hinted at the maximum leverage for the exchange’s upcoming derivatives trading.

Cryptocurrency exchange Bitfinex CTO Paolo Ardoino hinted at the maximum leverage for the exchange’s upcoming derivatives trading, in a tweet published on June 24.

In the tweet, Ardoino purportedly indicated the maximum leverage for Bitfinex’ forthcoming derivatives trading, which resulted in a heated discussion between community members.

In response to the answer whether it will be an isolated leverage, Ardoino said that it will be isolated at the beginning, adding that it is better for risk management. Ardoino also revealed that instruments with high leverage will be used separately from the main margin market limited to 3.3x. He stated:

“We have quite a steep margin requirement enforcement, with position increases. I’m proud of the result and the protections we have. Of course we’ll have to learn also from experience.”

Recently, Bitfinex announced a LEO token burn initiative that will see the exchange’s parent company iFinex funnel its gross revenue into purchasing LEO tokens at market prices as part of the UNUS SED LEO burn mechanism. 

This new system will launch alongside the LEO Transparency Dashboard, which will reportedly provide real-time information on collected platform fees and LEO token burns.

Bitfinex-owned hybrid cryptocurrency exchange Ethfinex Trustless announced the launch of its on-chain decentralized over-the-counter service. The system allegedly has no centralized order book or matching engine, and only financial instruments are restricted from the platform.

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Mike Novogratz’s Galaxy Digital to Launch Crypto Options Contracts Trading: Report

Mike Novogratz’s Galaxy Digital launches crypto options trading in response to increasing demand from institutional investors.

Mike Novogratz’s crypto investment bank Galaxy Digital is expanding its services to offer crypto options contracts trading, industry media outlet The Block reports on June 21.

According to the report, Galaxy Digital’s new initiative is made in response to increasing demand from institutional investors in order to hedge the high volatility that is a calling card of crypto assets.

Bitcoin (BTC) options are a type of crypto derivative that are a wide-spread method of profiting from a highly volatile market by strategically hedging risks such as reducing portfolio risks, and in turn, losses from trading. Similar to traditional finance, there are two types of crypto options that can be bought — call options and put options. Respectively, these translate to right to purchase and right to sell the holding at the determined price.

Yoshi Nakamura, global head of business development at Galaxy Digital, reportedly claimed that crypto-related businesses such as mining firms and lenders have been expressing more interest to crypto options recently. However, the executive declined to reveal specific numbers about growth of the business, adding that Galaxy’s crypto options business is “relatively new.”

According to an executive from crypto investment firm BlockTower Capital, the demand for crypto options has been increasing indeed, which is primarily driven by non-crypto firms.

According to the report, Galaxy is not the only firm in offering crypto options, with the service being reportedly supported by over-the-counter (OTC) trading operators such as Akuna Capital and Cumberland, the Chicago-based cryptocurrency trading unit of DRW Holdings LLC.

As reported earlier today, high volatility is the biggest reason people give up on cryptocurrencies, accounting for 31% of answers from those polled as to why they stopped using crypto.

Meanwhile, BTC futures, which is another type of crypto derivatives, have briefly broken $10,000 mark today on the Chicago Mercantile Exchange’s (CME).

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Bloomberg: UK Interdealer Broker TP ICAP to Sell CME’s Bitcoin Futures

United Kingdom-based interdealer broker TP ICAP will sell bitcoin financial derivatives.

United Kingdom-based interdealer broker TP ICAP will sell bitcoin (BTC) financial derivatives, Bloomberg reports on June 17.

Per the report, the ICAP unit of the firm now allows its customers to buy or sell the Chicago Mercantile Exchange’s (CME) bitcoin futures. In June, the Chicago Board Options Exchange’s bitcoin futures will expire with no current plans for renewal, leaving the CME as the sole offerer of BTC futures.

TP ICAP also reportedly expects to add non-deliverable forwards tied to the largest cryptocurrency, and then plans to open desks in Asia and the United States. Bloomberg claims that the company took the decision due to a decrease of its core business model:

“Interdealer brokers have traditionally relied on handling trades for banks, but their volumes shrunk in the aftermath of the financial crisis. A profit warning last year wiped 36% from TP ICAP’s market value in a day. It’s regained about 10% since then to 1.6 billion pounds ($2 billion).”

The author of the report also points out that customers have to comply with Know Your Client and Anti-Money Laundering regulations in order to access bitcoin through the firm’s services. Furthermore, TP ICAP also reportedly considers other digital assets, such as altcoins and tokenized, to be real-world assets. Bloomberg quotes the firm’s head of digital asset market, Duncan Trenholme, illustrating the company’s interest in the industry:

“We want to be close to what’s happening within this nascent asset class because we believe it’s important to invest in the early stages of a growing market. […] TP ICAP also understands that this technology could disrupt or impact other asset classes where we currently operate, so we feel it’s important to be informed.”

According to the company’s 2018 financial results disclosure, TP ICAP reported a revenue of £1,763 billion ($2.219 billion) last year.

As Cointelegraph reported earlier today, bitcoin surpassed one million daily active addresses on June 14, according to blockchain statistics website CoinMetrics.

Earlier this week, JPMorgan Chase wrote in a report that the Bitcoin industry has changed considerably since 2017, citing an increase in institutional interest.

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Open Positions on Chicago Mercantile Exchange Bitcoin Futures Hit Record High

The number of open contracts for CME bitcoin futures is reportedly at an all-time high.

The number of open contracts for the Chicago Mercantile Exchange’s (CME) bitcoin (BTC) futures is reportedly at an all-time high, cryptocurrency news outlet Coindesk reported on June 3.

According to visible data released by the United States Commodity Futures Trading Commission (CFTC) data, the number of open positions for the aforementioned future contract in the week from May 27 to June 3 is 5,190.

Coindesk claims that this is the highest number of open positions that CME’s bitcoin futures have ever reported and a 7% increase over the previous week.

Per the report, the recent increase in futures trading activity could be a sign of increased institutional interest in bitcoin. This is a continuation of the trend lately reported by the bitcoin futures, that also saw record volume on May 13.

As Cointelegraph reported at the time, CME’s bitcoin futures were also expected to hit new heights in May. CME  purportedly revealed that the average daily bitcoin futures trading volume hit a new high of 14,000 contracts in May 2019.

An unnamed official allegedly said at the beginning of last month that the CFTC is open to the idea of ether (ETH) futures trading, should the product meet the CFTC’s various requirements.

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SEC Commissioner Hester Peirce Encourages Less Caution Toward ETF Innovation

SEC commissioner Hester Peirce urged for a less cautious approach towards innovation in the ETF space.

Hester Peirce, commissioner at the United States securities regulator, has urged for a less cautious approach towards innovation in the exchange-traded funds (ETFs) space on the regulator’s part. The Financial Times reported on her remarks on June 2.

Per the report, the Security and Exchange Commission’s (SEC) Peirce called on her co-commissioners to allow for innovation in the ETF space by lessening their caution.

She reportedly commented on the SEC’s approach towards this category of highly regulated financial derivatives, noting that the SEC is “still smothering ETFs with personalised attention as if they were infants.”

Peirce also noted that she believes the regulator was wrong in its decision to reject the bitcoin (BTC)-based ETF application introduced by the Winklevoss twins, who are also founders of the Gemini cryptocurrency exchange. According to Peirce, an ETF would encourage institutional investors to participate in the cryptocurrency market.

The CEO of world’s third-largest asset manager, State Street Global Advisers, Cyrus Taraporevala commented to the Financial Times:

“If something does go awry with them, then the whole industry gets painted with the same brush. […] We do not do inverse ETFs or leveraged ETFs. That will be the case as long as I am in my role.”

In 2010, the SEC reportedly banned leveraged and inverse ETFs, presumably because they can produce particularly large losses, the Financial Times notes. Still, Peirce noted that other types of mutual funds also use derivatives to amplify their exposure, and it was clear that unsophisticated retail investors are not the target for leveraged ETFs. She reportedly commented:

“The unwillingness to allow more competitors to offer geared ETFs seems to be another example of denying or curtailing access to a product that would be useful to some investors.”

The Financial Times further notes that the U.S. regulator in question is also expected to introduce new ETF regulation, which is expected to speed up innovation in the space.

As Cointelegraph reported at the end of May, the Japanese Financial Services Agency has also showed a cautious approach towards cryptocurrency-based ETFs, according to comments from the finance committee of the upper house of the National Diet.

A recently released Cointelegraph analysis writes that part of the crypto community believes bitcoin’s volatility could render the odds of an ETF based on the coin being approved significantly lower.

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Japanese Financial Services Agency Approaches Crypto ETFs With Caution, Cites Volatility

The Japanese Financial Services Agency showed a cautious approach towards cryptocurrency-based ETFs.

The Japanese Financial Services Agency (FSA) showed a cautious approach towards cryptocurrency-based exchange-traded funds (ETFs) in comments at the finance committee of the upper house of the National Diet on May 30. Cointelegraph Japan reported on the comments earlier today.

Per the report, local politician Takeshi Fujimaki noted during the meeting that he expects a crypto-based ETF to be approved in the United States, citing both positive and negative statements released by United States Securities and Exchange Commission commissioner Hester Peirce. He then noted that such a product would be an important development and that Japan should not be left behind other countries in this regard.

Fujimaki also reportedly addressed hacking, stating that — in the case of ETFs — crypto assets would be entrusted to banks and kept by custodians. Furthermore, he claimed that the introduction of such an asset would result in growth for the market by making institutional investment easier, resulting in lower volatility.

However, an FSA representative reportedly showed opposing views during the meeting, claiming that cryptocurrencies such as bitcoin (BTC) lack intrinsic value, which could result in unbearable price volatility. Fujimaki answered, reiterating his idea that an ETF would diminish the volatility of cryptocurrencies and make it easier to invest in an asset that he deems desirable and necessary.

As Cointelegraph recently reported, the Japanese House of Representatives has passed new crypto regulation in the upper house of the National Diet.

In April, Japan’s Minister of Finance and deputy prime minister Taro Aso urged reporters to stop using the term virtual currencies and switch to the newly-proposed legal name crypto assets.

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Crypto Derivatives Platform Vows to Tackle Socialized Losses Seen on Other Exchanges

A crypto derivatives exchange says it offers competitive advantages over rivals thanks to its partnerships with established industry players.

A crypto futures exchange says its features mean it is well-positioned to solve current problems that exist among rivals.

The team behind FTX claims they were driven to act after “hours of feedback” to established exchanges about the problems with their products went ignored.

As a result, the company claims that its platform “reduces the likelihood of clawbacks” through a three-tiered liquidation model — tackling the problem represented by “significant amount of customer funds on other derivatives exchanges that have been claimed by socialized losses.”

In a blog post, the exchange explained: “FTX really does see clawbacks as a worst-case scenario that we hope never happens. We designed a system that we think will withstand huge market moves and huge volume without leading to any clawbacks.”

This is achieved through a “backstop liquidity provider system” in which providers that have opted into the system have the opportunity to take over an account’s obligation before it goes bankrupt, meaning they can attempt to manage the position and “instantly inject liquidity from other exchanges.”

FTX claims that testing showed that “even market moves of 40 percent in a 20-minute period were not enough to cause clawbacks.”

Competitive advantages

FTX says that its backstop liquidity provider system is coupled with universal margin wallets via TrueUSD or USDCoin that enable users to trade all derivatives in one place. In addition, the company claims traders can “instantly” put on short or long positions with up to triple leverage without maintaining any collateral in margin.

In addition, FTX offers noninverted futures. Specially, its USDT/USD and BNB/USD futures provide easy and effective hedging opportunities for USDT and BNB positions. The exchange has also launched leveraged tokens on USDT, BTC, ETH, EOS, XRP with -1, +3 and -3 leverage, allowing users to put on positions that would typically require posting collateral without doing so.

When it comes to over-the-counter trading, FTX says that it offers “some of the tightest spreads in the industry” despite the recent bear market and a competitive landscape thanks to an automated request-for-quote system.

FTX is available here

The crypto exchange adds that it is backed by Alameda Research, which it claims has become “one of the largest liquidity providers and market makers in the space,” trading anywhere between $200 million and $1 billion a day, depending on market volatility.

FTX argues that its offering is hard to replicate because of how many of its unique selling points depend on Alameda’s expertise. A summary of its white paper adds: “FTX is designed by people who really know the products. Everything from collateral to maintenance margin to liquidation processes to product listing has been redesigned from the ground up by one of the heaviest users of the products. It is built by traders, for traders.”

When it comes to developing new features, the exchange says that it is able to tap into Alameda’s tech team — and claims they are able to build “complex crypto trading systems under time pressure,” resulting in a development cycle that is much shorter than those of other established platforms.

A token with purpose

FTX has issued a token called FTT, which the exchange says offers significant utility to users. It can be used as collateral for futures positions, while simultaneously reducing fees and margin trading requirements. The startup also says that holders can benefit from lower spreads for over-the-counter trading, and that FTT “will become even more useful when we add other derivative products to the platform.”

The exchange says its team has a rich background, drawing from Wall Street firms and major tech companies such as Facebook and Google. The first round of FTX’s public token sale began on April 11, and the company says it hopes to conclude the fundraising drive within a few months.

Learn more about FTX

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