Within the financial services sector, a derivative is a financial product whose value is linked to a characteristic of an underlying asset. In other words, the buying and selling of a derivatives contract does not involve the actual exchange of the underlying asset itself. Rather, the value of the derivative being traded is a function of a specific, pre-established metric associated with its underlying asset. Since a derivative’s value is based on a dynamic characteristic of its underlying asset, over the course of a derivative contract’s existence the market price of that contract typically fluctuates in accordance with the expected outcome of the trade.
A derivative can be based on practically anything, tangible or intangible, as long as it has a characteristic that can be assigned a price based on a mutually agreeable framework. As a result, there are a wide variety of derivatives — ranging from futures and options to swaps and collateralized debt obligations — that can be pegged to nearly anything imaginable, from the price of soybeans to the outcome of the next World Cup. Futures are the most commonly traded type of derivative. They are an agreement to trade an asset on a future date, and are often used as a means to hedge a major investment position or gain leveraged market exposure to an asset without having to directly own that underlying asset. Due to their flexibility, derivatives can provide investors with greater optionality, and are often an effective tool for improving liquidity and helping to manage a wide range of financial risks.
The cryptocurrency industry is relatively new, and over the past decade most crypto investors have primarily engaged in spot trading, which is the direct buying and selling of an asset at a mutually agreed-upon price. However, as investor interest in the space has grown, new cryptocurrency-based derivatives have developed, which provide traders with access to a broader range of potential investment strategies.
In 2011, the first crypto derivatives came to market, although they were limited to futures contracts based on the price of bitcoin (BTC). Several years later, exchanges began offering a broader selection of derivatives that investors could use to hedge against expected market movements and profit off of future price volatility, and by 2020 the crypto derivatives trading market had exploded to record highs. As of May 2020, the crypto spot market had a 24-hour trading volume of $200 billion, while the crypto derivatives market had a trading volume of approximately $320 billion — around 60% higher than the spot market. With an increasing number of institutional investors making efforts to hedge their positions in large-cap cryptos like BTC, many experts believe the trading volume lead that crypto derivatives hold over crypto spot trading might grow even larger yet.
While the growing number of crypto-based derivatives is an exciting development which underscores the industry’s gradual maturation, these financial products generally still operate within the conventional framework set by legacy financial institutions. As a result, one of the most exciting syntheses of blockchain technology and the global derivatives market resides in blockchain’s potential to change the way the traditional derivatives market itself works.