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,
he value of the derivative being traded is a function of a specific, pre-established metric associated with its un
derlying asset. Since a derivative’s value is based on a dynamic character
istic of its underlying asset, over the course of a derivative contract’s e
xistence 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 ag
reeable framework. As a result, there are a wide variety of derivatives — ranging from futures and options to swaps and collateralized debt obligations — that ca
n be pegged to nearly
to the outcome of the next World Cup. Futures are the most commonly traded type of derivative. They are an agreement t
o 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 a
sset without having to directly own that underlying asset. Due to their flexibility, derivatives can pro
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vide 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 de
cade 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 deri
vatives that investors could use to hedge against expected market movements and profit off of future price volatil
ity, and by 2020 the crypto derivatives trading market had exploded to record highs. As of May 2020, the crypto s
pot market had a 24-hour trading volume of $200 billion, while the crypto derivatives market had a trading volume of a
proximately $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.