Derivatives are one of the most popular financial instruments in today’s market; they date back to the 17th century when the Dijoma rice exchange was launched in Japan. Currently, this market is well over 10 trillion dollars; the latest statistics from the Bank of International Settlements (BIS) show over-the-counter (OTC) trades grossed $15.8 trillion during the first half of 2020.
So, how does this market work? Let’s define what derivatives are for starters as we narrow down to the different markets, including crypto derivatives - the latest kid in the block. Fundamentally, derivatives are financial instruments whose value is derived from an underlying asset. Derivative contracts can be defined by various underlying assets such as commodities, indexes, currencies, interest payments, bonds and crypto assets.
Unlike spot markets where stakeholders are directly exposed to an asset, the derivative market allows traders to purchase contracts that indirectly expose them to the price movements of an underlying asset. Most traders in traditional financial markets and nascent ecosystems like crypto use derivative instruments for speculative purposes. This is because the derivative contracts are settled at a future date instead of the actual purchase date.
Derivatives as Market Hedging Instruments
With derivatives, traders can purchase a futures or forward contract that allows them to buy or sell the underlying asset at a predetermined price hence the right and obligation to exercise the contract upon maturity. These contracts feature predetermined expiry dates and prices, allowing speculators to bet on whether the price of an underlying asset will be higher or lower than its market price on the settlement date.
For instance, a trader can use derivative instruments to hedge against the eventuality that oil prices will be higher on a settlement date scheduled six months from now. In this case, they would buy a futures contract with a lower settlement price than their predictions.
Should the prediction be correct, the trader will be in the money as they will purchase the oil cheaper than the prevailing market prices. On the other hand, a trader would be out of the money if their predictions were higher than the spot prices on the settlement date.
As mentioned earlier, derivatives go way back to the 17th century, with the Dojima rice exchange marking the debut of this market. Well, it is no longer limited to commodities or financial instruments such as equities. The derivative market has found its way into the crypto ecosystem and now accounts for over half of the total crypto volumes, according to the latest report by CryptoCompare.
The Rise of Crypto Derivatives
Though a relatively new market, cryptocurrencies have proven to match the wild west when it comes to the rate of innovation. Today, most leading crypto exchanges, including Binance, FTX and Deribit, offer Bitcoin and Ether futures. It is no surprise that some analysts are now using the open interest data for BTC and ETH futures to predict future crypto market prices. Notably, the crypto market has experienced substantial volatility swings during monthly and quarterly settlement dates in the previous year.
While centralized exchanges dominate the crypto derivatives market, there has been an increased interest in DeFi derivatives, especially with crackdowns by authorities such as China’s CCP, which recently went hard on crypto miners and exchanges. DeFi, short for Decentralized Finance, changes the narrative of centralized financial services by introducing smart contract platforms governed through code and communities instead of a third party.
In the early DeFi days, the most focus was on decentralized exchanges (DEXes), giving rise to Uniswap and Sushiwap. However, innovators are now building advanced financial ecosystems featuring lending platforms and decentralized crypto derivatives exchanges. One emerging DeFi derivative platform that is ultimately changing the game is SynFutures, an open and decentralized platform that allows users to trade synthetic assets.
The SynFutures crypto derivatives platform allows users to synthesize Ethereum-native, cross-chain, off-chain and real-world assets and trade them freely. This ecosystem features user-generated markets, enabling anyone to list a trading pair within 30 seconds. Projects can also create their own futures market margined by native tokens.
Another exciting feature is the platform’s single token model; essentially, users looking to trade crypto derivatives on SynFutures are only required to provide one single crypto asset of a trading pair while the underlying smart contract synthesizes the other pair. So far, SynFutures has already launched its V1 on popular blockchain networks, including Ethereum, Polygon, Arbitrum and Binance Smart Chain (BSC).
With interest in DeFi growing by the day, decentralized crypto derivative platforms such as SynFutures and competitors like DyDx will likely onboard more traders. Even better, these trading environments are exposing individuals previously limited by KYC to opportunities in crypto derivatives.
Derivatives have proven their resilience and value proposition in traditional and upcoming markets. These financial instruments are not only good for speculation but asset diversification and profit maximization, given that exchanges often provide leverage with some going up to 100x.
That said, the ever-changing dynamics of the crypto ecosystem show that traders are gradually adopting decentralized financial services. Going by the tone of powerful governments such as the US and China, it is likely that traders from these jurisdictions will opt for decentralized crypto derivatives platforms to continue eating a piece of the pie.
After all, the idea behind cryptocurrencies revolves around decentralized ecosystems. It only makes sense for the whole industry to be decentralized, from spot markets to crypto derivative instruments. This may take a while, but the shift will undoubtedly happen, maybe sooner than most stakeholders expect.