Crypto derivatives are directional bets on the future spot price of bitcoin or other digital assets. The market for these contractual side-bets has exploded in recent years, with top exchanges that offer derivatives seeing average daily trading volumes of over $100 billion.
Per a recent report from CyLab researchers at Carnegie Mellon University, the crypto derivatives markets are going mainstream, with both retail and institutional investors eager to cash in on these high-risk, high-reward endeavors.
The report highlights that, on average, the traded volume in the derivatives markets is five times higher than the regular volume on spot markets. The data shows that derivatives are growing into a crucial part of the crypto market and have a significant influence on the prices of individual crypto assets.
Read on to learn how the exploding derivatives markets are becoming an integral part of the crypto ecosystem. We shall also examine how the expiration of futures contracts impact the spot price of BTC, as well as how these events affect investors’ trading operations.
The Most Common Forms of Crypto Derivatives
Crypto derivatives are essentially complex, high-risk financial instruments that market participants, including traders, governments, and institutions, leverage to hedge against volatility.
Investors can also use derivatives to speculate on the future prices of digital assets by betting long or short to cash in on price volatility. These tradable financial contracts derive their value from the underlying digital asset.
The most common form of crypto derivatives is bitcoin futures contracts, constituting the largest derivatives market in the crypto sphere. The product allows two traders on an exchange like Binance to enter into a contractual agreement to buy or sell BTC at an agreed-upon price at a specified date in the future.
These contracts come in standard and perpetual futures, with the former having a fixed expiry date and the latter having no selected settlement date.
Most investors opt to enter into a futures contract rather than trading bitcoin directly on the spot market to mitigate against the risk of price fluctuations. Futures also help traders speculate on the market movements and earn returns from volatility.
In Jan 2021 alone, over $650 billion BTC futures contracts were traded after the flagship crypto logged a remarkable rally past its 2017 lifetime high.
The other most used derivative product is options, which give sophisticated traders leveraged returns and downside protection against adverse market movements. Unlike futures, this class of derivatives offers market participants the right to buy or sell a specified digital asset (primarily BTC and ETH) at a fixed price in the future.
Options are newer than their futures counterparts but are gaining tremendous pace in the market. The derivatives class hit an open interest of over $1 billion in 2020 before cooling slightly down this year.
Crypto Derivatives are Essential to the Crypto Economy
The functions of derivatives are essential in growing individual investment portfolios. They allow for leverage trading, where traders can capitalize on crypto volatility and generate higher gains on a digital asset’s daily return with only a fraction of its total cost.
Another critical use case for the derivatives in crypto trading is portfolio diversification. Here pro traders develop complex strategies such as arbitrage and short-selling to maximize returns on their trades.
As mentioned earlier, derivatives give investors the tools they need to hedge their portfolios against downside risk. Without this product, investors who are long BTC or other crypto assets wouldn’t have the ability to protect their portfolios from high market volatility.
Professional traders also use derivatives to predict market risk and adjust their trading strategy accordingly. For instance, overbought options often reflect a bearish market sentiment that alerts traders to hedge their portfolios against unexpected risks.
Finally, derivatives play a vital role in helping the underlying asset achieve price discovery. Without these financial products, investors would have no means to express sentiment in the market and would only have the option to buy and “hodl” the cryptocurrency itself.
Case in point, the lack of bitcoin futures on exchanges led to the market bubble in 2017, which only popped after the launch of futures contracts by pioneers such as CME and Cboe.
The Impact of Futures Expirations on BTC Prices
Bitcoin futures contracts are designed to expire after the lapse of their preset calendar cycle, typically set by exchanges to occur quarterly. After each four-month contract expires, investors can opt to exit their position or roll over their contract to a further-out month.
Most short-term traders often choose to exit their position before the contract expiry date to avoid the costs and hassles of settlement, as well as to hedge against market volatility.
The main impact of bitcoin futures expiration on the crypto markets is a substantial decline in liquidity as traders roll over to the next contract. The reduced liquidity leads to widening bid-ask spreads on expiring contracts, resulting in higher transaction costs.
Therefore, traders are often advised to adopt a prudent strategy around futures expirations by unwinding their positions before the contract calendar cycle closes.
During futures expiry periods for large derivative markets, volatility has historically spiked due to increased trading activity. Furthermore, short-term traders often rush to take profits off the table, leading to even more volatility. This increased volatility creates a spill-over effect on the underlying crypto asset.
Historically, bitcoin average daily returns have been known to rise significantly during the expiration period, as shown in the chart below from crypto trading platform Interdax.
The chart shows that expiration dates have an undeniable effect on bitcoin performances, pushing volatility up as investors scramble to exit their positions or roll over to the next futures contract.
Given these observations, market participants such as miners, hedgers, and speculators should exercise greater risk management in the run-up to large BTC futures expirations.
The launch of quality derivatives has dramatically improved the liquidity of underlying crypto assets, allowing the market to meet the high demands of retail and institutional traders.
These regulated derivatives also injected an influx of capital into the crypto space, which helps legitimize digital assets and attract more big-money institutions. Each new derivatives product helps boost bitcoin’s mainstream adoption by increasing liquidity and generating organic price discovery for the digital coin.
Fast-growing crypto derivatives such as bitcoin futures are rivaling traditional financial products like bonds, stock, and commodities. In the long run, these derivatives could emerge as the go-to venue for retailers and large-scale institutions looking for alternative ways to grow their wealth portfolios.