Whether or not you like them, cryptocurrencies are the big thing today, polarising opinions across the globe. With figures like Paul Krugman, Warren Buffett or Howard Marks dismissing cryptocurrencies as bubbles doomed to bad endings, on one hand, there are a plethora of bulls headed by the brilliant and eccentric Elon Musk on the other. At the very least, their capricious price movements grab headlines, leaving conventional markets in the dust. Just this week, Shiba Inu, another one of those seemingly endless, eccentric coins, soared in price. The benchmark S&P index has gained 39% in the 15 months since the coin was launched; Shiba Inu gained more than 16.1 million percent in the same time.

This article, however, focuses on another aspect of the cryptocurrency market: crypto derivatives. Crypto is one of the most volatile assets one can own; in June this year, Bitcoin reached a 30-day volatility of 117.04%. For comparison’s sake, the volatility of gold averages around 1.2%. Understandably so, people are apprehensive of investing in an asset that can swing in price in fewer than 140 characters from someone on Twitter. Yet, it’s difficult not to rue a lost opportunity when the price swings up. The solution to exposing oneself to the market, without actually buying into the volatility, might just be crypto derivatives.

How Derivatives Work

The role of derivatives in financial markets cannot be understated. Crypto derivatives work like any other derivatives, which refer to financial instruments pegged to an underlying asset – in this case, the cryptocurrency itself. It, therefore, allows investors to gain exposure to the market without the need to spend as much on the asset itself and protects the buyer from significant losses should he be able to lock in prices in advance. Known as hedging a position, this keeps an investor from losing out to unexpected, significant losses.

The early markets for crypto derivatives operated in a fairly rudimentary fashion, with traders buying currency on spot and selling futures contracts, earning a premium. While these were traditionally regulated and conducted by banking systems, the decentralised nature of cryptocurrency meant that such marketplaces could be set up online by themselves.

There are a few major types of crypto derivatives, the largest being the futures market, which operate in the same manner as traditional futures. Bitcoin futures is the largest futures market, averaging around $60 billion in trade daily at the start of this year. A more unique form of futures for crypto is the perpetual futures, which do not have an expiry date, and instead give the holder the option to hold them to perpetuity. This unique derivative strengthened the connection between spot markets and derivatives markets, making arbitrage easier. Apart from these, there are also options and leveraged tokens.

As with any mature market, derivatives play an important function in risk management, hedging against volatile positions that are ever so common in the crypto markets. The proliferation of derivatives has also increased the liquidity in the market, and exchanges have largely been allowed to operate in less restrictive regulatory environments.

A Perpetually Changing Market

However, that’s not to say that crypto and its derivatives have managed to steer clear completely. China’s cryptocurrency crackdown, which culminated last month in a blanket ban on all transactions and mining, is just one example of the global crackdown, with regulators afraid of increased risk, the energy-intensive mining process, and perhaps most importantly, the undermining of traditional systems. The Financial Conduct Authority in the UK recently banned the sale of crypto derivatives to retail investors, citing, amongst other issues, the lack of a reliable underlying asset for valuation of the derivative. These have had consequences on exchanges as well; for example, Huobi, a major crypto exchange, announced that they would end derivatives trading in mainland China.

Despite all of this, the market for derivatives is far from bearish. Binance, for all the regulatory backlash and issues it faces, remains popular, just recently announcing that the cumulative transactions on the Binance Smart Chain had surpassed 1.5 billion, barely 14 months since the platform launched, with ambitious expansion plans in the pipeline. Earlier in October, the first bitcoin futures ETF traded in the US, with the Proshares Bitcoin Strategy ETF launching on the NYSE seeing around a billion dollars traded in the first day. Cboe Global Markets is expected to close an acquisition of ErisX, a regulated futures exchange and clearing house.

Such robust developments reflect the growing popularity of the still-nascent crypto and its derivatives. However, if there ever were a word to describe cryptocurrencies and their related products, it would be unpredictable. The regulation does appear to be mounting, and if crypto becomes more commonly used and gains legitimacy as a serious asset class, blurring the lines between the crypto world and the real world, there are bound to be monumental changes ahead.

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