What are Crypto Derivatives? Types, Features & Top Exchanges

“Derivative markets are important because their behavior influences the price dynamics of cryptocurrencies themselves.”

Nicolas Christin. CyLab Security & Privacy Institute

We have previously written about spot exchanges in crypto, DeFi exchanges in crypto and today we will cover derivative exchanges. Please make sure that you’ve read our disclaimer on investment-related topics before proceeding.

What is derivative trading?

A derivative is a contract or product whose value is determined by an underlying asset. Currencies, exchange rates, commodities, stocks, and the rate of interest are all examples of derivative assets. The buyer and seller of such contracts have directly opposed predictions for the future trading price. To earn a profit, both parties wager on the underlying assets’ future value.

What is derivative trading in crypto?

The underlying asset in crypto derivatives trading can be any cryptocurrency token. Two parties that enter into a financial contract speculate on the cryptocurrency’s price on a future date. During the first phase of the contract, the sides agree on a selling/buying price for the cryptocurrency on a specific day, regardless of the market price. As a result, investors can profit from changes in the underlying asset’s price by purchasing the currency at a cheaper price and selling it at a higher price.

How big is the derivative market in crypto?

According to Tokeninsight’s Cryptocurrency Derivatives Exchange Industry Report, the cryptocurrency derivatives market’s trading volume for the third quarter of 2020 was $2.7 trillion, based on data from 42 exchanges. This marks a 25.1% increase from the previous quarter and a year-on-year 159.4% increase from the third quarter of 2019, demonstrating the enormous growth in crypto-derivatives over the last years.

What are the most popular types of derivatives in crypto?

Crypto derivatives can be of the following types, depending on the conditions of a contract:

• Futures: A futures contract is a legal agreement between two parties to purchase or sell an underlying asset at a specified price and date in the future. The contract is directly executed on a regulated exchange.
• Options: A trader with an options contract has the choice, but not the duty, to purchase or sell an underlying asset at a defined future date and price.
• Perpetual contracts: Unlike futures or options, perpetual contracts have no expiration or settlement date. Under some circumstances (e.g. the account holds certain amount of a crypto etc.), traders can keep their positions open indefinitely.
• Swaps: A swap is a contract between two parties to exchange cash flows at a later date according to a pre-determined formula. They are OTC (over-the-counter) contracts, similar to forwards, and are not traded on exchanges.

What are some derivative trading features?

• Auto Deleveraging (ADL): When a position cannot be liquidated at a price that is better than the bankruptcy price and there is insufficient insurance to cover the contract loss, your crypto exchange’s ADL system will automatically deleverage an opposing position from a designated trader in the case of liquidation.
• Stop/Loss Take Profit: Allows traders to specify the floor and ceiling prices for an order, allowing them to exit the market automatically when conditions are favorable.
• Partial Close Orders: Permits traders to take partial gains while continuing to benefit from the growing market by partially closing their orders.
• Insurance Funds: Even if their holdings fall below the maintenance margin level, it helps traders preserve their funds from auto-deleveraging.

Where to trade crypto derivatives?

Derivatives in cryptocurrency can be traded on both centralized and decentralized exchange platforms. Cryptocurrency derivatives exchange can be used by exchange owners to reach out to additional investors. A crypto derivative trading platform is more flexible than spot margin trading and gives you access to markets that would otherwise be inaccessible to you.

What are the advantages of using derivatives?

• Low transaction costs: Since derivative contracts are risk management instruments, they help to reduce market transaction costs. As a result, as compared to other securities such as spot trading, the cost of transaction in derivative trading is cheaper.
• Used in risk management: The price of the underlying crypto coin/token has a direct relationship with the value of a derivative contract. As a result, derivatives are utilized to mitigate the risks associated with fluctuating underlying asset prices. Mr A, for example, purchases a derivative contract whose value swings in the opposite direction of the crypto coin/token he owns. He’ll be able to offset losses in the underlying crypto coin/token with gains from the derivatives.
• Market efficiency: Derivative trading entails the practice of arbitrage, which is critical for ensuring that the market finds equilibrium and that the prices of the underlying assets are accurate.
• Determines an underlying asset’s price: Derivative contracts are frequently used to determine the price of an underlying asset.
• Risk may be transferred: Derivatives allow investors, corporations, and other parties to shift risk to others.

What are the disadvantages of using derivatives?

• High risk: Derivative contracts are extremely volatile due to the fast fluctuation in the value of underlying crypto coins/tokens. As a result, traders run the danger of losing a lot of money.
• Speculative: Derivative contracts are frequently employed as speculative instruments. Because of the significant risk involved and the unpredictability of their value swings, speculative investments sometimes result in large losses.

Top 10 Crypto Derivative Exchanges

(*) Source: CoinmarketCap
(**) Source: CoinGecko
Note that all figures on the table were compiled on 11/10/2021

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This article was originally written by former AIMultiple industry analyst Izgi Arda Ozsubasi and reviewed by Cem Dilmegani