Are Crypto Derivatives DeFi, or Just More CeFi?

Crypto derivatives represent a high-risk tool that enables traders and investors to bet on the future price of various assets and thus make higher profits. 

Similar to derivatives in traditional financial markets, cryptocurrency derivatives don’t have any value per se. Instead, they “derive” their price from underlying digital assets.

In this article, we are going to review how crypto derivatives work, what types of crypto derivatives exist and what risks one may come across when using this trading tool.

What is a Crypto Derivative?

Derivative trading has been around long before cryptocurrencies came into existence.

In a nutshell, derivatives are contracts where a buyer and a seller make opposite bets on the future asset prices. The party whose bet eventually wins gets to take the profit. 

In traditional finance, the underlying assets can be currencies, stocks, bonds, commodities, and any other type of tradeable items. When applied to cryptocurrencies, the approach is exactly the same. Buyers and sellers enter a financial contract on crypto exchanges speculating on the price of a given digital asset at a specific moment in the future. 

Thanks to the highly volatile nature of the crypto industry, the potential gains can be really huge. At this, cryptocurrency derivatives enable traders to make higher profits.

Types of Crypto Derivatives

Crypto derivatives fall into the following categories depending on the derivative contract conditions.

Crypto futures

Futures represent an agreement between a buyer and a seller to exchange a specific crypto asset in the future at a determined price regardless of the real market conditions. 

Here’s how it works in practice.

Assume that the current Bitcoin price equals $20,000. Bob expects the BTC price to grow. He purchases a futures contract worth one Bitcoin with a 1-month expiry date.

If the BTC price increases up to $25,000 on the specified date, Bob will still purchase BTC for $20,000, then sell it and thus gain $5,000 in profit. On the contrary, if the price drops down to $15,000 he will lose the same amount.

Crypto options

These contracts are very much similar to the futures with the only key difference. A buyer of an option doesn’t necessarily have to purchase an asset when the specific date comes.

There are two key types of options:

• Call options enable traders to buy assets on a specific date.
• Put options enable them to sell them.

Thanks to options, traders can realize their purchases with leverage. For example, a trader may buy only a fraction of Bitcoin and gain a whole BTC if his bet wins. 

On the contrary, if his bet loses he will only have to pay as much as he initially put on the bet.

Perpetual contracts

Also known as crypto swaps, these contracts are also similar to crypto futures. There is only one aspect that makes them different.

As the name implies, perpetual swaps don’t have an expiry date. This means that traders may hold them for an indefinite period of time provided that they pay the holding fees.

Advantages of Crypto Derivatives

Crypto derivatives play an important role in the crypto economy. At this, they provide traders and investors with a set of benefits.

Risk management

The cryptocurrency market is well-known for its high volatility. The price of digital assets may spike or drop dramatically without any warning signs.

Derivatives enable professional traders and institutional investors to buy or sell assets at a predefined price. Thus, they help them to avoid sudden market moves and mitigate risks.

Portfolio diversification

Crypto derivatives represent one more asset class that investors may add to their portfolio for the sake of diversification. 

Derivatives are high-risk tools, that’s true. Yet, putting all eggs into a single basket is not a wise decision either. Therefore, adding such assets to one’s portfolio is a good way of diversification that helps to reduce overall risks.

High profits

With crypto derivatives it is possible to make a fortune while investing a relatively small amount of money. 

High liquidity

According to CME Group, the average daily trading volume of Bitcoin futures alone equaled around $15-20k. Thus, crypto derivatives represent highly liquid items that one can easily cash out at any moment in time.

Disadvantages of Crypto Derivatives

Cryptocurrency derivatives have their drawbacks as well. Here are some of the most critical aspects that can make investors reconsider their decisions.

High risks

Crypto derivatives can make you get fast profits, but only provided that you are an extremely lucky person. The high volatility of the crypto market puts the factor of luck on top of all your wits and skills.

Derivatives are a good solution for long-term risk mitigation. Yet, short-term fluctuations may result in heavy losses. Therefore, these trading tools are only a good fit for traders with a solid strategy and nerves of steel.

Regulatory concerns

Not all regions have solid legal frameworks to regulate cryptocurrencies, let alone crypto derivatives. Therefore, the parties engaged in crypto derivative trading should operate in countries where crypto derivatives are not officially prohibited. Otherwise, these activities are associated with counterparty risk.

The lack of transparency

Centralized exchanges often do not provide the due level of transparency. This makes it easy for them to manipulate the market prices for their own benefit and deprives traders of all chances to make profits. In addition, centralized crypto derivatives exchanges may go offline and cause their customers’ positions to get liquidated.

In fact, aside from the high market volatility, this is the key aspect that makes crypto derivatives trading so risky and makes the majority of traders lose money.

Centralized vs Decentralized crypto derivatives

While there is little one can do to improve the regulatory environment, there is a solution to the transparency problem.

Decentralized exchanges fueled by smart contracts offer a much more fair way of trading crypto derivatives. In the absence of a centralized entity to govern all the processes, traders can make use of the full transparency provided by the blockchain itself.

The lack of liquidity is still a major obstacle that prevents DeFi derivatives from getting adopted at scale. Yet, as the market matures, this problem is likely to disappear in time.