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What is Derivatives Trading? Crypto Derivatives | Gemini

Blockchain’s Next Frontier: Crypto Derivatives

The blockchain industry has presented various paths through which blockchain can transform traditional systems while improving operational efficiency, expanding optionality, and reducing costs. Nowhere is this perhaps more apparent than in the financial services industry, where interest in exploring blockchain-enabled decentralized finance (DeFi) applications has dramatically increased in recent years.

With the blockchain sector continuing to pave the way for an exciting wave of new, real-world solutions that increasingly align with mainstream investor interest, this new technology has begun to be incorporated into a growing array of financial products. As a result, blockchain’s ongoing adoption has made an impact on the global derivatives market, which has been estimated to be worth over $1 quadrillion USD.

What Are Financial Derivatives?

Within the financial services sector, a derivative is a financial product whose value is linked to a characteristic of an underlying asset. In other words, the buying and selling of a derivatives contract does not involve the actual exchange of the underlying asset itself. Rather, the value of the derivative being traded is a function of a specific, pre-established metric associated with its underlying asset. Since a derivative’s value is based on a dynamic characteristic of its underlying asset, over the course of a derivative contract’s existence the market price of that contract typically fluctuates in accordance with the expected outcome of the trade.

A derivative can be based on practically anything, tangible or intangible, as long as it has a characteristic that can be assigned a price based on a mutually agreeable framework. As a result, there are a wide variety of derivatives — ranging from futures and options to swaps and collateralized debt obligations — that can be pegged to nearly anything imaginable, from the price of soybeans to the outcome of the next World Cup. Futures are the most commonly traded type of derivative. They are an agreement to trade an asset on a future date, and are often used as a means to hedge a major investment position or gain leveraged market exposure to an asset without having to directly own that underlying asset. Due to their flexibility, derivatives can provide investors with greater optionality, and are often an effective tool for improving liquidity and helping to manage a wide range of financial risks.

Crypto Derivatives

The cryptocurrency industry is relatively new, and over the past decade most crypto investors have primarily engaged in spot trading, which is the direct buying and selling of an asset at a mutually agreed-upon price. However, as investor interest in the space has grown, new cryptocurrency-based derivatives have developed, which provide traders with access to a broader range of potential investment strategies.

In 2011, the first crypto derivatives came to market, although they were limited to futures contracts based on the price of bitcoin (BTC). Several years later, exchanges began offering a broader selection of derivatives that investors could use to hedge against expected market movements and profit off of future price volatility, and by 2020 the crypto derivatives trading market had exploded to record highs. As of May 2020, the crypto spot market had a 24-hour trading volume of $200 billion, while the crypto derivatives market had a trading volume of approximately $320 billion — around 60% higher than the spot market. With an increasing number of institutional investors making efforts to hedge their positions in large-cap cryptos like BTC, many experts believe the trading volume lead that crypto derivatives hold over crypto spot trading might grow even larger yet.

While the growing number of crypto-based derivatives is an exciting development which underscores the industry’s gradual maturation, these financial products generally still operate within the conventional framework set by legacy financial institutions. As a result, one of the most exciting syntheses of blockchain technology and the global derivatives market resides in blockchain’s potential to change the way the traditional derivatives market itself works.

Blockchain-Enabled Derivative Trading

While the crypto market is mainly limited to cryptocurrency-based derivatives for now, the number of derivative products offered in traditional financial markets is essentially endless, since derivatives can be pegged to pretty much any real-world asset. However, with the development of on-chain synthetic assets that mirror the performance of real-world assets, the range of derivatives being offered on blockchain derivatives trading platforms is rapidly expanding.

In traditional financial markets, synthetic assets refer to a bundle of assets – usually derivatives such as options, futures, or swaps – that mimics the characteristics of another asset when viewed in the aggregate. For instance, instead of buying a particular stock, an investor may buy a call option and sell a put option on that stock, which would achieve the same net balance as directly holding that stock for the duration of the two option contracts. By contrast, blockchain-enabled synthetic assets are digital tokens that represent derivatives and other tradeable assets being bought and sold in traditional financial markets. In many situations, these synthetic assets can offer several unique advantages over their conventional counterparts:

  • Permissionless value creation and distribution: Blockchain’s flexible, open-source nature empowers anyone to create new synthetic assets without any centralized oversight or external approval. An increasing number of platforms are offering services that seek to help users without coding experience or technical background to create and exchange synthetic assets. Most synthetic assets are security tokens offered by centralized crypto exchanges that abide by the regulations of the markets they operate within. However, blockchain technology has the potential to bypass the need for centralized third parties to authorize and facilitate the creation and exchange of new financial products — for example via decentralized exchanges (DEXs). While these innovations could reshape our understanding of what is possible within the financial services sector, some such decentralized derivatives (as well as some of the DEX platforms hosting them) might fall into gray areas in terms of regulatory compliance, which might in turn increase risk for investors trading or holding DEX-generated blockchain derivatives. That said, do remember that this article is not investment or legal advice, and is only intended for informational purposes — please consult with a qualified financial professional and do your own research before making any financial decisions.

  • Enhanced transparency and efficiency: One of blockchain’s greatest advantages lies in its transparent and immutable method of storing data, which allows all market participants to see what is happening in real time. Since variables such as an asset’s circulating supply, custody chain, and smart contract rules are available on the blockchain ledger for anyone to view, there is no need to keep manual external records of what is occurring within these markets. Further, since these records are updated in real time and cannot be readily modified, traders are able to make better-informed decisions that help reduce trade-associated risks. Additionally, blockchain networks often require minimal maintenance and upkeep relative to many of the existing IT systems underpinning the global derivatives trading market. Many of these traditional systems can be expensive to implement and maintain, compared to automated blockchain protocols which can simultaneously validate and execute transactions, store data, and secure network functions. Furthermore, the blockchain-enabled automation of trading documentation can help decrease asset prices and mitigate the risk of human error. For these reasons, many blockchain and financial services experts believe the aging network infrastructures supporting the traditional derivatives market will eventually give way to more nimble, cost-effective blockchain-based decentralized systems.

  • More access: Currently, a large portion of the derivatives market is limited to a cloistered collective of hedge funds, commercial banks, and other institutional players, many of whom charge high fees to create and enforce derivative contracts. Given blockchain’s distributed, immutable design, synthetic assets launched on a blockchain network can be easier to trade and transfer relative to their conventional counterparts. Furthermore, unlike conventional derivatives markets, synthetic assets on blockchain platforms pull their data from markets that operate around the clock using smart contract-based price discovery protocols such as decentralized oracles, which allows investors to benefit from longer trading periods, unencumbered by time zone restrictions.

In other words, blockchain-enabled synthetic assets have the ability to bring most or even all of what is currently offered in traditional financial markets into the crypto ecosystem in a way that enhances market efficiency and transparency. Several crypto projects have already made significant strides to accelerate this shift. Two notable examples are Synthetix, a protocol for creating global liquidity for a wide range of synthetic assets on Ethereum, and UMA, which allows users to stake essentially any cryptocurrency as collateral to create new synthetic assets. As decentralized exchanges (DEXs) continue to improve their offerings and take market share from centralized platforms, many blockchain and financial services experts contend that a growing number of financial instruments will migrate to decentralized markets.

The Upcoming Convergence of Derivative Trading

The global financial derivatives market plays a crucial role in providing market liquidity, creating investment optionality, and providing more ways for investors to hedge their positions. By leveraging blockchain technology to develop new financial instruments and migrate existing products to decentralized, globally accessible platforms, financial institutions offering derivatives stand to capitalize on increased market transparency and efficiency in a way that can simultaneously benefit institutional and retail investors alike.

Therefore, as the infrastructure underpinning this interconnected web of decentralized finance platforms continues to mature, the blockchain space and the legacy financial services sector are poised to converge into a more equitable, feature-rich financial ecosystem.

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