What are blockchain derivatives?

As the price of cryptocurrencies soared from the trough at the beginning of the year to the summer, and then gradually declined in volatility recently, the market volatility that experienced “strong winds and waves” was stronger than other investment objects of the same period. Although the recent trading volume and price gradually declined, and the drop in the price of currency made the public doubt the future of digital currency. However, a large number of investors in the market still like the high volatility of the digital currency market, which magnifies the arbitrage opportunities and investment risks and attracts a large number of investors to enter the spot market of digital currency. In order to attract more players and funds, exchanges have designed a variety of financial derivatives based on digital currency, which also meet the risk investment preference of some investors who want to pursue extreme arbitrage.

Starting from this article, I will continue to conduct research and analysis on the derivatives market of digital currency. Starting from the essence of the derivatives industry, I will try to discuss the basic gameplay of the main products, major exchanges, business models, and other aspects that need to be paid attention to in this industry.

Overview of the derivatives market

The definition of “derivative”: “A derivative is a financial contract whose value depends on one or more underlying assets or indexes. The underlying types of the contract include forward, futures, swap (swap), and options. Derivatives also include structured financial instruments with one or more of the features of forwards, futures, swaps or options.”

The above explanation is too academic. When dealing with goods in everyday life, our primary purpose is their usefulness, rather than their risk, value, etc.

But for commodity dealers in the market, for example:

Fruits and vegetables, grain, and other businesses, they are in the process of trading, still have to bear the commodity prices in different quarters, price volatility of different times, in order to reduce this risk, which in the ordinary course of business transactions, spawned a certain time period for the future of commodity contracts, dealer to control the price risk, manufacturers to ensure that the goods sales.

The derivatives market that we’re going to discuss next is all about financial products.

Financial derivatives market

Financial derivatives markets from medieval merchants fairs, to the 17th century “tulip mania” frenzied period, traders buy tulips at the stipulated price contract, to meet the various needs of the market now options, futures, and other derivatives, after centuries of development, the financial derivatives market has become one of the most popular financial products.

According to their own and contract characteristics, financial derivatives can be divided into forward, futures, options, swaps, and structured financial derivatives. Its value depends on one or more underlying assets, often referred to as the underlying assets of the contract.

Forward: a contract in which two parties agree to buy or sell a certain amount of an underlying asset at a certain price at a certain time in the future.

Futures: a contract signed by two parties to buy or sell an underlying asset at a fixed price at a fixed time in the future.

Option: a contract that gives the option buyer the right to buy or sell a certain financial asset within a specified period of time at a mutually agreed price.

Swap: A swap is a contract between two parties to exchange cash flows that they deem to be of equal economic value during a certain future period.

Since its birth, financial derivatives have been regarded as an effective tool to reduce market economic risks and stabilize exchange rate risks in international trade. Its value is based on exchange rates, interest rates, commodities, credit, equities, and other underlying assets. With the change of investors’ risk preference and speculative demand, the development of the financial derivatives market is accelerating day by day, with a wide range of products, market segmentation, and rapid growth of transaction scale.

According to the bank for international settlements, in recent years, the overall size of the global financial derivatives market is about $600 trillion, and the current spot market only about 12% of the derivatives market, including over-the-counter derivatives, the overall size is likely to reach $2000 trillion, you can see the importance to the whole financial market of the financial derivatives market.

The nature of financial derivatives

Thinking on the Nature of Financial Derivatives We first start from the basic characteristics of derivatives, including intertemporal, leverage, association, uncertainty, high risk, hedge, and speculative.

1. Intertemporal and associative:

A financial derivative is a contract in which both parties agree to trade or choose whether to trade at a certain time in the future according to certain conditions by predicting the trend of changes in factors such as interest rate, exchange rate, and stock price. The characteristics of inter-period trading are very prominent. The value of a derivative is closely related to the underlying product or the underlying variable, and the rules change. Typically, the payment characteristics of the link are specified by the derivative contract.

2. Leverage and high risk:

Financial derivatives generally only need to pay a small margin or royalty to enter into a large forward contract or swap different financial instruments. The outcome of derivatives trading depends on the accuracy of the trader’s prediction and judgment of the future price (value) of the underlying instrument (variable). The vagaries of the price of the underlying instrument determine the instability of the profit and loss of financial derivatives trading.

3. Risk hedging and value preservation:

The use of financial derivatives can effectively avoid the risk of violent price fluctuations, is an effective risk management tool, hedging enables enterprises to prevent the risk of spot prices falling during delivery, through the futures market trading with the number of spot contracts, risk hedging.

4. Speculative:

Derivatives are contracts in which one party (usually the buyer) trades to avoid risk, but what is the role of the other party? The other side takes the risk as well as the proceeds by selling the derivative contracts. The seller of a derivative transaction takes the risk to earn the income from selling the derivative, which is a kind of speculation.

Due to the characteristics of financial derivatives, the most sensitive nature for traders is: risk hedging + speculation

Because of its characteristics, the speculative function of derivatives has been infinitely magnified, from angel to devil, the trading more and more deviated from hedging to pure speculative bet, the trading model has been artificially designed more and more complex. Sophisticated trading patterns, catalyzed by greed and fraud, turned derivatives into weapons of financial mass destruction, harming companies and markets. The financial crisis of 2008, for example, destroyed CDS, which was derived from loan contracts between banks and home borrowers.

Blockchain derivatives market

With the advent of Bitcoin, blockchain technology has brought a large number of cryptocurrencies, and derivatives based on cryptocurrencies have gradually been invented and used by traders.

The derivative of cryptocurrency is the same as that of financial derivatives. The underlying asset is digital currency or index, which is the derivative related to digital assets. Financial derivatives can include digital currency derivatives, so all characteristics of financial derivatives are applicable. In addition, it should be noted that margin trading only needs to pay a certain proportion of margin to carry out the full transaction, without the need for actual principal transfer. Cash difference settlement is adopted to conduct the transaction, which has a leverage effect.

The current digital currency derivatives market is mainly divided into two categories, options and futures, futures contract products similar to traditional derivatives contracts, and various exchanges are generally, settlement and delivery time, divided into weekly, monthly, quarterly, and other mature automatic delivery, the contract can be predicted hedge market risk, also can play a role of hedging.

But the design of the product digital currency derivatives market has more risk of “gambling tools”, first of all, for the average futures contract, part of the platform support as much as one hundred times of futures leverage, digital currency spot of high volatility has been far beyond the traditional financial market, one hundred times leverage will undoubtedly high volatility into the “rough”, blowing up the risk is extremely high. The second Exchange also designed a “sustainable” contract, just as its name implies is not delivery of futures contracts, although investors can lower the barriers to entry, increase the market activity, more convenient investment institutions to enter, the cut off time, lose the essence of hedge risk, more like a “gambling tools” based on margin, blasting warehouse, warehouse.

Options contracts, which give the holder the right, but not the obligation, to buy or sell an asset at a specific price at a specific date in the future, are relatively niche and are backed by only a handful of trading platforms.

Derivatives market comparison

1. All futures contracts are settled in cash, except Bakkt futures, which are settled in physical form.

The biggest problem with cash settlement is that it affects the circulation and demand of a digital currency in the market.

In the traditional commodity futures, all physical delivery is adopted.

Although physical delivery is a relatively small part of the overall derivatives market, it is physical delivery and this potential that makes the futures price change synchronously with the relevant spot price change, and gradually approach as the contract expiration date approaches.

2. The correlation is not strong. The correlation between the spot market and the derivatives market is poor, so the role of using the funds in the derivatives market to hedge risks is weakened.

3. The hedging effect of digital assets is weakened. Due to the high liquidity of assets, there is no regular demand for spot buying and selling, and the demand for hedging is very low.

4. The risk is stronger than the traditional asset derivatives. Most of the underlying assets of derivatives themselves have higher volatility, and the high leverage tool supports them, which makes the volatility of derivatives stronger.

At present, the investors of digital asset derivatives are mainly individuals and retail investors, while in the traditional derivatives market, institutional investors account for a large proportion.

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