A derivative is a financial instrument whose value is derived from an underlying asset. It is an agreement between a buyer and a seller over the future price of a digital asset.
The Long Explanation
The derivative is one of the oldest forms of financial contracts to ever exist. Its history can be traced back to the antiquities markets of medieval times when it was used to facilitate trade among merchants who traded across Europe.
Over the years, derivatives evolved into a sophisticated financial tool that derives its value from a preset benchmark or an underlying asset. It is a contract signed between two (or more) parties for the purchase of an asset in the future at a price fixed today.
As is the case in the stock market, derivatives in crypto are primarily used to hedge against risk. By setting a fixed price for the asset in advance, the seller is protected against the risks associated with price fluctuations.
But derivatives have also become very popular speculative assets. Instead of purchasing an asset, a trader could bet on its future value via a derivative. For a market as volatile as the crypto market, the risk-hedging function of derivatives has been a major driver for risk-averse institutional investors.
Different kinds of crypto derivatives exist today, many of which can be traded on either traditional exchanges or centralized crypto exchanges. The first crypto derivative to be launched was Bitcoin futures which can be traded on the Chicago Board Options Exchange.
In addition to the CBOE, Nasdaq is also exploring the expansion of its suite of crypto derivatives, having first introduced crypto derivatives in 2019.
Today, most centralized crypto exchanges have a variety of derivative offerings.
A variety of crypto derivatives are available today – via a crypto exchange or as a trade between two direct parties. Some of these include:
- Futures: This is a legal contract between two parties to trade (buy or sell) an underlying asset at a specific price on a future date.
- Margins: A trade mechanism that allows traders to open positions at a fraction of the cost. The margin trader borrows to buy into a position, in order to expand his potential wins when his price prediction is achieved.
- Swaps: An over-the-counter contract between two parties to exchange cash flows at a future date according to a preset formula.
- Options: Similar to a futures contract, an options trader sets a specific price for an asset at a specific future date. Unlike a futures contract, however, the trader is not obligated to buy or sell the underlying asset when the time comes.