By Jean Miao, Co-Founder of MCDEX
With DeFi growing faster than anyone imagined, it’s easy to get lost in the whirl of platforms, options, and trading types. It seems as though a new opportunity to play the crypto market presents itself every day. However, one of the most interesting and dynamic ways to engage with the DeFi market is through derivatives trading – but why is that? What exactly are crypto derivatives, how does the trading work in simple terms, and why are people saying it is so important to the future of crypto? Let’s delve into all of this and look at the basic facts of crypto derivatives.
Is Everything Derivative?
Crypto derivatives are the same thing as derivatives in the traditional finance (TradFi) markets – a secondary contract that represents the derived value of some other asset. Of course, since we’re talking about a crypto derivative, then the asset would be a cryptocurrency, like Bitcoin or Ethereum. These derivatives are utilized for two primary trading functions: speculating and hedging.
Compare this approach to the more familiar spot market model of trading where one must already own or want to purchase a crypto asset directly to enter a trade, and you can see the first major difference that derivatives represent. In spot market trading, a trader only makes money when the price of the market price of the asset they are holding goes up. If the price drops while the trader is holding that asset, they lose money. This is a standardized form of trading everyone is familiar with – you have to own something and depending on the value of that asset as the market changes determines what the value of your holdings is – pretty simple!
A Bitcoin derivative, on the other hand, can allow people to trade on derivatives of a cryptocurrency without ever having to hold the asset in question – no one involved in the trade must own any crypto to make or lose money.
How Can We Be Derivative?
Now that we understand what a crypto derivative is we can start utilizing them ourselves by firing up our favorite DEX and trading! Let’s go through a hypothetical trade, so we can see how this basic idea of hedging and speculating is actually put into practice in a trading environment.
To start our fictional derivatives trade we see the price of BTC is $500 (yes, five hundred, let’s keep the math simple!) and we think that price will go up. However, someone else thinks it will go down. You want to speculate, while someone else wants to hedge their bets – well then, you and the other party would sign an agreement maintaining that after a certain amount of time, depending on how the price of BTC moves, one of the traders in our scenario will have to pay the other the difference in the price movement. If BTC rises to $600 by the time the contract is settled, the opposing trader will owe you $100 – the difference by which it went over your threshold of $500. However, what if our luck turns and the price of BTC drops to $400? Well, then the inverse applies, and we would owe $100 on the contract.
Now why would anyone want to engage in this type of trading? It almost feels like you’re betting on a horse down at the track! Well, for a few reasons. Derivatives trading opens a whole host of market options, while also helping to mature the entire market by way of some of the dynamic effects inherent to any market that offers it as an option.
How Does Offering Derivatives Help DeFi Continue to Grow?
Derivatives trading plays a vital part establishing crypto as a formally accepted asset class. It brings modern options of TradFi market traders to the crypto world and provides a more comfortable entry point for retail and institutional investors who are still, for whatever reason, unsure if they want to directly hold a volatile crypto asset. This freedom for diversification helps to mitigate the risk associated with highly speculative markets and attracts more types of traders and investors.
This option makes the entire market more liquid, as people are more apt to put money into it. The more liquid any given market tends to be, the less risky it seems, as positions can be opened or closed more swiftly, allowing for more nimble market moves. Increasing market liquidity also inherently lowers transaction costs as traders and investors will experience less “slippage,” that is, less of a difference between what they think something is worth and what it is actually worth in the time it takes to close a contract in the market. This all creates a snowball effect that continues to attract more traders, making it easier to find people that land on both sides of the speculating and hedging scenario.
This also leads us to the concept of “price discovery” – which is just a fancy way of saying you can trust a market to provide you accurate pricing on whatever assets are in play. A good oracle – a mechanism that pulls price data – engenders trust in traders because they can be assured that all the information they’re using to make trading decisions is correct and up-to-date. This creates a more accurate, transparent, efficient, and agile market for traders and investors to engage in.
Professional traders are always concerned about their overall exposure to risk. Without a proper derivatives market, professional traders are left with less ways to protect their portfolios from unexpected risk, which just makes them less likely to engage the market. As DeFi continues to evolve and DEXs continue to add necessary trading features such as derivatives trading as a standard, more diversity will exist in the crypto markets, and that rising tide will continue to lift all boats.
Jean Miao is a co-founder at MCDEX.