What are crypto derivatives?

What are crypto derivatives?

Crypto derivatives are financial products where payoff (cashflow you get at maturity) is a formula of a price of crypto coin or crypto-related index (e.g. BTC price or BTC volatility index) . Crypto derivatives can be listed on exchanges (e.g. deribit or CME) or OTC ( over-the-counter) which are used primarly by institutions. Here we will consider only listed crypto derivatives.

What are the three common types of crypto derivatives?

the most traded crypto derivatives are the following:

1. perpetual swaps.

Crypto perpetual swap is the most traded crypto derivative.
perpetual swaps( also called perpetual futures, or perps) are most similar to usual CFD (contract for difference) products usually provided by common FX brokers. Holding a perpetual swap is more or less equivalent of holding underlying coin with leverage. perpetual swaps do not have a maturity date.
this is the most liquid type of crypto derivative.

2. crypto futures

Crypto futures have a maturity date on which you receive payoff of (S_T-S0) e.g. difference between price of underlying coin on maturity date and price of that underlying coin on purchase date. this is roughly equivalent of holding underlying coin with leverage, with an obligation to settle contract on maturity date (unlike perps)

3. crypto options

Crypto options also have a maturity date on which you receive payoff of max(S_T-K,0) e.g. you receive
difference between price at maturity date and strike price of the option , but only if it is positive.

The example formula of max(S_T-K,0) is for the call option . for put options formula payoff is max(K-S_T,0) e.g. you receive positive part of Strike minus maturity price of the underlying coin.

crypto options can be linear and inverse. inverse crypto options (e..g original crypto options listed on deribit) will pay payoff in crypto , while linear option will pay payoff in stablecoin (e.g. USDC/USDT)
margin of linear options is usually also calculated in stablecoin , while inverse margin is usually in underlying crypto coin.

how crypto derivatives are used:

crypto derivative usage is similar to that of financial derivatives: speculation or hedging and market making.

Example usage of speculation:

trader speculates that BTC price will be higher on 31 december than today.
he can buy (=go long) BTC perp, and wait 31 december. if price went up and was always higher than liquidation price up until 31 december . he will receive the difference between price on 31 december and purchase price multiplied by leverage. during lifetime of perpetual swap he would pay/receive funding payments (every 8 hours or 1 hour, depends on exchange) .

in case he does not want to bother with funding payments, he can instead buy crypto futures with maturity date of 31 december. in this case there are no funding payments and he would receive (S_T-S0)* leverage on maturity date, conditional on BTC price always being above his liquidation price.

in case he does not want to bother with the risk of being liquidated due to leverage, he can instead buy crypto call option. in that case there are no funding payments, and there BTC price can dip below any threshold before 31 december, he would still receive the payoff of max(St-K,0) on the maturity date.
this convenience is not free and on going long /buying the call option he has to pay option premium.
in case of perpetuals and futures, there is no any option premium to pay. (e.g. there is no cashflow at purchase time)

in case he speculates BTC price will go down, he can 1.sell perptual (= go short) 2. sell BTC futures 3. buy put option .

example usage of hedging:

Let’s say BTC miner wants to secure dollar profit of mining bitcoin for Year end of 31december. in that case upon receiving the BTC mining reward, he can enter short position on inverse BTC future with the maturity date of 31 december. if he uses his newly mining BTC reward as a margin, without using leverage, he can guarantee the BTC price as of the date of mining . even if BTC price went down after mining, the futures payoff will compensate for the difference. in case BTC price goes up , miner will not benefit from that appeciation. in case he does want to profit from possible BTC appreciation before 31 december, instead of selling futures contract he can buy put option. in this case if BTC price is lower on 31 december, long put option will compensate for it, but in case BTC price is higher, put option will expire worthless , but miner can sell his original BTC reward with higher price.

Crypto derivatives vs traditional financial derivatives

The difference with traditional derivatives is that in crypto settlement on crypto exchanges has usually much shorter time (seconds) instead of days. Traditional finance exchanges usually do not offer perpetual swaps and inverse instruements. The disadvanage of using crypto exchanges is that usually they have higher counterparty risk than traditional equity derivatives exchanges.

Another difference is the interest rate. in traditional financial derivatives pricing one can use liquid interest rate markets to determine interest rate used in formulas to price options and futures. in crypto there is no yet liquid interest rate market, thus crypto exchanges usually calculate implied volailities and other greeks using 0 interest rate e.g. pricing crypto option with underlying being futures instead of spot)

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