The first experience modern laymen likely had with derivatives involved the Enron collapse and all the associations that came with it. As a result, derivatives have acquired a largely unearned reputation as something dirty, paper-shuffling disguised as honest work or investment.
The truth is much different. Derivatives serve a valuable function in financial paper markets, and they’re making inroads into the ever-expanding and always complex cryptocurrency world.
What Are Derivatives?
As their name suggests, derivatives are financial securities that are based or tied in some way to another asset. That is, their value and behavior are derived from the base asset or assets. They take the form of a contract between at least two parties, centered on the assets in question, and priced according to fluctuations in the price of that base asset. The majority of derivatives are sold on an over-the-counter, unregulated basis, although there exists a significant standardized derivatives market on exchanges.
Risk is one of the key features of derivatives, both from a management standpoint and an opportunity standpoint. At their heart, derivatives provide market players with a vehicle for transferring their risk to another party in a sort of hedge. These risk-management agreements can create chains and webs that can cascade out of control if one or more parties default. The most famous recent example of this occurred as a prelude to the 2009 Great Recession, when over-the-counter swaps in the lending and housing markets began to fail. The result was widespread chaos and a deep recession, all predicated on the uncontrolled growth of selling risk.
It’s perhaps easy to see, then, why derivatives invite a sideways glance from casual investors. The 2015 movie “The Big Short” and the 2010 book it was based on are largely the tale of credit default swaps – a derivative product – run amok.
Cryptocurrency markets already suffer from a bad rap. In addition to the risks associated with unregulated markets, like scams and pump-and-dump schemes, the technological complexity of the market – and its participants – make hacking a serious concern. Then there is the fundamental novelty of the whole system. Very few people predicted Bitcoin’s meteoric rise, and guesses are all over the place concerning whether prices as a whole will rise, fall, retreat, consolidate, or collapse. Crypto is a bubble one day, the very crest of the wave of the future the next.
Making accurate predictions in the cryptocurrency sphere is tough and risky. Derivatives offer a level of insulation from the raw heat of the market and an opportunity for more players to get involved.
How Are Derivatives Making Waves in Crypto?
Several big names have recently announced their intentions to offer derivatives with crypto coins as their basis – among them Cboe Global Markets, TrueEx, and Goldman Sachs.
This is big news for the crypto sphere, if only tangentially.
A well-developed paper market for cryptocurrency indirectly increases the liquidity and volume in the base asset, as more and more diverse players get the opportunity to dip their toes in.
That’s good news for everyone that isn’t Bitcoin, Ethereum, or Ripple. The top three volume mega-coins currently enjoy a level of respectability that attracts institutional money. This is, in part, a feedback loop. Greater volumes and institutional investment keep volatility tamped down, which, in turn, drives greater volumes and institutional investment. Financial tools for managing volatility in lower-volume coins bring more investors to the table, boosting volume and further reducing volatility. Altcoins stand to gain from that same feedback loop.
Cryptocurrency is a playground for risk-takers, and a derivatives market allows players with risk-management experience to enter the sphere and potentially reap big profits, while simultaneously lowing the risk factor for the market as a whole.
That’s not to say that risk is going away. In fact, players entering the crypto derivatives market are being advised that they are entering dicey waters by the United Kingdom’s Financial Conduct Authority.
In an open letter to investors, the authority warns that some crypto derivatives, specifically contract-for-difference (CFD) deals and financial betting spreads, carry an unusual amount of risk due to crypto price volatility, leverages as high as 50:1, associated charges, and relatively opaque pricing.
“A cryptocurrency is a virtual currency that is not issued or backed by a central bank or government. They have experienced significant price volatility in the past year which, in combination with leverage, places you at risk of suffering significant losses and potentially losing more than you have invested,” the authority wrote. “Cryptocurrency CFDs are an extremely high-risk, speculative investment. You should be aware of the risks involved and fully consider whether investing in cryptocurrency CFDs is appropriate for you.”
Cryptocurrency’s very gray regulation zone also plays to the advantage of the derivatives market, as most over-the-counter derivative products are unregulated, anyway. In other words, this is familiar territory for over-the-counter purveyors of more traditional derivative products. What imaginative products those can be, too – at least one provider offers derivatives based on the weather.
While this is also flagged by the Financial Conduct Authority as a reason to be cautious when entering crypto derivatives markets, it might have an unintended consequence – attracting additional government regulation.
Following the high-profile credit and housing market collapses and the subsequent bank bailouts, U.S. regulatory agencies have been keeping a close watch out for potential new troublemakers. Cryptocurrency has only attracted marginal interest, so far. It is not even clear that all cryptocurrencies could or would be treated as securities by the U.S. government in the event of further regulation.
But a well-developed paper market tends to attract attention, and that attention could lead to greater government involvement in the crypto sphere. Purists may balk at this, but it’s almost guaranteed to reduce some of the risk and volatility in the market. It might also have a calming effect on nervous traditional investors. When they step into the crypto pool, they can take comfort in knowing that a governmental lifeguard is nearby.
A Developing Market
All markets experience growing pains, and cryptocurrency is no different. The speed with which cryptocurrencies moved from theoretical white papers to the headlines of the Wall Street Journal greatly outpaced the ability of traditional market players, institutions, and government agencies to keep up.
The eye-popping sums of money now being tossed around in the crypto sphere could never have gone unnoticed for long. Banks are paying attention, as are government regulatory and tax agencies. Now, paper market players are finding an appropriate vehicle for their financial tools in crypto. In a way, crypto seems to be the ideal over-the-counter derivatives product – high risk, high potential gain, little to no regulation, and low current liquidity, leaving plenty of room for growth. There’s no shortage of coins to bet on, either. The last count on Coin Market Cap was 1,610 – and that list is far from comprehensive.
It’s unclear exactly where cryptocurrency derivatives will take the market. It is clear, however, that an active paper market will introduce definite changes. It remains to be seen whether those changes are catastrophic, as they ultimately proved to be for mortgages, or whether they’ll help to tame the wild crypto market.