Crypto derivatives might be a new concept for many people. But these financial instruments actually have already seen major traction on cryptocurrency exchanges in the last year, primarily on those that are unregulated. Going forward, the derivatives market will no doubt carve out an important role within regulated exchanges as well. Let’s take a look at how this is playing out. First, let’s cover the basics:
Definition of Derivative
A derivative is a contract between to buy or sell an underlying asset or group of assets. The price of a derivative is based on the price fluctuations of the underlying asset. This could be an index, bonds, commodities, and interest rate, or specific security. Some of the most common derivatives in traditional finance include options, swaps, and futures.
By using derivatives, investors are able to potentially earn large returns from small fluctuations in the price of the underlying asset. They also run the risk of substantial losses when the underlying price moves against them in a significant way.
Derivative Markets in Crypto
Having a thriving derivatives market may be one of the most important keys to ‘gentrifying’ cryptocurrencies. In that scenario, retail and institutional investors alike are able to actively participate in a healthy blockchain system. Many consider it a strong sign that Bitcoin futures have gone over so well and experienced so much growth already. It points to a strengthening crypto derivatives market, where demand for such products is increasing significantly.
Unregulated vs. Regulated Crypto Exchanges
When we talk about exchanges that host crypto derivatives products, there are two different kinds: regulated and unregulated. Some of the most popular crypto exchanges are unregulated, which means the exchange has no governmental financial authority regulating its operations and that it’s a decentralized entity. For instance, BitMex and Binance are examples of unregulated exchanges offering crypto derivatives, and examples of regulated exchanges include Bakkt and LedgeX.
The above quote is impressive alone. But when you realize that Binance just rolled out futures in September of 2019, it’s hard to believe that in just four short months, they have achieved such numbers. Their growth in the number of users and trading volume suggests that the Binance Futures program is setting itself up as a price discovery leader for hedging risk in the derivatives market.
The second unregulated exchange we’re covering today is BitMEX. This derivatives platform was the first to introduce Bitcoin perpetual swaps. These futures contracts are also known as “inverse Bitcoin futures”. They settle in BTC, even though fiat currencies may be part of the underlying asset in the futures contract. What this does is eliminate regulatory obstacles that come into play when settling in USD or other fiat currencies.
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Regulated Crypto Derivatives Exchanges
Bakkt and LedgerX have entered the market, but are still trying to carve out their edge. Both have worked with regulators every step of the way. So it is natural that innovation is taking longer with regulated derivatives exchanges. But innovation is certainly happening. Many leaders in the space believe that there is room for them in a booming crypto derivatives market.
From their homepage, shown below, it’s clear that Bakkt is catering to traditional finance:The main goal of Bakkt is to create a secure ecosystem for institutional, merchant, and consumer level investors. As they are working directly with US regulators for compliance as they create crypto derivatives, their focus is on creating a safe place – especially one that is trusted by institutional investors.
LedgerX specializes in Bitcoin derivatives in a fully CFTC-regulated exchange and clearing facility. They offer physically-settled Bitcoin call and put options, with other derivative products in the works. Available to US residents, LedgerX provides the platform for fully-collateralized, physically settled Bitcoin options and swaps for institutional clients.
How do unregulated vs regulated exchanges compare?
The differences between these types of exchanges are clear and point directly to a non-stop year of massive growth on the unregulated end. As it is, regulated exchanges Bakkt and LedgerX are playing catch-up. For instance, Bitcoin-settled futures were approved this year for Bakkt, after several years of regulatory push and pull. But they have yet to offer that feature. With their name literally coming from the “backing” of Bitcoin derivatives in BTC, their community was not quick to embrace cash-settled futures.