Comparing Traditional and Cryptocurrency Derivatives

Derivatives are a type of financial contract that derives value from an underlying asset (like gold).

They are used by more advanced traders to gain exposure to assets without directly purchasing the underlying since they offer benefits such as leveraged trading and the opportunity to set up sophisticated strategies to optimize profits and hedge risks.

The assets underlying traditional financial derivatives are the same assets traded on financial markets – stocks (like Apple or General Motors), commodities (like gold or oil) and bonds. In general, the more liquid the market for a given asset, the higher the demand will be for derivatives on that same asset.

Derivatives can be classified by contract type. For each type, there is always a contract seller (who may also be the contract writer) and a contract buyer.

A future, or forward, is a contract for the future sale of a given asset at a fixed price on a set date. The obligation to conclude the sale is binding; however, the contract can specify settlement in cash rather than the asset itself. Futures are typically standard contracts traded on exchanges, while forwards are more customizable instruments traded over the counter between institutions and enterprises.

An option is a contract that conveys the right, but not the obligation, to buy or sell a particular asset for a fixed price, known as the strike price, on or before the contract's expiry date. Options can be traded on exchanges or over the counter.

A swap is a contract for the financial exchange of cash flows or liabilities between two entities. They are only traded as over-the-counter instruments between institutions and corporate entities.

Cryptocurrency derivatives comparison

The headline differences when comparing derivatives markets are the types of underlying assets and the types of derivatives contracts to trade.

ryptocurrency derivatives are financial instruments tied to the price of a cryptocurrency, with Bitcoin (BTC) and Ethereum (ETH) being the most common due to their high liquidity and widespread adoption in the market.

Cryptocurrency derivatives include futures and options like traditional markets, whereas swaps are not typically used. However, the crypto markets originated a new type of derivative called perpetual futures contracts, or perpetuals. These contracts don’t have an expiry date; instead, they settle periodically based on a funding rate that reflects the delta between the spot market price and the contract price.

Key similarities and differences when comparing derivatives markets

There are several other differences between traditional financial vs cryptocurrency derivatives.

Regulatory landscape

Most types of derivatives trading are regulated by financial authorities, with strict penalties for operators who don’t comply. This can include assigning partial responsibility for trading risk to brokers or issuers of derivatives contracts.

While some cryptocurrency derivatives trading is regulated or compliant, crypto they are traded on largely unregulated markets. While the centralized markets are now subject to regulations such as the FATF Travel Rule, requiring a minimum level of Know-Your-Customer and anti-money laundering checks, it’s still commonplace for decentralized exchanges to operate without such measures. While regulated markets don’t offer any protection against trading losses, they can protect traders from the worst effects of bad actors.

The offer of cryptocurrency derivatives to retail traders is outlawed in some markets, such as the US.

Liquidity

Traditional derivatives markets, often centralized, are known for their deep liquidity and efficiency, which allows traders to execute large trades with minimal slippage and tight bid-ask spreads.

In the crypto markets, liquidity is limited to BTC and ETH derivatives. However, even for those instruments, liquidity is fragmented across multiple exchanges and trading platforms. Trading crypto-assets is, therefore, likely to come with more slippage and larger spreads than traditional derivatives.

It’s also worth bearing in mind that liquidity can be a function of available leverage, implying that the market may not be as stable as it seems. A sudden market crash could result in mass deleveraging, resulting in a dramatic loss of liquidity.

Risk and volatility

The volatile nature of the cryptocurrency markets makes them attractive to many traders since they offer plenty of speculative opportunities. However, volatility comes with some amount of risk since the market can quickly move against a profitable position.

Several factors can also conspire to increase risk. As mentioned, low liquidity can create slippage, which further eats into trading profits. Cryptocurrency derivatives trading is often also available with high leverage, which can go up to as much as one hundred times the trader’s available collateral or even more.

High leverage can amplify the risk of losses as well as gains, so should be used with caution. Experienced traders use risk management techniques such as trading with only a small percentage of their portfolio and planning the entry and exit points for a trade.

Market access and participation

Most traditional derivatives markets are exclusively comprised of institutional and professional traders due to the need to meet certain criteria, such as minimum capital requirements and an understanding of the markets.

In contrast, many cryptocurrency derivatives markets are accessible to, and heavily comprised of, retail traders.

Centralized vs. decentralized

All traditional derivatives trading, and most cryptocurrency derivatives trading, takes place on centralized marketplaces, where the trading software and associated infrastructure are managed by a single entity. Funds must be deposited on the exchange or with a broker to be able to trade.

There is a relatively small DeFi segment of decentralized cryptocurrency derivatives traded on platforms, including Jupiter and dYdX. Decentralized derivatives are traded as on-chain instruments using smart contract infrastructure to manage transactions via self-custodial crypto wallets.

Traditional vs. crypto derivatives essentials

• Traditional derivatives, comprising futures, forwards, options, and swaps, are issued based on traditional assets, including stocks, commodities, and bonds.
• Cryptocurrency derivatives, comprising futures, perpetual futures, and options, are issued based on crypto-assets, most commonly BTC and ETH.
• Crypto derivatives markets tend to be less liquid, more volatile and risky, and with a less regulated status than their traditional counterparts.