The Basics of Crypto Derivatives Exchanges

They are traded on exchanges, which can offer a wide variety of derivative products, trading conditions, and even the underlying mechanics of the exchange itself.

Overview of crypto derivatives exchanges

Cryptocurrency derivatives platforms fall into two categories: centralized and decentralized. Of these two, the centralized segment is by far the largest, most liquid, most established, and with the greatest chance of being regulated. Decentralized derivatives trading is a newer market that emerged as a segment of decentralized finance and is still relatively illiquid, although it’s growing rapidly.

The key difference between the two is that a centralized exchange is run by a company where the company takes custody of customer funds and operates the trading platform using centrally managed software. A decentralized crypto derivatives exchange handles trading transactions on-chain using smart contracts that execute automatically without taking custody of customer funds.

Centralized crypto derivatives exchanges serve two primary customer bases – retail users and institutions. Many of the largest platforms might serve both audiences with offerings tailored to each specific audience. The Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (Cboe) are both examples of established institutional trading venues that have expanded into offering cryptocurrency derivatives. Institutional offerings may include services such as over-the-counter (OTC) trading or access to higher leverage.

Decentralized crypto derivatives exchanges, including dYdX, Jupiter, and Hyperliquid, predominantly serve retail markets and a niche segment of crypto-native professional users such as fund managers.

Depending on the type of exchange, the user journey will be somewhat different. Centralized exchanges require the user to open an account, submit identification to undergo a KYC check, and deposit funds (which may be fiat or cryptocurrency) to start trading. A decentralized exchange requires a compatible cryptocurrency wallet loaded with funds for trading.

Once onboarded, the trader can begin placing orders for their chosen products. Due to the nature of derivatives markets, each order must be matched, so a buy order must be matched with an equivalent sell order to be executed, and vice versa.

Types of cryptocurrency derivatives products

Cryptocurrency derivatives fall into three main categories: futures, options, and perpetual swaps.

Futures

Cryptocurrency futures are an agreement between two parties to buy or sell a digital asset for a set price at a fixed date in the future. Traders buy contracts in a particular asset if they believe the price will go up, or they sell if they think the price will go down.

The contract represents a legally binding agreement to conclude the sale under the agreed terms, so futures offer a way to guarantee a fixed price for an asset regardless of how the underlying spot market performs. Therefore, they can be used as a tool to hedge against the risk of a downturn in price, as well as to speculate on the price going up.

Options

Options differ from futures in the way the contract is structured. An option contract gives the option, or right, to buy or sell a given asset on or by a set date. The sale is concluded at the price agreed on in the option contract, known as the strike price. Unlike the futures contract, there is no obligation to execute the transaction.

The option contract may be structured for a buy transaction, also known as a call option, which allows the holder to buy the asset at the strike price. The other alternative is a put option, which gives the right to sell the asset at the strike price.

When the option holder buys or sells the asset under the terms of the option, it’s known as exercising the option. However, when the option can be exercised depends on the option type. European-style options can only be exercised on the expiration date itself and not before, while American-style options can be exercised at any point before the expiration date.

Options offer more sophisticated opportunities for speculation and hedging. However, they come with a degree of complexity, and as such, the market is still less liquid than those of futures and perpetuals.

Perpetual swaps

Perpetual swaps, also known as perpetual futures or simply perpetuals or perps, are a type of futures contract without an expiry date. Like futures, traders buy contracts to go long or sell to go short, but since the contract has no settlement date, exchanges use a funding rate mechanism to settle contracts periodically.

Every few hours, the funding rate is updated based on the deviation between spot prices and the perpetual contract price. A positive funding rate means that longs pay shorts, and vice versa if the funding rate is negative.

The lack of an expiry date makes perpetual swaps a flexible and low–barrier way to gain exposure to the price of an asset, which can be attractive for short-term traders.

Key features of crypto derivatives exchanges

There are several key features that traders should consider when choosing the best crypto derivatives exchange.

Liquidity

The key measures of liquidity on a crypto derivatives exchange are open interest, which indicates the aggregated value of open positions on the exchange at any given moment, and trading volume, which indicates the value of contracts traded in a given time frame. Exchanges with high open interest and high volume offer deeper liquidity and are, therefore, more likely to be able to find a suitable match for the order quickly, reducing the risk of slippage.

Fees

Many traders choose derivatives due to the ability to trade with leverage; therefore, fees are an important consideration. Fees are typically calculated as a percentage of the position value, so a multiple of 10x applied to a trade will also apply to the value of the fee. Fees are also payable on both winning and losing positions. Therefore, a small difference in trading fees can make an exponential difference in profitability when trading with margin and leverage.

Technology and infrastructural capabilities

The speed of a matching engine and the ability of an exchange to continue trading operations even during periods of high volatility are a key feature of the best crypto derivatives exchanges. During volatile periods in the market, many traders are trying to enter and exit positions and outage incidents have been commonplace in the past. In such an event, traders can become trapped in losing positions that they cannot exit and risk becoming liquidated. Robust architecture and proven technological capabilities during busy trading periods should be an important consideration for any trader.

Other factors when choosing a crypto derivatives exchange

Several other factors may also play a part in choosing a crypto derivatives exchange. Some exchanges offer features such as analysis and charting tools, which may appeal to traders who rely heavily on technical indicators.

Security is another consideration. Exchanges should be able to demonstrate a solid record of protecting customer funds using bank-grade security protocols and with appropriate measures in place for responding to incidents, such as insurance.

Exchanges may have variations in policy around liquidations or how they handle losses – for example, many operate an insurance fund that can protect winning traders if a losing trader cannot make good on their obligations. However, in the worst case, an exchange may operate “clawback” policies that allow it to socialize losses among traders in the event of a liquidation that would otherwise cause the exchange to go bankrupt.

Tips for selecting the right exchange

The features above provide a helpful checklist for things to consider when selecting a crypto derivatives exchange. Exchanges are competing in an increasingly competitive market, so it’s worth spending some time researching the instruments on offer and the trading conditions to make sure they fit any chosen trading strategy.

Although offers of high leverage and introductory deals on trading fees may be superficially attractive, factors such as deep liquidity and robust infrastructure will ultimately make for a more stable and enjoyable user experience and will better support trading needs in the longer term.

Crypto derivatives exchange essentials

• Crypto derivatives are traded on centralized or decentralized exchanges, with the bulk of liquidity still concentrated in the first category.
• Types of crypto derivatives products include futures, options, and perpetual swaps.
• Traders assess the suitability of exchanges based on factors such as the depth of liquidity, fees, and technological capabilities, among others.