THE FUTURE OF OUR FINANCIAL SYSTEMS: CRYPTOCURRENCY
One of the main points of difference between cryptocurrency and traditional financial assets is creating derivatives markets around crypto. However, while this creates some massive opportunities for crypto investors, it also comes with a long list of risks that need to be addressed. This blog post will cover everything you need to know about cryptocurrency derivatives and the impact they could have on the market.
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A small introduction to derivatives
A derivative is a financial security with a value dependent upon or derived from an underlying asset or group of assets. The derivative itself is a contract between two parties, usually referred to as the buyer and seller of the derivative. These assets are typically a stock, bond, currency, or market index. The value of the derivative will change as the underlying asset changes.
Derivatives are used for essentially two reasons: hedging and speculation. Hedging means that you’re reducing your risk by offsetting it with another investment. Speculation means that you’re betting on the price of something going up or down — hopefully making a profit in the process. Examples of common derivatives include interest rate swaps, spot price swaps, options, futures, bids and offers, and more.
How are crypto derivatives different?
When you buy a commodity derivative, like an oil future, you are making a bet on the price of a commodity. When you buy a crypto derivative, you’re making a bet on the rise or fall of the underlying asset. In the case of BTC futures, you are betting on the price of BTC going up or down.
In other words, you would hold onto your Bitcoin until the price goes up or down (like the hedge fund manager or retail investor would)
You can create a forward contract if the price of commodity changes (this is known as a call or put option). As long as the option has a strike price equal to or greater than the current price of a commodity, you can return the same amount of money — minus the premium or commission — in the future for a fixed amount of time.
What makes crypto derivatives dangerous?
Cryptocurrency derivatives are risky because they are highly volatile and unregulated, so they’re subject to market manipulation. If you don’t understand what you’re investing in, you could lose a lot of money. Initial investments into Bitcoin are risky due to its unregulated price and high risk of collapse. Bitcoin is akin to a wildcard asset.
Unlike investment options like stocks or bonds, Bitcoin is not tracked by any central authority. The users value it, and each user can have earnings dependent on the value of Bitcoin. Speculators buy up Bitcoin because it spirals up or collapses based on user demand, and this triggers the profits without the need to own it.
The coming crash of the derivatives market
For the past ten years, central banks have been flooding the world with cheap money by creating massive amounts of credit and other forms of debt. The surplus capital has been loaned out to many industries, and it has produced a derivatives bubble of epic proportions. We’re now at the point where this derivatives bubble has become so large that it dwarfs the entire world economy.
Today, almost everyone is using a derivative. That means that you have a complex web of companies and people selling you contracts tied to the price of Bitcoin, Ethereum, and some altcoins. This is a big problem because these derivative products are not backed by anything. They’re bets on the future price of these assets. And no one knows what those future prices are.
Most companies either have the privilege to hedge with huge spreads or pay considerable amounts to hedge. Both of these lead to huge losses and make no one other than the big Wall Street banks really financially happy.
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