Crypto derivatives as financial guarantees boost up investment attractiveness, and hence the demand for the underlying asset and its price
Introducing cryptocurrency futures to traditional stock exchanges and other platforms has become one of the hottest topics of discussion recently. American CME Group, the world’s largest commodity derivative exchange, Man Group, an investment fund, and the Swiss bank Vontobel have announced the start of bitcoin futures trading. In the present article, CDER.IO experts will try to explain what derivative financial instruments are and how futures affect the cryptocurrency rate.
What are conventional futures?
Futures are an obligation to buy or sell a certain asset (it is called an underlying asset) at a certain price on a specific date in the future. Each futures contract is defined by the amount of the underlying asset (for example, number of shares), the contract execution date (expiration date) and, of course, by the price (strike price) which the buyer agrees to pay for the underlying asset, and the price the owner wants to sell it for.
Therefore, the seller undertakes to sell a certain amount of the underlying asset in the future at a certain price, and the buyer agrees to buy it at a certain price in due time. The transaction is secured by the exchange, which takes insurance deposits from both participants of the transaction.
What are cryptocurrency futures?
Let’s first analyze the concept of futures, or, more broadly, a derivative, i.e. a derivative of a financial instrument. A derivative is a financial contract between parties based on the future value of the underlying asset. This contract has certain conditions for its existence and execution, the main ones being the price of execution and the duration of the contract. Any goods or services can act as underlying assets. In our case, bitcoin or any other cryptocurrency is the underlying asset. Thus the underlying asset is the main difference between crypto and conventional futures.
Futures (futures contracts) are the most common form of derivatives. According to the terms of such fixed-term contract, its holder undertakes to buy or sell a certain amount of the underlying asset at a fixed price in a certain timeframe. Futures can be sold and purchased before the expiration of their validity, and in order to run these transactions, you do not need to pay the full value of assets set forth in the futures contract.
Only a part of the full value of the transaction is pledged for the right to own futures; this is a so-called initial margin.
How cryptocurrency futures work
A cryptocurrency futures contract is an obligation to sell or buy a certain number of bitcoins at a certain price before the expiration of the contract.
The initial margin, which is considered to be the price of the futures, can only reach 10–15% of the entire transaction amount. In this case, the “leverage” effect occurs, and market participants have the opportunity to obtain a relatively large income by making small investments.
Throughout the life of the contract, you can sell or buy futures, and their price may differ significantly from the price of the underlying asset. Depending on the price of the underlying asset in the futures contract and the price of the asset in the market, you can benefit not only from the growth of prices, but also from their fall.
With the right analysis, any change in price can bring income to a trader, as long as there are buyers and sellers of the futures contracts he needs.
Large exchanges, such as CME, set quite a high market entry threshold; one can trade in smaller amounts by concluding an agreement with one of the brokers. For example, in the specification for prospective bitcoin futures, the CME sets the amount of one contract at 5 BTC (currently it is worth about $ 40,000). The minimum number of contracts for the transaction and the amount of collateral for the contract have not yet been established.
How futures affect exchange rate and cryptocurrency market
Crypto derivatives as financial guarantees boost up investment attractiveness, and hence the demand for the underlying asset and its price. It means there is a potential growth of the global demand for cryptocurrency and market liquidity. Given the limited resource and expected emission of “digital gold”, these factors can increase the price and, at the same time, reduce its volatility. This will make cryptocurrency even more attractive for long-term investments.
However, it cuts both ways, and introduction of cryptocurrency to traditional markets carries risks. After all, unlike classical trade, that is, direct exchange of cryptocurrency for the US dollars and other fiat currencies, derivatives can push the price both up and down. This provides a wide range of possibilities for market manipulations and can both raise and drop the price of any cryptocurrency.
For example, if large CME traders open billion-dollar deals, speculating for a fall of bitcoin, then panic would break out at the crypto-exchange markets, and traders will start to massively discard bitcoins, while margin trading platforms will be opening “short” deals or “shorts”. This will cause a completely out-of-control collapse of the price — in fact, bitcoin does not have a “bottom mark” and its share in the real economy is little to none.
Despite the optimism of large holders of cryptocurrency, speculators, armed with derivatives and large stocks of liquidity, can easily decrease the price multiple times, even for a short time. This means that the introduction of cryptocurrency futures on large exchanges should be treated with caution; one shall not expect an explosive and continuous growth. cryptocurrency has yet to win a legal reputation among institutional investors.
Turnover of futures trading will increase, and professional investors will burst the bubble, bringing reason back to the financial markets. In reality, everything is bound to be more complicated. There is no doubt that cryptocurrency derivatives market will grow bigger and more liquid than the cryptocurrency market — this is the essence of futures and options. For instance, the conditional value of gold derivatives issued for the end of June is around $376 billion, which is 10 times higher than the cost of 953 tons of gold, purchased during this quarter. But it’s more than just the market scope. As this liquidity is supposed to aid in pricing, the futures reflect the spot market at the same rate as the reversal processes. The derivatives market would attract either more sellers who go short or those who go long. This could result in an increase in prices, especially because investors will be coming to cryptocurrency market from much bigger markets.
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