Derivatives as an Instrument: From Ancient Times to Modern Trends
The abundance of terms available on the financial market is as scary as it is confusing for the average uninitiated trader looking to start making a fortune on their assets. Starting traders who were used to the cozy and familiar confines of the checkout at the local grocery store will find themselves on a wild roller coaster ride the moment they step into the crazy world of financial instruments. But the financial devil is not as terrifying as he’s made out to be.
Futures, options, forwards, swaps, and so on are some of the terms that threaten starting traders with shattered dreams and torturous nightmares, drenching their backs with cold sweat at the sight of the ominous Japanese candles and convoluted geometrical figures on frightening charts. But it’s really not that terrifying, as the theory of virtually every single financial instrument is tightly knit into the fabric of everyday life. The simplest and most common instrument that every single person who has ever watched even a minute of financial news has heard of is the basic derivative.
“Derivative” is just a fancy name for a contract whose value relies on a large variety of instruments on the financial market better known as stocks, bonds, commodities, currencies, interest rates, and other variables. In fact, there are derivatives on virtually anything imaginable, and a very simple example can be betting, where the profit of one party in the contract is dependent on the outcome of a certain event.
Derivatives can be purchased OTC (over the counter) or on stock exchanges. It’s also a common practice for most derivatives to be purchased through brokers. The sight from CNN of a ruffled — up man in a white shirt and glasses with a computer tablet in hand constantly staring at a large number of screens at the New York Stock Exchange is as common to many viewers as morning coffee. And those people who constantly monitor derivative prices for their clients are brokers.
The Long Way
The history of derivative contracts goes back to ancient times. The instrument has come a long way since its primitive form as a verbal agreement between merchants seeking to attract funding for their ventures. One of the oldest known examples is that of Babylonian merchants, who drew up risk-sharing agreements and received loans for their caravans. The loans could be repaid if the goods were successfully delivered and sold in distant lands. The Templars further developed loans, as they used to give money to pilgrims traveling to the Holy Land and would later charge interest on the funds. The Conquistadors were similar, as they signed futures contracts with the Spanish Crown and wealthy Spaniards for their ventures into the New World, where the booty and plunder pilfered from the hapless natives would serve as the payoff. The first modern derivative contracts appeared on the London Stock Exchange in the 1830s, and they entered into practice in the United States in the 1850s.
In the cryptocurrency world, the first derivatives were issued on BTC as Bitcoin futures, and options are still successfully traded on the Chicago Mercantile Exchange (CME Group), the Chicago Board Options Exchange (CBOE), and a number of cryptocurrency exchanges, in particular BitMex, BitFinex, OKCoin, and others.
Types of Derivatives
There are various types of derivatives available to traders. Most of them operate on the same principles with several differences tailored to the specific requirements the traders put forward.
Forwards
A forward contract is a private agreement between two parties with an obligation to exchange an asset at a set price at a future point in time. Under a forward contract, the buyer and seller can customize the terms of the deal, its volume, and the settlement process. An important aspect of forwards is that more than two parties can be involved in the contract to offset the risks.
Forwards are not traded on exchanges but OTC and therefore face the problem of a lack of liquidity. Counterparty risks — the risk that one of the parties will not be able to fulfill their obligations — are an inherent problem with forwards. Therefore, the next stage in the evolution of forwards is futures, which solved these challenges.
Futures Contracts
Futures contracts are one of the most common types of derivatives and are similar to forwards in nature. Futures are traded on exchanges as standardized forms. This type of derivative is usually used by traders to hedge risks or speculate on the prices of various assets. A classic example is speculations on the price of oil, gold, the US dollar, or the British pound.
The expiration of futures contracts does not necessarily require the delivery of the asset, since many derivatives are settled in cash. Basically, the trade gain or loss is a positive or negative cash flow for the trader. Interest-rate futures, stock-index futures, and many more are also called cash-settled contracts.
Swaps
Swaps are a derivative under which it’s possible to swap one kind of cash flow for another. For example, it’s possible to switch from a variable interest-rate loan to a fixed interest-rate loan or vice versa. Such derivatives are very popular for offsetting risks and are extremely useful when dealing with currencies.
Options
Options are a rather free form of contract between two parties. The buyer of an option has a right but not an obligation to buy or sell the predefined amount of the certain asset at or before the predefined date. The seller of the option must fulfill the transaction if the buyer decides to execute it. Options are commonly used for hedging or price speculation on assets.
Opinions on Derivatives
The opinions of market specialists on derivatives vary dramatically, as many herald them as the be-all end-all of the market, while others criticize them for excessive volatility and other market troubles.
Proponents of Bitcoin futures claim that their arrival will help stabilize the market, thus civilizing the nature of trading for the entire market. Another important argument in favor of derivatives with crypto assets is the trust factor: Crypto enthusiasts are certain that the introduction of such instruments on regulated and reputable exchanges will help garner trust from institutional investors and attract them to the market of crypto assets, thus generating liquidity and minimizing volatility. In addition, when trading Bitcoin contracts, the trader incurs no risks for storing and transporting the underlying asset, which is a great advantage for traders worldwide.
“With every company, exchange, or investor who trades anything cryptocurrency-related, regulators feel further pressure to regulate them more fairly. The current “no man’s land” crypto is in can’t last forever, and if the adoption of derivatives helps, then this is a clear benefit.”
William Barlett
“The Effect of Derivatives on Crypto” at Hacked
On the other side are those stating that derivatives have their limitations, as they are quite difficult to valuate. One of the difficulties with derivatives is that traders can trade them without actually owning crypto assets, and therefore their mass adoption is rather doubtful. Bitcoin futures are one example, as owning Bitcoins is not necessary for trading instruments based on them.
The most recent criticism was directed at Bitcoin futures, which initially caused the value of Bitcoin to jump but eventually failed to maintain the high price in the long run. The failure of Bitcoin futures contracts to have any serious long-term effects on the asset’s price can be attributed to the immense news background determining the price of such an asset, once again proving the limitations of derivatives on classical exchanges and their amalgamations on the crypto market.
Zennon Kapron, managing director of Shanghai-based consulting firm Kapronasia, said, “It’s rare that you see something more volatile than Bitcoin, but we found it: Bitcoin futures.”
All things taken into account, the option of having derivatives is better than not having them, since they are set to attract large institutional investors to the crypto market, and that in itself is an important development that will lead to an increase in liquidity.
The Xena Exchange Approach
Trading is an art form, but there are plenty of techniques and ways of streamlining and smoothing out the learning curve necessary to becoming a true master.
Xena Exchange offers beginner traders a hefty repertoire of instruments for making trading convenient, profitable, and full of variety. In addition to the spot trading engine, the derivative contract trading engine is also live, with BTC perpetual contracts as the first contract. The order types present on Xena Exchange suit a variety of needs and tastes that fit the strategies of traders.
In addition to launching derivative contracts on the highly anticipated GRAM token on February 27, Xena Exchange also plans to launch contracts for the BTC volatility index and mining complexity index. Contracts on Xena Exchange never expire, have up to 100x leverage, possess the ability to go short, and have a safe liquidation option, which means the leveraged positions are never liquidated on spikes until the price is confirmed.
Xena Exchange offers a lot that beginner traders can use in taking their first steps to make sense of financial instruments and participate in the trade operations taking place on the crypto market. It’s high time to start learning, since the best time is right now, when the crypto market is still developing, and becoming a master early on is the best way to make headway into the future. And the place to start is Xena Exchange!
Tally
The world of finance and trading is not that scary if properly explained. In fact, the world of trading is a logical reflection of many of the situations we encounter in daily life and are already used to. These situations simply acquire different titles and applications in the world of trading.
Xena Exchange intends to offer its users a wide variety of instruments so they can start trading freely and safely on the market and is determined to attract new participants by popularizing the trade of crypto derivatives.
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