Crypto Derivatives

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“If any one owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for the year.” 

The above is the 48th law of the Code of Hammurabi. Derivative traders would describe it as an early form of an option, a species of financial derivatives. Under the Code of Hammurabi, Mesopotamian farmers held an option which allowed them to exercise their right to not make a payment on debts in the event of a natural catastrophe. 

In Aristotle’s Politics, Aristotle tells the story of Thales, another greek philosopher, who during wintertime, speculated that there was going to be an unusually large olive harvest the following autumn. Thales negotiated with the olive press owners for the right, but not the obligation, to hire all of the olive presses in the region for the following autumn. To secure this right, Thales made a cash deposit, which in modern options parlance would be known as the “premium”. The harvest went exactly as Thales speculated and the demand for the use of olive presses soared. Thales was then able to lease the presses at a substantial premium and made a fortune. Thales purchased what would be now known as a call option. 

Although derivatives sound intimidating and extremely modern they are conceptually very old. For centuries they’ve been primarily used for agricultural commodities to insure and facilitate their trade and mitigate risks. They’re still used for physical commodities but they’re currently dwarfed by their use of financial assets like stocks and bonds.

Now digital assets like Bitcoin have entered the derivatives game.  It’s only a matter of time before more digital assets enter the arena and even blockchain based derivative exchanges start attracting a lot of value. 

Below we’ll walk through the basics of what derivatives are as well as the purpose(s) they serve.

Derivatives: Options and Futures

A derivative, at its most basic, is a financial contract between two or more parties that derives its value from an underlying asset. A derivative is not the asset itself but a contract that describes the relationship between the parties with respect to the asset. Today we’ll briefly cover the two derivatives that are most relevant: options and futures.

Options

An option gives the holder of the option the right, but not the obligation, to buy or sell some asset at some future date. The two different types of options are calls or puts.

A bitcoin call option is the right, but not an obligation, to buy bitcoin at a predetermined price (strike price) on a predetermined date (expiry date). The buyer of a bitcoin call option is betting on the price of bitcoin going up. The buyer of a call option must pay a deposit (premium) to gain access to this optionality. If the price of bitcoin doesn’t go up the holder of the call option can walk away from their right to buy at the strike price. If the holder walks away, the only money lost was the premium which gave them the right to buy the asset at the strike price. 

A bitcoin put option is the right, but not the obligation, to sell bitcoin at the strike price on the expiry date. The buyer of a put option is betting on the price of bitcoin going down. If the price goes up, the holder of a put option can relinquish their right to sell at the strike price. If the holder walks away, the only money paid was the premium which gave them the right to sell the asset at the strike price.

Options traders describe an option as being ‘in the money’ (ITM), ‘at the money’ (ATM) or ‘out of the money’ (OTM).

For call options, when:

Strike Price < Current Asset Price, the option is in the money (profitable)

Strike Price = Current Asset Price, the option is at the money (break-even)

Strike Price > Current Asset Price, the option is out of the money (un-profitable)

For put options, when:

Strike Price < Current Asset Price, the option is out of the money (un-profitable)

Strike Price = Current Asset Price, the option is at the money (break-even)

Strike Price > Current Asset Price, the option is in the money (profitable)

Futures

A futures contract is an agreement to buy or sell some asset at a predetermined price at a specific time in the future. 

Futures exchanges require both parties to put up a deposit known as margin. Margin is usually set as a percentage of the value of the futures contract itself. That percentage must be maintained throughout the life of the contract as the value of the contract fluctuates. This reduces the credit risk the futures exchange takes on when facilitating these contracts. 

There are two types of futures contracts: physical delivery and cash settlement. 

Physical delivery − means the underlying asset of the contract, in our case Bitcoin, is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is most common with commodities and bonds, but In practice, it occurs only on a minority of contracts. In traditional futures markets in which physical delivery is possible, most futures contracts are cancelled out by purchasing a new contract. Physical delivery can happen, but for most contracts it doesn’t. 

In contrast, cash settled futures are those that are not and cannot be settled by delivery of the underlying asset—for example, Bitcoin. They are settled in the exchange’s chosen fiat currency. 

Purpose & Benefits

The underlying purpose of derivatives is risk management. Producers, consumers, and traders can use options and futures to reduce the uncertainty of future outcomes around inherently uncertain markets. With some simple and complex tools and strategies a producer of Bitcoin, a consumer of Bitcoin, and a trader of Bitcoin can set up strategies to smooth out any market movements that could affect them negatively. They pay to reduce these uncertainties via premiums in the options market and via margins in the futures market. 

“From an institutional standpoint, derivatives are essential if it is to be adopted in the broader global money markets. When used correctly, they offer a way to hedge trades and manage risk.”- CME

The maturation and increased use of these tools will reduce the volatility of the Bitcoin market. Producers of Bitcoin, miners, internalize a lot of price risk which exacerbates the booms and busts of Bitcoin. When Bitcoin crashes, miners have to sell an increasing percentage of their block rewards in the market to cover their expenses, adding even more pressure to a price decline. Miners now have increased access to mature derivatives markets, allowing them to hedge out their production for up to a year. If done right, miners can lock in their margins at a profitable level for some time, even during a downturn,  reducing their need to add to the selling pressure already in the market. Market makers and traders can profit from taking on that risk for the miners, and consumers benefit from a more stable store of value and medium of exchange. 

Although  risk mitigation is the foundation of the derivatives market, speculation is what drives their immense financial size. Risk mitigation is conservative and good practice but a lot of money can be made quickly with very little capital speculating on price movements or taking advantage of the pricings of derivatives themselves. Speculation often gets a bad name, but it’s endemic to human behavior to speculate about the future. This isn’t going away, and we often reward those who make the right call on how the future will manifest itself. The speculators, winners and losers alike, provide deep, liquid markets for producers and consumers alike to take advantage of the tools available to them. 

A side effect of the massive speculation in derivative markets is the creation of something called a forward curve. The forward curve shows how the market is pricing certain assets over a certain expanse of time. 

However, one shouldn’t think of forward curves as perfect oracles into the future. No trader or firm can, with any degree of certainty, predict the price of oil or bitcoin or the S&P 500 in three years, nor the next month. Forward curves are simply the current evaluation of all market participants of future prices. Since many people and institutions have invested large amounts of money in this market, it can be assumed to be a relatively informed guess, especially compared to guesses with no form of loss when wrong. The forward curve is the best predictor, the best guess that we have available – however false it may turn out in retrospect.

Futures price-based forecasts are hard to beat. Futures prices perform at least as well as a random walk for most commodities and at most horizons and, in some cases, do significantly better. -IMF

We also get better price discovery because of derivative markets. Good price discovery is crucial to market participants getting an accurate picture of the ebbs and flows of a market for a particular asset. Derivative markets are often the first ones to react to events because the transaction costs involved in taking a position or repositioning is much lower than the transaction costs in the corresponding spot market. Because of this, we get a better picture of how a market is reacting to new information throughout different slices of time, giving on-lookers the market’s view of what is likely to happen over those different slices of time. The result is better price discovery than one would get with only spot markets available.

 When we put this all together, we see that the creation of derivative markets for Bitcoin provides risk management, better price discovery, insight into how the market views the future, and more powerful tools for speculation. 

Risks & Concerns

Many have raised concerns about derivatives and their possible role in market manipulation. Could there be a way that the tail (derivatives) wags the dog (spot)? Sure, every market is ripe for manipulation. There is no fool proof market. When there’s a lot of money on the line, firms and individuals will spend as much time and money as possible to get every advantage available. Participants in the gold market have complained for a while that the price of gold is suppressed through the futures market. However, the operative question is how easy is it to do with Bitcoin as the underlying asset and how long can it be done for? 

Do the properties of Bitcoin make it easier or harder to manipulate than other assets? We’re not aware at this time of any attributes that make it easier than any other asset. But there may be a case to be made that it’s harder to manipulate Bitcoin spot prices through the derivatives market. Keep in mind that the ability to audit Bitcoin is unlike any other asset in history. Transparency isn’t a good friend to would be manipulators. And if exchanges that offer physical delivery have enough market share it seems that would make it even harder to indirectly inflate supply and suppress the price of Bitcoin. 

Plus, with the proliferation of crypto derivative exchanges all around the world, and even native crypto derivative exchanges breaking innovative ground, the coordination efforts and costs for such an attack might be prohibitively expensive.

If the difficulty is high enough and the speed at which manipulation can be discovered and stamped out is sufficient, the potential risks of genuine, long term manipulation remain low.

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