What are crypto derivatives and how do they affect the price of cryptocurrencies

There are three basic types of cryptocurrency derivatives:

Crypto futures: These contracts represent an agreement to buy or sell a particular cryptocurrency at a future price and date.  The contract carries terms that both the buyer and seller have agreed upon, such as the price, date of expiry, and method of settlement (usually in US dollars). Based on the future price of the particular cryptocurrency, the parties will either stand to gain or lose from their investment.

For example, a trader chooses to buy a Bitcoin futures contract worth 1 Bitcoin ($27,000 based on the current price). If the price of Bitcoin rises to $50,000 by the time the contract expires, the trader would have profited by $13,000. If the price of Bitcoin slips to $10,000 before contract expiry, then the trader would have made a loss of $17,000.

Crypto options: Options work similarly to futures but with a key difference – the trader can choose whether or not to buy or sell the cryptocurrency upon contract expiry. However, that does not mean the contract is completely risk-free. Traders would have to pay the fees associated with the options contract, regardless of whether they choose to exercise the option or not. There are two types of options – a call option and a put option. Through a call option, you can buy a particular cryptocurrency at a future date and price, and through a sell option, you can sell a particular cryptocurrency at a future date and price.

For example, let us assume that a trader purchases a call option for Bitcoin at $50,000 and pays $1,000 in fees for the same. If the spot price of Bitcoin falls to $40,000 by the time of contract expiry, the trader would have normally incurred a loss of $10,000. However, the trader can simply choose to let the option expire and avoid the loss. Instead, the only loss the trader takes is the $1,000 he paid for the option.

Crypto perpetuals: Perpetuals are akin to futures and options but do not come with an expiry rate, allowing traders to hold these contracts indefinitely. Instead, the traders must pay a fee known as the funding rate to keep their positions open. The funding rate is a periodic payment that is paid to the opposite party, depending on the difference between contract prices and spot prices. A positive funding rate is observed when more long positions are open than short positions, and a negative funding rate is observed when more short positions are open than long positions.

Now you may be wondering how spot prices can vary based on derivatives, especially since the former’s price affects the latter. However, an inverse relationship is possible. Consider that many traders are optimistic about the future price of Bitcoin and load up on ‘buy’ contracts. Since data on crypto derivatives is open to the public, traders in the spot market might see this bullish sentiment and start to buy Bitcoins. The same could actually trigger an increase in Bitcoin’s spot price. This unique relationship allows the underlying asset to maintain a fair value between its spot and future prices.

Recently, research firm Kaiko released a report on the state of crypto derivatives in 2023 and highlighted how the futures market drove Bitcoin and Ethereum rallies this year.

The report outlined Bitcoin’s surge from $27,800 to $31,000 during mid-April. Prior to the increase, Kaiko noted a build-up of $2 billion worth of open interest on 10 April, coinciding with some of the most positive funding rates during the month. A quick note here is that open interest refers to the number of open positions in the derivatives market, either long or short.

By combining the open interest and funding rate, Kaiko determined that Bitcoin’s mid-April rally of 11.5 percent was driven by speculative long positions. The report also claimed that Bitcoin’s price topped out at around $31,000 and fell lower once the funding rates turned negative.

Coming down to Ethereum, the world’s largest altcoin jumped by as much as 15 percent and touched a near 10-month high at $2,100 between April 10-16. As with Bitcoin, Ethereum showed a similar relationship between its funding rate and open interest during April, indicating that activity in the derivatives market fuelled its price increase. Kaiko also noted that ETH option market volumes drastically rose pre- and post-Shapella, which may have affected its price in the following months.

As Kaiko notes, the crypto derivatives market is not only where the most speculation occurs, but also where a great number of sophisticated investors place their bets. The direction of these bets can give investors great insight into market sentiment, particularly before and after big market events, such as a Federal Reserve meeting or a blockchain hard fork. Many a time, these insights can stimulate buying and selling in the spot market, which in turn, can affect the price of cryptocurrencies.

With its ability to attract ‘big money’, the crypto derivatives market has matured over the years, becoming even larger than the spot crypto market. According to Crypto.com, derivatives trading represented over 70 percent of the entire crypto market as of March 2023, worth over $2 trillion. The sheer size of the crypto derivatives market makes it a force to be reckoned with. However, investing in derivatives comes with its own risks and it is advised that you do comprehensive research before jumping into the derivatives market.