What are Bitcoin Derivatives and How Do They Work?
Bitcoin derivatives are poorly understood, but are one of the strong pillars for Bitcoin adoption. Learn about Bitcoin futures and options in this article.
By now, you most likely know how to buy and sell Bitcoin through a broker like Easy Crypto. To buy, you simply transfer your money, and we’ll send you Bitcoin directly to your wallet. Doing so means you’re participating in the spot market for Bitcoin — and it doesn’t get any simpler than that.
However, decentralised finance has matured to the point where we can see a mirror image of traditional finance in the blockchain world. You may have heard of something called Bitcoin derivatives.
While Easy Crypto aims to make crypto easy for people, we can also help you understand the more complex financial topics for your own benefit. So, let’s dive into Bitcoin derivatives, and see how they work.
New to crypto? Learn the basics with our crypto 101 guide.
What are Bitcoin derivatives?
Derivatives are financial instruments whose value depends on the price of the real asset that they derive from. The most common Bitcoin derivatives are Bitcoin futures and Bitcoin options.
In the Bitcoin derivatives market, these can have slightly different prices compared to the Bitcoin (spot) price. Bitcoin derivatives allow traders to speculate on the future price of Bitcoin, and some instruments even allow them to make a profit even if the Bitcoin price falls.
Another advantage of trading Bitcoin derivatives is that traders can do insanely fast short-term trading, without paying for transaction fees, as they don’t actually transact real Bitcoin.
Of course, this also means they don’t have to manage their wallets and private keys during the duration of Bitcoin derivatives trading.
Is Bitcoin a derivative?
The short answer is, probably not. Here’s why.
What sets Bitcoin derivatives from wrapped Bitcoin is the pricing. Wrapped Bitcoin will follow the price of Bitcoin more closely than Bitcoin derivatives.
On the other hand, Bitcoin derivatives can be far more volatile, even if, in the long run, they are moving with the price of real Bitcoin.
Further reading: What is Bitcoin? How does it work?
How are Bitcoin derivatives issued?
Bitcoin is an isolated blockchain that can’t be transferred to another blockchain. However, some people have figured out a way to “move” the value of Bitcoin across the chain onto, say, the Ethereum blockchain.
Unfortunately, there is currently no programmatic way to securely reserve Bitcoin using computer code via smart contracts, like tokens on Ethereum. This means Bitcoin must be held in a reserve controlled by a centralised exchange.
The exchange will then issue a Bitcoin derivatives token on Ethereum as an ERC-20 token. If the exchange remains resilient against theft, then the ERC-20 token will hold its value.
Bitcoin derivatives are mostly traded on large, centralised exchanges like Binance, but rarely so on decentralised exchanges.
It’s good to take note — even if Bitcoin derivatives are traded on decentralised exchanges, its price integrity is dependent on the issuing exchange.
What is an ERC-20 token?
In short, these are simply tokens that are used on the Ethereum blockchain and act as assets that facilitate the various utilities and functions on the network. Learn more with our guide.
What is a Bitcoin Futures Contract?
Futures, or futures contract, basically works like this. It’s a contract that makes the holder promise to buy or sell an asset at a set price on a certain date.
When the contract ends (on the set date in the future), the buyer has to buy and receive the asset, and the seller has to sell and give up the asset to the buyer. Because of this obligation, futures can be traded around to someone who can take the risk and follow through with the promise.
Some Bitcoin mining companies issue and sell Bitcoin futures contracts to earn revenue on future mined Bitcoins. This allows them to operate smoothly despite the highly volatile Bitcoin price.
However, some exchanges take Bitcoin futures one step further by allowing traders to trade Bitcoin futures with leverage, to profit when Bitcoin prices go up or down.
Related: What makes Bitcoin valuable?
How can someone profit from falling Bitcoin prices with Bitcoin futures?
It’s possible, because a trader could borrow Bitcoin futures, and then sell them for their current market price. When the price of Bitcoin falls, the Bitcoin futures price falls with it, which makes Bitcoin futures cheaper.
The same trader can then buy back the Bitcoin futures and return all the owed amount. In this trade, the trader profits from the money they didn’t spend on buying back the Bitcoin futures (as it became cheaper).
This trade is known as a short trade, a risky bet on a downward price movement, which is usually facilitated by trading Bitcoin futures.
What is a Bitcoin Options Contract?
Options work in similar ways as futures contracts. The difference is that holders of the options contract are not obliged to follow through with the trade deal, when the contract expires.
In traditional finance, options protect the future buyer from buying an asset at a higher price than it will be in the future.
For example, in an options contract for asset XYZ, the seller agrees to sell XYZ at $1,000 per unit, but on the contract expiration date, the price of XYZ is $800. The buyer can choose not to buy XYZ to avoid bearing a $200 loss per unit.
Like Bitcoin futures, Bitcoin options traders can trade with leverage, and profit from either an upward or downward price movement of the Bitcoin spot market price.
Trading Bitcoin options is a little bit more technical, and as a result, it is less common than Bitcoin futures trading.
In fact, the crypto market has produced a unique type of futures contract which has that “optional” functionality built-in, similar to options contracts.
Bitcoin perpetual futures is one such contract that technically never expires. This means a trader can hold this derivative asset for as long as they choose — just like Bitcoin options.
Why do some people trade Bitcoin derivatives, not Bitcoin?
As prefaced in the introduction, Bitcoin spot trading may seem straightforward. However, advanced traders still prefer to trade Bitcoin derivatives for the following reasons:
- Crypto derivatives trading can potentially multiply their profit potential, as with their risk levels.
- They can trade with a much lower starting capital, and use leverage.
- They don’t have to worry about Bitcoin transaction fees from multiple trading sessions.
- They don’t need to maintain a Bitcoin wallet for Bitcoin derivatives trading.
Bitcoin derivative trading is (surprisingly) regulated
You may think that the complexities of Bitcoin derivative trading could mean that it’s a difficult activity for regulators to monitor. The opposite is actually true.
For example, in the United States, the Securities and Exchange Commission (SEC) gave hedge funds and other financial institutions the permission to offer products based on Bitcoin futures. Surprisingly, they denied the use of the actual Bitcoin itself to derive their products.
The products in question are Bitcoin exchange-traded funds (ETFs) and Bitcoin trusts that allow high net-worth investors to gain exposure to Bitcoin indirectly.
Bitcoin derivatives are unknown to most retail investors. However, it has been proven useful for the adoption of Bitcoin in the context of using it in traditional financial markets.
Advanced traders can also use Bitcoin futures to significantly increase their earning potential with calculated risk-taking.
It’s important to remember that Bitcoin derivatives are not actual Bitcoins. Proponents of Bitcoin have often argued that it’s less risky to buy and hold Bitcoin in self-custody wallets than to use Bitcoin derivatives.
The integrity of Bitcoin derivatives is also highly dependent on the exchange or party that issues the contract, which can make for a less secure form of investment if it’s not highly regulated by the government. Before making a derivatives trade, it’s best to carefully consider the terms and risks of each contract.
Further reading: Explore more topics on all things crypto in our learning hub.
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Disclaimer: Information is current as at the date of publication. This is general information only and is not intended to be advice. Crypto is volatile, carries risk and the value can go up and down. Past performance is not an indicator of future returns. Please do your own research.
Last updated February 14, 2023