A compulsory course for miners: understanding cryptocurrency derivatives

Since the birth of Bitcoin, the entire cryptocurrency market has undergone more than ten years of evolution and development. Generally speaking, cryptocurrency, as a new type of asset, has high volatility compared to various products in the traditional financial industry (such as securities, commodities, foreign exchange, etc.) , and is accompanied by extremely high risks. With the gradual improvement and maturity of the cryptocurrency spot market, users' demand for cryptocurrency trading is no longer limited to simple spot trading, and major cryptocurrency exchanges have begun to gradually launch various derivative products .

The following article will mainly introduce the situation of traditional financial derivatives, thereby leading to an introduction to the types, functions and roles of derivatives in the cryptocurrency market, sorting out the current development status of derivatives in the cryptocurrency market, and summarizing the future development trends of derivatives in the cryptocurrency market.

01
Traditional financial derivatives

Financial derivatives are a general term for a special category of financial instruments that are bought and sold. The value of this type of derivative depends on the change in the value of the underlying financial asset , such as assets (commodities, stocks or bonds) , interest rates, exchange rates or various indices (stock index, consumer price index and weather index) . The performance of these factors will determine the rate of return and return time of a derivative. The product form is a contract signed between the two parties (buyer and seller) and is executed in accordance with the contract requirements within a specified time.

Derivative Types

1. Forward contracts and futures contracts

Both forward contracts and futures contracts are forms of transactions in which the two parties agree to buy or sell a certain quantity and quality of assets at a certain price at a certain time in the future. Futures contracts are standardized contracts formulated by futures exchanges, which have unified regulations on the contract expiration date and the type, quantity and quality of the assets to be bought and sold. Forward contracts are contracts signed by the buyer and seller based on their special needs and are over-the- counter transactions . Therefore, futures trading has higher liquidity, while forward trading has lower liquidity.

Contract trading in the cryptocurrency market has evolved from these two types of contracts. Due to the particularity of assets such as cryptocurrencies, cryptocurrency exchanges have innovated traditional contract products and derived perpetual contracts unique to the cryptocurrency market, which will be highlighted below.

2. Swap Contracts

A swap contract is a contract between two parties to exchange certain assets at a certain time in the future. More precisely, a swap contract is a contract between two parties to exchange cash flows that they believe to have equal economic value at a certain time in the future.

Swap contracts are generally used for foreign exchange transactions between banks and hedging or arbitrage between companies' import and export commodities, so they are not suitable for the cryptocurrency market.

3. Option contracts

An option contract is a transaction of buying and selling rights. An option contract stipulates the right to buy or sell a certain type and quantity of a native asset at a certain price at a certain time. Options can be divided into call options and put options according to the wishes of the option buyer. Option contracts provide investors with a wider range of investment options and meet the needs of investors with more diverse investment motivations and interests. Generally speaking, they will be used as a hedging tool to reduce risks for investors.

Currently, major exchanges in the cryptocurrency market have gradually launched option contracts , and their trading logic is almost the same as that of option contracts in the traditional financial industry.

Derivatives Trading Subject

The assets in the traditional financial market are more diversified, and the trading targets of derivatives include stocks, interest rates, exchange rates, commodities, indices, etc. In the cryptocurrency market, the main asset target is the token price . Some exchanges will innovate the targets of derivatives to include some sector indices, volatility indices , etc. The target objects tend to increase gradually with the growth of the cryptocurrency market.

Derivatives trading venues

There are two main types of derivatives trading venues: on-exchange trading and over-the-counter trading . On-exchange trading, also known as exchange trading, refers to the way in which all supply and demand parties gather in the exchange for bidding transactions. In this trading method, the exchange collects margin from trading participants, is responsible for clearing and assuming the responsibility of performance guarantee, and all traders concentrate on trading to increase liquidity. Futures contracts and some standardized option contracts belong to this trading method. Derivatives trading in the cryptocurrency market is mainly this method. The exchange can guarantee liquidity while also providing users with convenient and fast trading needs.

Over-the-counter trading, also known as counter trading, refers to a trading method in which both parties become counterparties directly . This trading method can design different products according to the different needs of each participant, so that different trading needs of users can be met and each contract is unique. The clearing step is carried out by both parties to the transaction, which requires a high level of credit from the user.

Derivatives are complex financial instruments that can provide users with different investment methods and purposes. The combination of derivatives and cryptocurrencies increases the user threshold. For inexperienced lay investors, derivatives will be more difficult to manage and operate.

02
Introduction to Cryptocurrency Derivatives

At present, the mainstream derivatives in the cryptocurrency market are: leveraged trading, futures contracts, options contracts and leveraged tokens . Among them, some cryptocurrency exchanges do not classify leveraged trading and leveraged tokens as derivatives, but these two trading methods, which are different from spot trading, do bring users diversified operations and can achieve the effects that derivatives can achieve. Therefore, this article classifies them as derivatives.

1. Leveraged Trading

Margin trading is a way of trading assets using funds provided by a third party . Compared with regular spot trading, margin trading allows users to obtain more funds, amplify trading results, and enable users to obtain greater profits in profitable transactions.

In traditional financial markets, leveraged trading is generally referred to as margin trading , and the borrowed funds are generally provided by stockbrokers . However, in the cryptocurrency market, borrowed funds are usually provided by other users in the exchange. Fund providers earn interest by placing assets in the exchange, and users who borrow assets through leverage pay leverage interest. The exchange acts as an intermediary by allocating assets and earning fees from them.

Margin trading can be used to open long and short positions . Long positions can borrow stablecoins to buy cryptocurrencies, reflecting the user's expectation of rising asset prices; while short positions borrow cryptocurrencies to sell immediately and buy back the corresponding currencies after the market falls, reflecting the opposite of long positions. When using margin trading to open long or short positions, the trader's assets will serve as collateral for the borrowed funds.

The leverage ratio provided by mainstream exchanges is currently 2-10 times . The so-called leverage refers to the ratio of borrowed funds to margin. For example, to open a 5x leverage ratio for a transaction of 50,000 US dollars, the user needs to pledge a margin of 10,000 US dollars. When the user's opening direction is opposite to the market trend and the market fluctuates violently, the total assets of the user's margin account are lower than the minimum margin requirement for leveraged trading, the exchange will force the sale of the user's pledged assets to close the position.

The advantage of leveraged trading is that it allows investors to open leveraged trading of multiple currencies with less investment cost , thus bringing higher returns to investors. Compared with spot trading, which can only buy long, leveraged trading provides investors with short-selling opportunities and can also make profits when the market goes down. However, when users misjudge the market direction, leveraged trading can also cause serious losses to users. High leverage borrowing means that even a small fluctuation in market prices may cause users to lose all their margin.

Due to the risk of margin trading, some exchanges provide users with full leverage and isolated leverage functions. Full leverage supports leverage trading of all trading pairs in the account, and the assets in the account are mutually guaranteed and shared. Once a margin trading occurs, all assets in the account will be closed. Isolated leverage means that each trading pair in each account has an independent position, and the risks of each isolated account do not affect each other. Once a margin trading occurs, it will not affect other isolated accounts.

In general, the position-by-position leverage function has a stronger awareness of risk control for the user's overall position, and can isolate the risks of different assets from each other, but users need to pay attention to the margin situation of different loan assets at all times. The full-position leverage function is conducive to risk control of a single asset. Compared with position-by-position, the centralized sharing of margin can better buffer the liquidation of a single currency, but the extreme market conditions of a certain asset may cause all positions to be closed.

2. Futures Contracts

Futures contracts are the earliest derivatives launched in the cryptocurrency market and are also the derivatives with the highest trading volume. There are two types of futures contracts in the cryptocurrency market: delivery contracts and perpetual contracts .

a. Introduction to delivery contracts

A delivery contract is a derivative product of crypto assets. Users can make profits from the rise/fall of digital asset prices by judging the rise and fall and choosing to buy long or sell short contracts. The delivery contracts of mainstream cryptocurrency exchanges generally use the mode of difference delivery . When the contract expires, the exchange will close all open contract orders. Only a few exchanges such as Bakkt support physical delivery of cryptocurrency contracts.

Currently, the delivery time of delivery contracts in the cryptocurrency market is mostly divided into " weekly, biweekly, and quarterly ", and a certain multiple of leverage can be added. Currently, mainstream exchanges support up to 125 times leverage. In a market with volatile market conditions, the risk of liquidation is relatively high.

b. Introduction to Perpetual Contract

Perpetual contract is an innovative derivative product , which is similar to delivery contract, but the perpetual contract has no delivery date , and users can hold it forever.

In traditional financial futures contracts, one party to the contract often needs to hold a contract subject (mainly commodities, such as wheat, gold, copper, etc.) , and holding the subject will actually increase the holding cost of the contract, resulting in a larger price gap between the contract market and the spot market. In order to ensure the long-term convergence between the perpetual contract price and the spot price, exchanges basically use the funding rate method.

Funding rate refers to the settlement of funds between all longs and shorts in the perpetual contract market, which is settled every 8 hours. The funding rate determines the payer and the payee; if the rate is positive, the longs pay the shorts; if it is negative, the shorts pay the longs. This can be considered a fee or a refund for traders to hold a contract position. This mechanism can balance the demand for perpetual contracts between buyers and sellers, so that the price of perpetual contracts is basically consistent with the price of the underlying asset.

Almost all mainstream cryptocurrency exchanges support perpetual contracts, with leverage up to 125 times . Perpetual contracts are also the most popular derivatives in the market.

The difference between delivery contracts and perpetual contracts

1. Perpetual contracts are easy to operate , and there is no need to consider delivery and position change, which can provide almost the same experience as spot contracts. For investors, the threshold for professional investment is lowered . If the delivery contract is automatically delivered by the system when it expires, a delivery fee needs to be paid. Compared with perpetual contracts, it is necessary to pay attention to the delivery time at all times.

2. Perpetual contracts do not have a delivery time , while delivery contracts have specific delivery times such as "this week, next week, quarter". Investors can hold perpetual contracts for a long time to obtain higher investment returns, but it should be noted that there will be a funding rate settlement every eight hours . If the contract is held as the fund payer, the assets will suffer a slight loss. Due to the rules of the funding rate, large contract traders generally close their positions before the funding rate settlement time to avoid capital wear and tear. More professional quantitative investors will use the long-short ratio and market conditions to open positions and become the beneficiaries of the funding rate.

3. The price of perpetual contracts is relatively close to the spot market price, while the price of delivery contracts deviates greatly. Due to the funding rate mechanism, the contract mark price of perpetual contracts is always close to the spot price. The further away the delivery time is from the delivery contract, the higher the deviation between its price and the spot price. When the delivery time is approaching, the volatility is often large due to the increase in the volume of liquidated transactions, and the " pin " phenomenon is prone to occur (pin refers to the contract price of a certain cryptocurrency rising or falling rapidly at a certain point in time due to market manipulation and other reasons, and then quickly returning to normal prices. Although the price has not changed, it causes a large number of positions to be liquidated.) .

c. Forward contract and reverse contract

In the cryptocurrency market, a forward contract is also called a stablecoin contract , which uses stablecoins (USDT) as margin in the contract. A reverse contract is also called a coin-based contract , which uses the currency as the contract margin for the corresponding trading pair.

Derivatives in traditional financial markets are generally forward contracts that are settled in cash, while reverse contracts are an innovation in the cryptocurrency market. Using cryptocurrencies (BTC, ETH, etc.) as collateral for opening derivative positions has greatly increased the demand for cryptocurrencies in the secondary market and boosted market liquidity .

Solution to the warehouse liquidation

A position squeeze means that after a user's contract is liquidated, his position cannot be forcibly liquidated due to liquidity reasons, that is, there is no counterparty in the trading market that can match this order. Generally speaking, in this case, the exchange will take over the user's remaining positions, which will cause the exchange to suffer losses. Mainstream exchanges (such as Binance, Huobi, OKEx, etc.) will set up risk guarantee funds , which are intended to compensate for losses caused by the user's contract asset margin being lower than 0. The additional fees paid by non-bankruptcy forced liquidation users will be injected into the risk guarantee fund. The main purpose of the risk guarantee fund is to reduce the possibility that users cannot be forced to liquidate.

When the risk guarantee fund is unable to take over the positions of users who have been liquidated, there are currently two mainstream solutions in cryptocurrency exchanges.

1. Apportionment of short positions . When settling profits and losses on the delivery date, the exchange will consolidate the short position losses caused by the liquidation orders of all contracts and apportion them according to the total income of all profitable users.

2. Automatic position reduction . The exchange will close positions according to the priority ranking of users. The priority ranking is calculated based on the user's profit and leverage multiple. Generally, the more profitable and the higher the leverage multiple of the user, the first position will be closed. The above two schemes both achieve the profit and loss balance of the system by reducing the profit part of the profitable party of the contract. The position reduction sharing mechanism will share the profit among all profitable users, while the automatic position reduction is for the users with the most profit.

Cryptocurrency exchanges generally launch multiple delivery contracts with different delivery times to meet the needs of most users, which will also divert user funds and cause poor liquidity in some delivery contracts. However, perpetual contracts have better liquidity and the depth of the buy and sell orders is almost close to that of spot contracts, so the phenomenon of liquidation mostly occurs in delivery contracts.

3. Option Contracts

Currently, there are two main types of option contracts in the cryptocurrency market. One is the T-shaped quotation option contract mainly based on the Deribit exchange, and the other is the innovative option contract based on the cryptocurrency market launched by Binance.

a. T-type quotation option

T-type quote option contracts in the cryptocurrency market are almost the same as option contracts in traditional financial markets. They are all European options that can only be exercised on the expiration date. The exchange acts as a securities broker and provides users with a T-type quote table, which contains transaction information such as the underlying asset, expiration date, strike price, buy and sell price, etc. Users can act as option buyers or option sellers.

Figure: Deribit Option T-Type Quote Table

b. Simplified new options

The second type of options products are simplified new options (also called short-term options) launched by exchanges such as Binance and Gate.io. Compared with the complex T-shaped quotation table of traditional options, this type of options product simplifies the trading process to enhance the trading experience. To purchase options, users only need to select the option expiration time and purchase quantity, and the exercise price when placing an order is provided by the exchange in real time. According to the product characteristics of different exchanges, it can be divided into European options and American options. Compared with traditional options, its expiration time range is also shorter, ranging from 5 minutes to 1 day. Users can only gamble on option contracts with exchanges as option buyers. This type of simplified new options has the following characteristics:

1. High liquidity . Generally speaking, standard option contracts have multiple expiration dates and exercise prices, and have two options: buyers and sellers. The diversified product structure will also disperse the liquidity of each option contract. The seller of the simplified new option is the exchange, which can provide liquidity at any time, so users do not have to worry about the lack of counterparties due to lack of liquidity.

2. The operation is simple and easy to use, and the user experience is more friendly for novices. Options are essentially complex derivatives. A deep understanding of option contracts requires mastering the complex nonlinear relationship between the five Greek letters, and the learning cost and threshold are high. After being packaged by the exchange, the simplified new option has become an extremely simple derivative tool, which can be understood as the user's expected speculation on the short-term price of cryptocurrency assets.

3. The expiration date of options is short . The expiration date of simplified new options ranges from 5 minutes to 1 day, which is far from the one month or even one quarter of traditional option contracts. The main users of short-term options are more speculators, who speculate on the short-term rise or fall of the underlying assets, which is more like gambling.

4. Intrinsic value is not transparent . After being packaged by the exchange, short-term options do not provide users with important option data such as implied volatility, Delta, and trading volume, and users cannot calculate the true intrinsic value of options. Exchanges can sell options at high premiums to obtain high profits. The user's counterparty exchange has a natural advantage in mastering a large amount of real-time data on option targets. At the same time, the exchange can also reverse the operation through the T-type quotation table in other option exchanges to hedge the risk as a seller. Therefore, users as the option counterparty of the exchange need to bear higher risks , and even if the price of the option is not reasonable, they cannot learn from it.

4. Leveraged Tokens

Leveraged tokens are essentially tokens with leverage functions , designed to provide leverage multiples of the underlying asset. Unlike leveraged trading, users do not need any collateral or maintenance margin, nor do they need to worry about the risk of liquidation. Behind each leveraged token is a basket of underlying asset positions.

Depending on the product, the actual target leverage ratio behind the leveraged token is also different. The leveraged token maintains the target leverage by increasing or decreasing the position of the underlying asset through the exchange's rebalancing mechanism. From a functional perspective, the role of leveraged tokens is similar to that of ETFs (Exchange Traded Funds) in the traditional financial field.

For example, Binance's leveraged tokens BTCUP and BTCDOWN . BTCUP can achieve leveraged returns when BTC prices rise. Conversely, BTCDOWN can achieve leveraged returns when BTC prices fall. The basket of assets corresponding to the BTCUP leveraged token is 123,456.78 BTCUSDT perpetual contracts. The target leverage multiple of Binance leveraged tokens will remain between 1.5 and 3 times .

Although leveraged tokens do not require complicated operations like ordinary cryptocurrencies, the mechanism is relatively complicated and not suitable for novices. Leveraged tokens do not have the possibility of liquidation, but compared with holding spot assets, long-term holding of leveraged tokens will be affected by daily rebalancing and daily management fees, and assets will gradually be worn out by handling fees. Therefore, in short-term one-sided market conditions , leveraged tokens will play their advantages. Leveraged tokens will automatically use floating profits to increase the underlying asset positions, so that the actual leverage multiple exceeds the original leverage multiple to achieve more benefits.

03
The role of cryptocurrency derivatives

As the cryptocurrency market has developed to date, derivatives have become one of the indispensable financial instruments in the market. The development and innovation of cryptocurrency derivatives have promoted the entire market, and their main roles are as follows:

1. Hedging

Hedging refers to investors using derivatives to protect their investment portfolios. They use the profits from derivatives to make up for the losses in the spot market , or use the appreciation of the spot market to offset the losses caused by derivatives, so as to reduce risks.

For example, after obtaining mining income, a large number of Bitcoin miners are worried about the future decline in Bitcoin prices, so they use the short-selling mechanism of cryptocurrency derivatives to short-sell derivatives with the same value as the expected income to lock in the income in advance. For institutional investors, using derivatives such as options and futures contracts to conduct reverse operations can hedge the risks of investment funds and improve the risk management awareness of assets.

2. Speculation

Cryptocurrency derivatives provide retail investors with a variety of speculative means . Futures contracts with high leverage can allow small capital users to make a small bet on a large sum and obtain higher returns. However, this comes with higher risks . High leverage means that a slight fluctuation in asset prices can cause the user's capital position to explode.

For most exchanges, cryptocurrency derivatives, especially futures contracts that support high leverage, have become one of the main tools to attract users. For most novice users, opening a 100x contract in an exchange is tantamount to gambling, while professional quantitative trading teams can use market fluctuations to conduct strategic trading speculation , such as grid trading.

3. Value Discovery

In the cryptocurrency derivatives market, if the transaction volume and user base are large enough, then derivatives will have a value discovery effect on the underlying asset. The price of derivatives often reflects the market users' judgment on the future trend of the underlying asset, which has a certain reference significance for the future value outlook of the spot, and can even predict the future price of the spot market from a certain aspect.

4. Increase spot trading liquidity

At present, most of the derivatives provided by mainstream exchanges are reverse contracts , which means that cryptocurrency assets are required as margin. Users who trade derivatives need to hold a certain amount of cryptocurrency to open a position. In the case of volatile market conditions, users need to continue to purchase cryptocurrency in the spot market as margin to cover their positions. On the other hand, cryptocurrency assets that have made profits through derivatives trading also need to be traded in the spot market for withdrawal. Therefore, the derivatives market is highly linked to the spot market, and the sharp increase in the trading volume of the derivatives market will also lead to an increase in the liquidity of the spot market.

04
Current status of cryptocurrency derivatives

market

At present, most cryptocurrency exchanges in the market have launched derivatives trading functions, and the market share of derivatives has gradually expanded. According to CryptoCompare data, the trading volume of cryptocurrency derivatives reached about 445 billion US dollars in July 2020, an increase of 13.2% compared with June; the market share of derivatives in July accounted for 41% (38% in June). It can be seen that the share of the cryptocurrency derivatives market is increasing month by month.

Figure: Spot and derivative trading volume in the cryptocurrency market

In a mature traditional financial market, the trading volume of financial derivatives should account for more than 80% of the total trading market, while the market share of cryptocurrency derivatives accounts for less than half . This shows that the cryptocurrency derivatives market is still in its early stages of development, but there is huge room for future development.

Leveraged trading is gradually being replaced

Leveraged trading was introduced earlier in the cryptocurrency market, and as the only derivative tool that could be used for short selling, it attracted a large number of investors. However, with the introduction of new derivatives such as perpetual contracts, leveraged contracts no longer have an advantage.

1. First, leveraged trading requires paying higher borrowing fees . In leveraged trading, the borrower accumulates borrowing fees in real time, and the fees may be higher when the demand for currencies is small.

2. The leverage ratio is fixed and cannot be adjusted flexibly . According to the regulations of different cryptocurrency exchanges, the leverage ratio for leveraged trading is generally fixed at 3 times, 5 times or 10 times, etc. Users cannot adjust the leverage ratio at any time, which is not flexible enough compared to futures contracts.

3. Margin trading depends on the supply and demand sides in the spot market. When the supply is insufficient, users cannot conduct leveraged trading.

In short, the effect of leveraged trading on capital amplification can be achieved by multiple derivatives, such as perpetual contracts . In addition, the various limitations and shortcomings in leveraged trading have also been solved by the design of perpetual contracts. Therefore, with the emergence of more innovative derivatives, leveraged trading is no longer the first choice for users' mainstream derivatives.

Perpetual contracts are developing rapidly

From the perspective of derivatives trading types, futures contracts are still the mainstream derivatives in cryptocurrency exchanges. The main reasons are as follows.

1. First, the leverage ratio of futures is as high as 100 times . Cryptocurrency exchanges have almost become casinos for speculators, and the wealth effect brought by 100 times leverage is extremely tempting to speculators;

2. Futures contract trading is easy to understand and simple to operate . In particular, perpetual contracts, which are unique to the cryptocurrency market, only require users to determine the direction and choose the leverage multiple to open a position. For ordinary users, the threshold is low and does not require much learning cost;

3. Compared with other derivatives, futures contracts have the highest liquidity . The more participants there are, the better the liquidity provided, and the less transaction friction users experience when trading.

4. Exchanges continue to launch perpetual contracts based on altcoins . In addition to mainstream currencies such as BTC and ETH, XRP, EOS, LTC and other cryptocurrencies with lower market capitalization can also become the subject of futures contract opening by users. Exchanges can gradually launch contracts for small currencies based on market popularity, provide users with short-selling tools, and attract more users. Therefore, futures contracts have almost become a must-have product for cryptocurrency exchanges, and user participation is extremely high.

Figure: Trading volume of perpetual contracts and futures contracts in the cryptocurrency market

According to the chart provided by Coin Metrics , perpetual contracts account for the majority of total contract trading volume due to their unique features. According to TokenInsight data, the trading volume of perpetual contracts accounted for 75.2% of the total contract trading volume in the second quarter of 2020, while it was only 39.1% in the first quarter of 2020. This increase in data shows that the focus of contract traders is shifting from delivery contracts to perpetual contracts, and perpetual contracts have become the most important contract product of cryptocurrency exchanges.

Options contracts are in their infancy

As for option contracts, they are still in their infancy in the cryptocurrency market, and there are only a handful of exchanges that can provide option contract transactions. According to the data provided by the Skew website, only Deribit, LedgerX, Bakkt, OKEx and CME exchanges have included option trading volume data, and the total trading volume is very small compared to the futures contract trading volume. The above exchanges all provide T-type quotation standard options , so the demand for liquidity is extremely high.

The prosperous development of an options market requires a large number of market makers with pricing power to provide quotation services and increase liquidity. However, the current scale of the entire cryptocurrency market is still not sufficient to support the liquidity of the entire options derivative ecosystem.

Figure: Cryptocurrency market options contract trading volume

In order to solve the problem of insufficient liquidity of option contracts in the cryptocurrency market, a simplified new type of option contract was born. The advantage of this type of option contract is that the user's counterparty is the exchange, so there is no need to worry about the problem of poor liquidity. At the same time, compared with traditional options, it is simpler to operate and easier to understand.

However, for professional institutions and quantitative hedge traders, such options have a short expiration date and are not suitable as long-term hedging tools. In addition, the intrinsic value of such option contracts after being packaged by the exchange is not transparent, especially for professional investors and large institutions who are extremely sensitive to the price of derivatives.

In summary, option contracts are in the exploratory stage in the cryptocurrency market. Due to the limited liquidity of market makers, the trading volume is low. Innovative option products still have many problems that require time and the market to verify and improve.

Leveraged tokens continue to innovate but trading venues are limited

Leveraged tokens, as an innovative cryptocurrency derivative, have not been launched for long. Similar to ETFs in traditional financial markets, the target they track is not limited to a single asset. Since leveraged tokens require a cumbersome daily rebalancing mechanism, there are currently very limited exchanges that can provide leveraged tokens.

The launch of leveraged tokens originated from FTX , an exchange that focuses on innovation in cryptocurrency derivatives. In addition to tracking digital currency assets, FTX also provides tokens that track sector performance , cryptocurrency volatility tokens, etc., and even launched tokens that predict the presidential candidates in the 2020 US election.

It can be seen that such products have increased speculation and gambling connotations . The different assets or underlying objects tracked by leveraged tokens can meet the trading needs of more user groups. The diversification and innovation of leveraged tokens can bring more hot spots to the market, but the current development time of leveraged tokens is relatively short, and there are few exchanges that provide leveraged tokens, which also results in limited participating users.

Regulatory policies

At the end of 2017, the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) launched Bitcoin futures contracts ; at the same time, LedgerX launched the first physically settled Bitcoin futures contract in the United States. Bakkt also launched Bitcoin futures and options contracts in 2019. This product is the first Bitcoin option derivative approved by the U.S. Commodity Futures Trading Commission (CFTC) .

Currently, in the cryptocurrency market, only the above four US exchanges are approved by regulators and operate derivatives transactions in compliance. Apart from these, there are very few derivatives exchanges that are compliant and regulated worldwide. The exchanges that rank high in cryptocurrency derivatives trading volume, such as BitMEX and Deribit , are not actually compliant exchanges.

Judging from the current policies of various countries on cryptocurrencies, the regulation of cryptocurrencies is still in a vague state. Most countries are still waiting and watching, and there are no perfect legal policies to standardize them. Due to the natural cross-regional characteristics of blockchain technology, exchanges lack a unified and standardized management system for cryptocurrency derivatives, and the laws of various countries are also different. The cost of formulating a unified and standardized regulatory policy is extremely high .

Derivatives, as financial instruments of cryptocurrency spot, have higher risks, which are beyond the reach and control of ordinary investors. Therefore, the legalization of derivatives exchanges will be the future direction of the entire blockchain industry. The lack of regulatory policies will make it impossible to protect the interests of investors , and the malicious behavior of some small exchanges will directly lead to losses of user funds. Although it is extremely difficult to make derivatives exchanges compliant, this will improve the security of user assets, provide users with reasonable legal protection, and promote the rapid development of the derivatives industry in a more formal direction.

Disadvantages

As the trading volume of cryptocurrency derivatives increases year by year, users' expectations for derivatives launched by exchanges are also getting higher and higher. However, it is undeniable that the cryptocurrency industry is still in an early stage, and derivatives also have many drawbacks that need to be addressed.

1. Trading system issues

Due to the high volatility of cryptocurrency assets, they often cause dramatic fluctuations in multiple derivative markets such as leveraged trading and contracts. The trading system processing capacity of the exchange is particularly critical. If users cannot close or increase positions in time, it may cause huge financial losses. When the market is turbulent, it is common for exchanges to crash. Due to insufficient system technology processing capacity, users cannot provide timely operation needs, resulting in unnecessary losses of user assets.

Currently, mainstream derivatives exchanges such as BitMEX, OKEx, and Binance have experienced system downtime and freezes . If such problems continue to occur, it will erode users' confidence in the exchange and bring adverse development to the derivatives trading market. The continued expansion of the cryptocurrency market will bring more user traffic, and the exchange's system processing capacity and stability will be the primary issue to be solved.

2. Evil behavior of exchanges

At present, there are a lot of exchanges in the cryptocurrency market, and small exchanges are emerging one after another. They use models or small profits to attract new users to trade derivatives, and then use manual operations such as unplugging network cables and "plugging pins" to maliciously blow up user funds . Even worse, they simply run away without being able to repay user assets. Small exchanges have limited profit margins, so they have the motivation to do evil. All this is because there are no clear regulatory measures in the industry at present, and the specific flow of user funds cannot be transparent after being held by exchanges, resulting in loss of interests.

3. Low investment threshold

Traditional financial securities firms require investors to have a certain amount of funds and investment experience to open derivatives functions, while most cryptocurrency exchanges do not even require users to undergo KYC identity authentication to conduct derivatives transactions. New entrants are not familiar with ordinary spot transactions, and conducting complex derivatives operations is more like a gamble of tossing a coin to guess the heads or tails.

Cryptocurrency exchanges continue to attract new users and collect a large amount of fees from them, but rarely consider setting investment thresholds for users to protect the interests of novice users. This will gradually turn exchanges into casinos, which is not conducive to the future development of derivatives.

4. Derivatives risks continue to increase

The role of derivatives should be used as a product for investors to hedge and reduce risks . At present, most exchanges provide derivatives with extremely high risks, especially the leverage ratio of perpetual contracts on some exchanges can reach 125 times. Cryptocurrency assets have high volatility compared to traditional securities assets, and coupled with the amplification effect of 100 times of leverage, user funds are on the verge of liquidation in minutes.

As the exchange's trading processing system continues to be upgraded and improved, the leverage multiple is also increasing. Although derivatives can hedge risks, the derivatives provided by the exchange are more like a gambling tool . Most users ignore the huge risks brought by derivatives in order to gain high returns.

05
Summarize

From the perspective of the entire development history of the cryptocurrency market, options contracts and leveraged tokens that have gone through spot trading, leveraged trading, futures contracts and leveraged tokens launched in the past year. The entire cryptocurrency industry is in a very early stage. Although derivative products have gradually improved by the exchange, they still have many uncontrollable factors.

At present, almost all derivatives in the cryptocurrency market are traded on the market . As the only channel connecting users and derivatives, the exchange needs to solve and overcome many technical difficulties and user fund security issues. At the same time, it constantly provides users with rich and valuable hedging tools, becoming a trusted and safe and stable platform for users.

The continuous evolution and innovation of derivative products will be the trend of the entire industry. The implementation of regulatory policies in the future will help derivative products become more standardized and risk-controlled , bringing lasting benefits to the overall development of the cryptocurrency market.

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