Crypto Derivatives

This post was originally published on May 23, 2019, and sent to Messari Pro subscribers.

What do Thales of Miletus and hedge fund managers have in common? They use derivatives to speculate on the future. In pre-Socratic Greece, Thales believed a bountiful olive harvest was on its way. He went to the owners of the olive presses and paid them a fraction of the cost of the equipment for the right to use them in the following year. When the next harvest was as good as he predicted, people were clamoring for the presses, and Thales profited nicely by renting them out. This was the first recorded options contract.

Nowadays, bankers use options to speculate on anything from Apple stock to wheat to weather. Derivatives have become an integral part of the global financial system, for both speculation and risk management. In fact, derivatives have burgeoned into a $500 trillion dollar market, exceeding global GDP by over 7 times. After the ‘08 crisis, these financial instruments had their reputation tarnished - and rightfully so - as derivatives such as the CDO^3, three times repackaged collateralized debt obligation, masked enormous risk in the underlying mortgage market. This type of financial engineering added complexity to an already opaque market and created leverage that was difficult to identify in the system.

Still, certain derivatives are a necessary component for many businesses. Whether you’re an airline, a tomato farmer, or any business with credit needs there are ways derivatives can be used to manage risk. In these situations, an increase in the price of oil, a decrease in the price of tomatoes, or a rise in interest rates can significantly damage your bottom line. Derivatives allow you to lock in the price of a commodity or the interest rate on a loan in order to mitigate that risk. This type of hedging provides tangible benefits to these business owners. However, it wouldn’t be possible without the speculators. Someone always has to take the other side of the bet.

Just as gold miners have an inherent long position on gold, bitcoin miners have a similar position to bitcoin. In order to decrease the impacts of a precipitous drop in price, miners can use derivatives to offset some of that risk. This has not been easy for most of bitcoin’s existence. Creating these structured products requires regulatory approval, which as we know has been a hurdle for anything related to bitcoin. The first crypto derivative came about in 2014 after Tera Exchange received CFTC approval to list bitcoin swaps and forwards. Since then there have been a number of exchanges (including the largest derivatives exchange in the world - CME Group) looking to offer bitcoin derivatives.

A partial list of the largest crypto derivatives platforms today: