The use of derivatives as a vehicle for price speculation and hedging may be appealing to many traders who are transitioning from traditional finance into cryptocurrency markets. There are numerous exchanges and instruments available; however, traders should consider several key distinctions between crypto futures and traditional futures before dabbling in this rapidly growing market.
Related: Three essential facts about derivatives exchanges that every cryptocurrency trader should know
Different instruments
Futures contracts with a fixed expiration date will be familiar to traders who come from traditional markets and want to enter the cryptocurrency market.
However, despite the fact that fixed-expiration contracts are available on cryptocurrency exchanges, a significant portion of cryptocurrency futures trading is conducted in perpetual contracts, also known as perpetual swaps.
Due to the fact that this variation of a futures contract does not have a set expiration date, a trader can maintain an open position indefinitely.
Exchanges that trade perpetual contracts rely on a mechanism known as the „funding rate“ to maintain a constant price differential between the contract markets and the spot markets on a periodic basis.
If the funding rate is positive, the perpetual contract price is higher than the spot rate — longs pay shorts — and the perpetual contract price is higher than the spot rate.
A negative funding rate, on the other hand, indicates that shorts are compensated by longs.
Trading in cryptocurrency may also be familiar to traders who have come from traditional finance, who are accustomed to being able to move their positions between different exchanges.
In contrast, cryptocurrency exchanges typically operate as „walled gardens,“ which means that it is impossible to transfer derivatives contracts from one platform to another.
Related: Professional traders need a global crypto sea, not hundreds of lakes
Regulated vs. unregulated trading platforms
The vast majority of cryptocurrency futures trading — approximately 85 to 90 percent — has not yet been regulated.
This situation arose primarily as a result of the emergence of cryptocurrency futures markets at a time when regulators were still grappling with more fundamental questions regarding the legal status of digital assets, such as whether they were securities.
By utilizing coin-margined and collateralized contracts, BitMEX paved the way for cryptocurrency futures trading to take off.
The company was able to avoid the regulatory requirements associated with fiat on-ramps as a result of this strategy.
There are approximately a dozen major trading platforms available at any given time, but only a small number of them have obtained regulatory approval.
The Chicago Mercantile Exchange (CME) and Bakkt are both governed by the United States Commodity Futures Trading Commission (CFTC), which oversees commodity futures trading (CFTC).
Kraken Futures operates in Europe under the auspices of a multilateral trading facility license granted by the Financial Conduct Authority of the United Kingdom.
Vontobel and Leonteq, both based in Switzerland, offer mini-Bitcoin futures contracts through the SIX Swiss Exchange.
It is possible that traders in some countries will be unable to participate in non-regulated trading venues due to the regulatory environment.
This is especially true in the United States, where exchanges are cognizant of the fact that the Commodity Futures Trading Commission (CFTC) is currently pursuing BitMEX for violating anti-money laundering regulations and the Bank Secrecy Act.
However, the crypto futures platforms that are regulated in the United States have expanded their product offerings beyond pure Bitcoin (BTC) futures, most likely in response to increased demand.
The CME, for example, has recently expanded its offerings beyond Bitcoin futures and options to include Ether (ETH) futures as well as other cryptocurrencies.
Aside from that, Bakkt also provides Bitcoin monthly futures and options contracts.
Traders in countries where they are permitted to operate can trade futures contracts and perpetual swaps against a broader range of altcoins on unregulated platforms, but only in those countries where they are permitted to operate.
In any case, for the time being, the majority of the available liquidity is concentrated in bitcoin and ether futures.
Operational implications
Because of the differences in regulatory environments, as well as the differences in how perpetual contracts are managed, there are some practical differences between crypto futures and traditional futures.
Exchanges are exposed to significant risk because there is no central counterparty clearing system in place, which is compounded by the fact that many of them offer high leverage of up to 125 times in their trading operations.
In order to avoid this, any losing positions that reach the maintenance margin will be closed out.
In most cases, exchanges divert any profits from liquidations into an insurance fund, which is designed to protect traders‘ profits in the event that their counterparty does not have sufficient margin to cover the trade.
When trading on an unregulated exchange, the presence and relative health of an insurance fund is a critical consideration to take into account.
Profitable traders who do not have a fund, or who have a fund that is insufficient to cover the losses incurred by liquidations, run the risk of having their positions “auto-deleveraged” by the exchange if the fund runs out of money.
Another important operational consideration is the downtime of the exchange.
Many of the unregulated platforms have a reputation for crashing servers during periods of high volatility, causing traders to be unable to close their positions before their accounts are liquidated.
As a result, it is worthwhile to look into a platform’s history of downtime before signing up for an account.
Low barriers to entry
The cryptocurrency futures markets, on the whole, have a very low entry barrier to participation.
It takes minutes for a trader to open an account, go through the „know your customer“ process, deposit funds, and get started trading on the stock market.
The barriers to entry for exchange-traded futures, on the other hand, are high due to the large contract sizes involved, which are intended for use by institutional investors.
This is reflected in the offerings of regulated cryptocurrency futures contracts as well.
Contract sizes for cryptocurrency futures trading on the CME and Bakkt, the two regulated crypto futures trading venues, are 5 bitcoins and 1 bitcoin, respectively.
With prices currently exceeding $31,000, it is clear that these contracts are only intended for those who are prepared to make a significant financial commitment.
Through asset tokenization, blockchain, on the other hand, has the potential to significantly transform the futures markets in ways that go beyond cryptocurrencies.
If a futures contract for the Nasdaq-100 or the S&P 500 were made available as a token, what would happen?
This would allow it to be traded in fractional increments, lowering entry barriers and introducing new sources of liquidity into traditional markets.
Related: Understanding the systemic shift from digitization to tokenization of financial services
It is possible that such a scenario will be advantageous for those seeking to introduce more fine-grained diversification into their portfolios, which is currently only possible through the use of contracts for differences (CFD).
Despite the fact that they serve a similar function in the financial markets, CFDs are only available through brokers, reducing transparency for the trader in the process.
In addition, it fragments the available liquidity in the broader markets as a whole.
Despite their rapid growth, cryptocurrency futures markets are still in their infancy, particularly given the fact that institutional investment in cryptocurrency is only just getting started.
As the markets continue to grow and develop, we can expect to see the introduction of new and more sophisticated instruments, as well as some blurring of the lines between traditional and digital finance.
Furthermore, it appears likely that the regulatory environment will continue to evolve as more funds are brought into the industry.
One thing is certain: cryptocurrency futures have a long and prosperous future ahead of them.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of CoinNewsDaily.
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