Written by: JustinZhao
1. What are financial derivatives
Financial derivatives refer to contracts whose value depends on changes in the value of the underlying asset (Underlying Asset). Such contracts can be standardized or non-standardized. Standardized contracts mean that the transaction price, transaction time, asset characteristics, and transaction methods of the underlying assets (underlying assets) are all standardized in advance. Therefore, most of these contracts are listed and traded on exchanges, such as futures; non-standardized contracts refer to The above items are agreed upon by both parties to the transaction, so it has strong flexibility, such as forward contracts.
The common feature of financial derivatives is margin trading, that is, as long as a certain percentage of the margin is paid, the full transaction can be carried out without actual principal transfer. The conclusion of the contract is generally carried out by cash difference settlement, only after The contract that is fulfilled by physical delivery on the maturity date requires the buyer to pay the remaining amount. Therefore, financial derivatives trading has a leverage effect. The lower the margin, the greater the leverage effect, and the greater the corresponding risks and returns.
2. The nature and characteristics of financial derivatives
Derivatives can be used to hedge positions, or use leverage for speculation, and their value comes from fluctuations in the price of the underlying asset. In the beginning, derivatives were used to ensure an equilibrium exchange rate for internationally traded commodities. Due to the different connotation values of legal currencies in various countries, international traders need a system to resolve differences in international exchange rates. Nowadays, derivatives can be based on a variety of transactions and have more uses, and there are even derivatives based on weather data, such as derivatives that determine the price based on the amount of rainfall or sunny days in a certain area.
For example, suppose there is a European investor whose investment accounts are all denominated in Euros (EUR). The investor uses U.S. dollars (USD) to buy shares of American companies through American exchanges. Now, investors face exchange rate risks when holding the stock. If the value of the euro rises, any profit that the investor realizes when selling the stock will be reduced in value when converted to euros. In order to hedge this risk, investors can buy currency derivatives to lock in specific exchange rates, such as currency futures and currency swap contracts.
On the other hand, if a speculator believes that the euro will appreciate relative to the US dollar, he can profit by using a derivative that rises with the euro. When using derivatives to speculate on the price changes of the underlying asset, investors do not need to actually hold the underlying asset.
In summary, financial derivatives have the following characteristics:
1. Zero-sum game: that is, the profit and loss of the two parties in the contract transaction (whether it can be traded in a standardized contract is uncertain) are completely negatively correlated, and the net profit and loss is zero, so it is called “zero-sum”.
2. High leverage: The trading of derivatives adopts the margin system (margin), that is, the minimum capital required for the transaction only needs to meet a certain percentage of the value of the underlying asset.
Margin can be divided into initial margin (initial margin), maintenance margin (maintains margin), and the market-making system (marking to market) is adopted when trading on the exchange. If the margin ratio during the transaction is lower than the maintenance margin ratio, it will be charged To the margin call, if the investor does not make a timely margin call, the corresponding account will be forcibly closed. It can be seen that derivatives transactions also have the characteristics of high risk and high return.
The role of financial derivatives includes risk aversion and price discovery. It is a good way to hedge asset risks. However, everything has a good side and a bad side. There are two sides to everything. Risk aversion must be assumed by someone. The essence is risk transfer. The high leverage of derivatives is to transfer huge risks to those who are willing to bear. This type of trader is called Speculator, and the party who avoids the risk is called Hedger. The other type Traders are called Arbitragers. These three types of traders jointly maintain the above functions of the financial derivatives market.
3. Types of financial derivatives
There are many types of financial derivatives in the world, and active financial innovation activities continue to introduce new derivatives. There are mainly the following classification methods for financial derivatives:
3.1 According to product form
It can be divided into four categories: forwards, futures, options and swaps.
Both forward contracts and futures contracts are transactions in which both parties agree to buy and sell assets of a certain quantity and quality at a certain time and at a certain price in the future. The futures contract is a standardized contract formulated by the futures exchange, which has unified regulations on the expiry date of the contract and the type, quantity and quality of the assets it trades. A forward contract is a contract signed by the buyer and the seller based on their special needs. Therefore, the liquidity of futures trading is high, and the liquidity of forward trading is low.
A swap contract is a contract signed for both parties to exchange certain assets at a certain period in the future. To be more precise, a swap contract is a contract between the parties to exchange cash flows that they believe to have equal economic value (CashFlow) within a certain period in the future. The more common ones are interest rate swap contracts and currency swap contracts. If the exchange currency specified in the swap contract is the same currency, it is an interest rate swap; if it is a different currency, it is a currency swap.
Option trading is a transaction of buying and selling rights. Option contracts stipulate the right to buy or sell underlying assets of a specific type, quantity, and quality at a specific price at a specific time. Option contracts include standardized contracts listed on exchanges and non-standardized contracts over the counter (ie OTC).
3.2 According to the underlying assets
It can be divided into four categories, namely stocks, interest rates, exchange rates and commodities.
If further subdivided, the stock category includes specific stocks and stock indexes formed by stock combinations; the interest rate category can be divided into short-term interest rates represented by short-term deposit rates and long-term interest rates represented by long-term bond rates; The exchange rate currency category includes the ratio between various currencies: the commodity category includes various bulk physical commodities.
3.3 According to the transaction method
It can be divided into on-exchange and over-the-counter transactions.
Exchange trading, also known as exchange trading, refers to a trading method in which all supply and demand parties concentrate on the exchange for bidding transactions. This trading method has the characteristics of the exchange collecting margin from trading participants, and at the same time being responsible for clearing and assuming performance guarantee responsibilities. In addition, because each investor has different needs, the exchange designs standardized financial contracts in advance, and investors choose the contracts and quantities that are closest to their needs for trading. All traders concentrate on one place to conduct transactions, which increases the density of transactions and generally forms a market with higher liquidity. Futures trading and partial standardized option contract trading belong to this type of trading.
Over-the-counter transactions, also known as over-the-counter (OTC), refer to a transaction method in which both parties to a transaction directly become counterparties. This type of transaction has many forms, and products with different contents can be designed according to the different needs of each user. At the same time, in order to meet the specific requirements of customers, financial institutions that sell derivatives need to have superb financial technology and risk management capabilities. Over-the-counter transactions continue to generate financial innovation. However, since the settlement of each transaction is carried out by the two parties responsible for each other, transaction participants are limited to customers with a high degree of credit. Swap transactions and forward transactions are representative derivatives of counter transactions.
Comparison chart of on-market and off-market derivatives
4. Market status of traditional financial derivatives
According to statistics, among the holdings of financial derivatives, classified by transaction patterns, the holdings of forward transactions are the largest, accounting for 42% of the overall holdings, followed by swaps (27%), futures (18%) and options. (13%). Classified by transaction objects, financial derivatives related to interest rates represented by interest rate swaps and interest rate forward transactions accounted for the largest market share at 62%, followed by currency derivatives (37%) and stock and commodity derivatives. (1%). In the six years from 1989 to 1995, the financial derivatives market expanded by 5 to 7 times. The gap between various trading forms and various trading objects is not large, and the overall trend is expanding at a high speed.
In short, the derivatives market is huge. The high-end market is usually estimated to exceed $1 trillion, largely because there are a large number of derivatives. Almost all possible investment asset types can use derivatives, including stocks, commodities, bonds and currency. Some market analysts even believe that its market size is more than ten times the world’s gross domestic product (GDP).
According to the latest data from the Bank for International Settlements (BIS), in the first half of 2020, the total notional value of open positions in the derivatives market is estimated at US$600 trillion, but the total market value of all contracts is much less: about US$12 trillion . The over-the-counter derivatives market in nominal value is at its highest level since 2014. Interest rate derivatives account for most of the value of OTC nominal derivatives. The nominal value of interest rate contracts is close to US$200 trillion. At the same time, the total value of derivatives has been declining in recent years, but has rebounded in 2019.
Chart of changes in the nominal amount of OTC derivatives market (data source: BIS)
4.1 Futures contracts
Table of Changes in International Futures Market Transaction Volume by Currency (Data Source: BIS)
According to the latest statistics of the Bank for International Settlements, the unsettled contract position in March 2020 was US$3.24 trillion, and the average daily trading volume was US$1.22 trillion, while the unsettled position in December 2019 was US$3.5 trillion. Slightly more than in March this year, but the average daily transaction volume is only 0.48 trillion U.S. dollars, far less than the amount in March this year.
4.2 Option contract
Table of Changes in International Options Market Transaction Volume by Currency (Data Source: BIS)
The trading volume of the international options market also shows a similar pattern. The amount of unsettled options in March 2020 and December 2019 is not much different, slightly more than 6 trillion US dollars. However, the average daily transaction volume was US$0.37 trillion and US$0.13 trillion respectively. The average daily transaction volume in 2020 was nearly three times that of the same period last year and more than doubled. This may be related to the sharp decline in the equity market caused by the epidemic in March.
4.3 Swap contract
CDS market transaction volume change table by region (data source: BIS)
Credit default swaps (CDS) are the most common credit derivatives in foreign bond markets. In a credit default swap transaction, the default swap buyer will pay a certain fee to the default swap seller on a regular basis (called credit default swap spread), and once a credit event (mainly the bond subject’s inability to pay) occurs, the default Swap buyers will have the right to deliver bonds at face value to default swap sellers, thereby effectively avoiding credit risk. Since the definition of credit default swap products is simple, easy to achieve standardization, and transactions are concise, since the 1990s, this financial product has developed rapidly in developed foreign financial markets. According to the latest statistics from the Bank for International Settlements, in the second half of 2019, the transaction volume of credit default swaps (CDS) reached 0.76 trillion US dollars.
4.4 Advantages and disadvantages of traditional financial derivatives
As mentioned in the above example, derivatives are useful tools for companies and investors. They provide a way to lock in prices, hedge against unfavorable interest rate fluctuations and mitigate risks, usually at the expense of limited costs. In addition, derivatives can usually be purchased on margin (that is, purchased with borrowed funds), which makes them cheaper.
The downside is that derivatives are difficult to value because they are based on the price of another asset. The risks of OTC derivatives even include counterparty risks that are difficult to assess. Most derivatives are also sensitive to the expiry time, the cost of holding the subject matter, and changes in interest rates. These variables make it difficult to perfectly match the value of the derivative with the underlying asset.
In addition, because derivatives themselves have no intrinsic value (its value comes only from the subject matter), they are susceptible to market sentiment and market risks. Supply and demand factors may cause the price of derivatives and their liquidity to fluctuate up and down, regardless of the price of the underlying asset.
Regarding the supervision of financial derivatives, a three-level risk management model of enterprise self-control, industry association and exchange self-regulation, and government department supervision is basically adopted internationally. However, due to the restrictions on the liquidity of traditional financial objects and assets, financial derivatives are often unable to circulate across borders, resulting in a certain degree of regional imbalance and even over-centralization of liquidity, such as dollar hegemony. Another, excessively strict financial supervision, although protecting investors, but to a certain extent damage the innovation of financial technology and derivatives.
5. Current market status of digital asset derivatives
5.1 Comparison of digital assets and traditional assets
Bitcoin and other cryptocurrencies have been difficult to categorize since they entered the public eye. Many people believe that they are independent of traditional asset classes, although at the beginning of their birth, cryptocurrencies are considered to be able to make up for the shortcomings of the traditional investment market.
Cryptocurrency is not exactly like stocks, and cryptocurrency exchanges do not operate like traditional securities markets. Therefore, many crypto asset investment strategies based on conventional definitions of market share, capital, volatility, and trading volume have serious flaws. Misleading numbers mean that people lack understanding of the valuation and adoption of cryptocurrencies, which has caused the media and investors to misunderstand cryptocurrencies such as Bitcoin.
The first major difference between Bitcoin and securities is that most of the market value of Bitcoin comes from imagination of future application scenarios. Today, Bitcoin has been used by millions of users as a utility currency and store of value. Another important difference between the cryptocurrency market and the traditional market is the size of its order book. Traditional stocks like Apple are traded on an exchange. Every day, thousands of buyers and sellers offer tens of millions of stocks for trading. Therefore, securities markets like the New York Stock Exchange and the Nasdaq Stock Exchange have very little slippage, and they can effectively handle large orders and current market prices. The third important difference between cryptocurrency and traditional securities is the ratio of investment cost to market value. The total value of the company’s stock is based on investors’ belief in its future profit potential. This profitability is achieved by investing in stocks. Bitcoin is an open network, not a private entity, so its market value is the total value of all bitcoins calculated at current market prices, and the investment cost is the total investment in the bitcoin ecosystem. As of now (July 2020), websites that track the market value of cryptocurrencies (such as coinmarketcap.com) have reported that the market value of Bitcoin is $169.3 billion.
The development of cryptocurrency may be carried out in three stages: discovery, infrastructure and applications. The discovery phase was from 2008 to 2013, when the community determined the basic concepts and tools of cryptocurrency. The infrastructure phase began in 2013 when people realized the need to establish an alternative to the failed Mt Gox exchange. The current infrastructure phase involves the creation of an ecosystem consisting of consumers, trusted intermediaries, and suppliers that accept Bitcoin. Once a mature cryptocurrency infrastructure is established, it means entering this stage.
As we all know, as the underlying asset, cryptocurrency has super global liquidity and relatively high anonymity, which is also an important feature of the financial technology revolution brought about by blockchain technology. The emergence of ETH has also completely changed the process of crowdfunding and financing, making the financing before listing and directly facing global investors. If you have to make an analogy, IPOs in the stock market are ICOs and IEOs in cryptocurrencies. Currency listings on exchanges are similar to stock listings. Of course, there is also a big difference here. After all, IPO is a natural result of a relatively mature business model of a company, and it protects investors very strongly. However, ICO and IEO often occur in the initial stage of the team. If the later project fails and the token is returned to zero, investors will suffer a lot of losses.
5.2 Digital asset contract market
Because cryptocurrency as an asset class is still in a very early stage, the OTC market is dominated by fiat currency transactions, plus some lending, and there are not many OTC derivatives markets like traditional financial markets. On the contrary, the cryptocurrency derivatives market is dominated by exchange transactions, of which delivery futures account for the largest proportion, followed by perpetual swaps. Options trading has also begun to develop on a large scale this year.
According to TokenInsight’s statistics, in the first quarter of 2020, the total trading volume of digital asset futures reached $2104.8 billion, an increase of 314% from the average of the four quarters last year. It can be seen that in addition to a slight decline in the fourth quarter of 2019, the trading volume of digital asset futures has steadily increased in the past year, and the total market volume in this quarter has reached nearly 8 times that of the first quarter of last year.
Also from a report by TokenInsight, in the first quarter of 2020, the total volume of digital asset futures trading has accounted for two-thirds of the spot trading volume (including perpetual swap contracts). Compared with the current concept of cash as king in the traditional investment market, the digital asset futures industry is still developing rapidly.
Among many exchanges, the top futures exchanges (the top six exchanges in trading volume) have a relatively stable pattern. In the ranking of the first quarter of 2020, the top three exchanges accounted for 56% of the market volume and the top six accounted for 81%. The trading volume of futures on the other seven exchanges exceeded the $100 billion mark.
5.3 Perpetual contract
Compared with the delivery date of the delivery futures contract, the perpetual contract does not have to be in an embarrassing situation of having to close the position because the delivery date of the holding contract approaches. Perpetual contracts fundamentally get rid of the shackles of the delivery date, and also avoid repeatedly opening positions, missing the market, unnecessary handling fees, etc., making profits unable to maximize. The price mechanism of perpetual contracts is also different from that of delivery contracts. Perpetual contracts are benchmarked against spot prices and are not easy to be maliciously “pinned” to lead to uncontrollable liquidation and penetration.
Comparing perpetual swap contracts with traditional asset derivatives, they are a bit similar to perpetual bonds (it does not specify a maturity period, and the holder cannot claim the repayment of the principal, but can earn interest on schedule. Perpetual bonds generally only Limited to government bonds). Perpetual contract is an innovative financial derivative. The contract is similar to traditional delivery futures contract. The biggest difference is that: Perpetual contract has no expiration date or settlement date, and users can hold positions indefinitely.
In addition, the perpetual contract introduces the concept of spot price index, and through the corresponding mechanism, the price of the perpetual contract returns to the spot index price. Therefore, unlike traditional futures, the price of the perpetual contract will not deviate from the spot price most of the time too much. Imagine a futures contract for a physical commodity, such as gold. In the traditional futures market, these contracts mark the delivery date of gold. In other words, gold should be delivered when the futures contract expires. Since one party is required to actually hold gold in the traditional futures market, this will lead to the “holding cost” of the futures contract.
Perpetual contracts adopt the characteristics of futures contracts, especially without the need to deliver actual commodities. At the same time, it imitated the behavior of the spot market to narrow the gap between the futures price and the marked price. Compared with traditional futures contracts, this is a big improvement.
It can be seen from the chart that the perpetual contract trading market has been in a state of rapid development since 2016. The 30-day trading volume of each exchange contract went online from Bitmex’s 79 million USD to Huobi DM’s 9.27 billion USD, an increase of 117 times.
5.4 Option contracts
Compared with the rapid development of futures contracts, the current digital asset options market is still at an early stage. Its main features include:
The types of underlying assets are limited, and the reference prices of underlying assets are not uniform. In the current market, the underlying assets basically revolve around Bitcoin. Some platforms also provide ETH option products, but compared to the traditional options market, the underlying assets of digital asset options are still very single.
The number of options trading platforms is limited, and non-compliant platforms dominate innovation and trading volume. Because of the complexity of the option trading system, risk control capabilities, and other aspects of technical and financial knowledge requirements are relatively high, the development cost is also relatively large, so the current number of such platforms is small.
The options market has a higher counterparty risk. The digital asset market is highly speculative and prices fluctuate greatly. Investors have strong homogeneity, chasing ups and downs. These characteristics are transmitted in the options market, showing that investors often buy call options or put options at the same time. Therefore, the sellers in the digital asset options market are mostly the exchange itself or its anchor market makers. Due to the high transaction costs, high short selling costs and weak liquidity of the digital asset market, market makers or exchanges cannot completely hedge their positions. Risks have to be exposed to market risks, especially when the market fluctuates sharply. Therefore, for speculators, the potential default risk or counterparty risk of market makers or exchanges cannot be ignored. The existence of counterparty risk has led to a lack of institutional investors in the current options market and low trading volume. Comparing the daily trading volume of futures at US$12-30 billion, the current market-wide daily trading volume of options is about US$50-180 million (statistics on March 5, 2020).
5.5 Decentralized exchange
The popularity of digital assets has brought about the great development of blockchain technology, and the development of blockchain technology has brought about the explosion of “decentralized finance” (DeFi) that is fundamentally different from traditional finance. Decentralized exchange (DEX) is the fastest growing field in DeFi.
TokenInsight summarized the four stages that DEX has gone through in the past three years: (1) DEX began to appear in 2017; (2) DEX market began to develop in 2018; (3) The DEX market scale in 2019 did not change much, but the market competition pattern has undergone greater changes. Great changes; (4) 2020 is the beginning of the official outbreak of DEX. Not only the market scale is growing rapidly, but the market competition pattern is also becoming increasingly fierce.
In 2017, there was only one decentralized exchange (IDEX) whose annual transaction volume was less than 5 million U.S. dollars; in 2018, DEX transaction volume achieved explosive growth, with transaction volume reaching 2.7 billion U.S. dollars; in 2019, the transaction volume was slightly Shrinking; in 2020, the DEX industry as a whole has entered a stage of rapid development, and its first-quarter transaction volume (2.3 billion US dollars) almost equaled the full-year transaction volume of 2019. Total transaction volume in the second quarter rose to a record high: US$3.7 billion.
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The decentralized exchange DEX can be further divided into two areas, one is the spot exchange and the other is the derivatives exchange. The DEX discussed above are mainly spot transactions, and the derivative DEX has not yet been applied on a large scale due to the complexity of financial design. The derivatives DEX that will be launched in the second half of 2020 are Injective Protocol, DerivaDEX and MCDEX. Here is an example of the upcoming Injective Protocol.
Based on the Injective chain, its trading platform has also achieved a fully open source design, which is a completely decentralized network. ; But at the same time it provides a market maker-friendly API interface, which is close to the current mainstream exchange interface, and the user experience is no different from that of a centralized exchange. However, in terms of management system, the Injective trading platform has borrowed from the auditing system of centralized exchanges, and is modeled. The listing of coins requires auditing, but all this is based on community management, not just a word. In addition, the Injective trading platform has introduced the world’s top market makers and a strong liquidity incentive mechanism to ensure sufficient liquidity in the trading platform.
6 Conclusion
DEX will usher in an explosion in 2020, with a transaction volume of US$6 billion, but compared to the trillion-dollar scale of the traditional financial derivatives market, there is still a lot of room for development. The DEX industry is still in an immature state so far, and its market structure is currently relatively unclear. Obviously, the increase in market transaction volume in 2020 will obviously come from the newly emerging DEX projects. In the field of digital asset spot exchanges, the huge development of the derivatives market has been clearly noticed; and correspondingly, whether decentralized exchanges, or DEXs, will also experience such as the outbreak of the derivatives market, it is worth seeing.
references
1. MAB Think Tank Encyclopedia: Financial Derivatives
https://wiki.mbalib.com/wiki/%E9%87%91%E8%9E%8D%E8%A1%8D%E7%94%9F%E5%93%81
2. Investopedia: Derivative
https://www.investopedia.com/terms/d/derivative.asp
3. Investopedia: How Big Is the Derivatives Market?
https://www.investopedia.com/ask/answers/052715/how-big-derivatives-market.asp
4. BIS: About derivatives statistics
https://www.bis.org/statistics/about_derivatives_stats.htm?m=6%7C32%7C639
5. FEE: Three Key Differences between Traditional andCryptoasset Markets
https://fee.org/articles/three-key-differences-between-traditional-and-cryptoasset-markets/
6. TokenInsight: 2020 Q1 Digital Asset Derivatives Exchange Industry Research Report
7. TokenInsight: Analysis of Perpetual Contract Market in April 2020
8. TokenInsight: DeFi Industry Research Report Part 1 – DEX
