HOW THE DERIVATIVES MARKET WORKS

The derivatives market is nothing more than a market composed of financial instruments whose price is derived from an underlying asset, index or reference rate.

In traditional finance, derivatives are traded in contracts related to physical goods (such as coffee, gold and other commodities) and financial ones, such as shares or interest rates in different modalities, the main ones being swaps and futures contracts.

The negotiations are structured in 2 ways: buy (long) and sell (short), and the buyer does not necessarily receive the underlying asset of the contract in physical form, such as a bag of corn or coffee, or gold.

In the case of crypto-assets, the dynamics do not change much. But how did this modality come to the crypto market?

The increase in the flow of institutional investors has brought an increasing demand for derivatives. These instruments allow the efficient implementation of sophisticated portfolio management strategies and are financial tools that provide investors with several advantages such as risk transfer, capital efficiency and tax treatment.

Some of these benefits can be magnified by managing high volume portfolios, which is common for large investors. For these reasons, cryptocurrency derivatives have been positioning themselves as a hot market, with potential to increase in volume in the coming years.

Derivatives contracts are presebted in different compositions, the most common futures and options.

Of the products actively used in traditional financial markets, only a few are used to a substantial degree in the crypto market. Futures are the most common. While these, and perpetual swaps in particular, currently dominate in terms of trading volume, the use and development of the options market is also expanding rapidly.

UNDERSTANDING SOME TERMS: OPEN INTEREST

The concept of Open Interest refers to the sum of the total number of outstanding derivative contracts not yet settled, that is, the contracts of all long or short positions in the market that have not yet been zeroed out or settled, and continue to be held by market participants. Marketplace.

An indicator generally associated with the futures and options markets, as the number of existing contracts changes daily in greater volumes than in the spot market, the Open Interest is important for measuring the liquidity of derivative contracts, as well as for measuring the market trends.

This is because, based on the assumption that the futures market is composed of a different volume of bought and sold, Open Interest is able to capture nuances to confirm or even indicate trend reversals based on the number of open contracts and their price movement.

Open interest is still an efficient measure of identifying the flow of money to futures or options markets.

The increase in the amount of open interest is nothing more than money entering the market and vice versa, and, combined with prices, signals market trends and moments.

WHAT IS OPEN INTEREST

Some of the possible scenarios are:

1. A rising Open Interest and an increase in price confirm an uptrend in the futures market;

2. a price drop combined with an increase in Open Interest indicates a weak market.

Thus, Open Interest is crucial for investors, who use the indicator to, for example, assess the liquidity of an option, or study the opening of a position or hedge, in other words, the ease or difficulty of finding traders who close position at the opposite end.

AGGREGATE OPEN INTEREST IN BTC FUTURES

From the end of 2020 onwards, the indicator began an upward movement, with sudden drops in 2021 and a stability currently, around US$ 18 billion. The main BTC futures exchange is Binance.

AGGREGATE OPEN INTEREST IN ETHEREUM FUTURES

With its historic peak between late 2021 and early 2022, the indicator started its bullish move towards Ether also from 2020.

TRANSACTIONAL VOLUME AND OPEN INTEREST IN FUTURE MARKET

As Open Interest needs complementary indicators for a better mapping of market trends, the traded volume is shown as an additional metric in the derivatives market activities.

Each transaction, ie position opening and closing, is considered in the volume metric, with a higher volume indicating greater liquidity and activity in a derivative contract.

It is worth noting the difference between the volumes of open interest and volume. While the volume traded is in the trillions of dollars, open interest is in the billions.

That is, a higher volume relative to open interest indicates that considerable trading activity is taking place, signaling that there is room for investors to go beyond the spot market and be able to conduct considerable trades in the cryptocurrency derivatives space.

BTC FUTURES VOLUME

The volume of BTC futures contracts averages more than $1 trillion monthly.

VOLUME OF ETHEREUM FUTURES

The volume of ETH futures contracts averages more than $600 billion monthly.

BTC OPTIONS VOLUME

The volume of options has also shown considerable growth since July 2020, albeit in a lower gross proportion than the volume of futures.

Deribit is the industry's leading exchange, with an average trading volume of 15 billion per month.

VOLUME ETHEREUM OPTIONS

Despite being lower than the volume observed in the case of bitcoin, the volume of Ethereum options also grew from 2020 onwards, from an amount of $2 billion in July 2021 to a peak of approximately $17 billion in May 2020. 2021, settling at US$11 billion in March 2022.

Deribit also leads the Ethereum Options trading volume.

BIGGEST BROKERS FOR FUTURE CONTRACTS IN OPEN (OPEN INTEREST)

Binance is the largest in terms of open futures contracts, with $4.83 billion in open interest and 28.2% marketshare.

CME comes in second, with $2.83 billion and (16.5% in market share. dYdX is the decentralized exchange with the highest volume of open interest, $0.31 billion

The crypto derivatives market has come a long way since 2017, establishing itself and confirming the innovative potential of the sector, which can no longer be ignored by traditional financial market participants.

The growth of crypto derivatives activity has grown in recent years, representing more value than the segment's spot markets, a feat accomplished thanks to the traditional investor's increasing attention to capital efficiency with low transaction costs.

The maturation of crypto derivatives markets, increased liquidity and increased inflows from institutional investors can be important factors in attracting and expanding adoption of crypto assets in the medium and long term.

Currently, while regulators are still trying to find the right balance between trying to regulate the sector and allowing it to grow, it seems that the cryptocurrency market is likely to become more investable over the next few years, which indicates a good scenario for a even stronger growth in the derivatives segment.

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