Analysis: Why Crypto Derivatives Are Considered Dangerous

There is a new generation of cryptocurrency-based derivatives being launched in 2019 which could significantly increase overall trading flow and attract a new breed of investors. Derivatives are not without their controversies however. Over the years, they have acquired a negative reputation in some quarters, exacerbated by movies such as “The Big Short.”

Also read: Market Slump Puts Crypto Derivatives in the Spotlight

Understanding the Danger of Derivatives

The Big Short, 2015.

Derivatives are financial securities that are based or tied in some way to another asset. The majority of derivatives are sold over-the-counter (OTC) and the primary danger associated with trading these is counterparty and liquidity risks. The movie “The Big Short,” released in 2015, is useful in understanding the hazards of derivatives. But in that particular case, the mechanism under scrutiny was credit default swaps (CDS), a type of derivative which helped upset the global economy in 2007-2008. Due to the opaque nature of derivatives, as well as other inherent risks, world leaders have been taking increased interest in the products. 

Currently there are a number of major players in finance offering crypto derivatives. These include NASDAQ, Cboe Global Markets, and Goldman Sachs. Lars Seier Christensen, chairman of Concordium and founder of Saxo Bank, has said that the introduction of new cryptocurrency-based derivatives in 2019 will hinge on the overall trading flow.

Christensen said: “If the primary cryptocurrency exchange market continues to be in trouble there will be little appetite for launching new trading vehicles. On the other hand, if trading picks back up, it is quite likely that we will see a slew of new initiatives being launched — perhaps even some that have already been planned and gone through due diligence but where the offering party have been waiting for a better time to launch.” 

UK’s FCA Is Considering Banning Crypto-Based Derivatives

Before the crypto market gets ahead of itself with further launches of complex products, financiers should note that regulators are cracking down in some quarters. The U.K.’s Financial Conduct Authority has expressed concern and is considering banning some cryptocurrency-based derivatives. This move by the U.K. regulator has been noted as the first major intervention in the cryptocurrency market.  

Christopher Woolard, executive director of strategy and competition at the FCA, delivered a speech at the Regulation of Cryptocurrencies event in London, in which he said: 

“We’re concerned that retail consumers are being sold complex, volatile and often leveraged derivatives products based on exchange tokens with underlying market integrity issues. Given this, the FCA will also consult on a prohibition of the sale to retail consumers of derivatives referencing certain types of cryptoassets, for example, exchange tokens, including contracts-for-difference, options, futures and transferable securities.”

Frank Wagner, CEO of INVAO, a blockchain asset pool leveraging automated trading for active portfolio management, explained the concern with cryptocurrency based derivatives is that retail investors may be sold unreliable derivatives products, such as contracts for difference, options and futures.

Derivatives Have a Poor Reputation

Wagner said: “The nature of the crypto market being fast-moving and volatile in comparison to the traditional market has led to it attracting a measure of concern. Making accurate predictions on prices in the cryptocurrency market is difficult. This is combined with the fact that derivatives themselves have a poor reputation.” 

On the plus side, Wagner explained, derivatives can offer some insulation from market uncertainty and therefore an opportunity for new investors to get involved.

“There’s a lot of anticipation that crypto derivatives will actually make the market more reliable and legitimate by boosting investor activity, mainstream attention, and thus liquidity and trading volumes,” said Wagner.

Further Regulation Will Give Investors Security

According to Wagner, the concern that crypto derivatives are unregulated, and therefore unstable, can be solved through welcome government regulation of digital assets.

“If an exchange is to offer crypto derivatives, it must be regulated, legitimate and secure for investors, which is one of the many reasons why regulation is needed. Crypto derivatives will help to mature and stabilise the industry,” he added. 

The most eagerly anticipated crypto derivative in 2019 is Bakkt’s physical bitcoin futures. The success of this product, particularly in terms of investor uptake, will help to determine the rate at which subsequent derivatives are launched. Unlike in “The Big Short,” crypto derivatives do not threaten the global economy. Nevertheless, they remain a controversial financial product whose effects upon the cryptocurrency market have yet to be fully assessed.

What are your thoughts on cryptocurrency derivatives? Let us know in the comments section below.

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