Crypto derivatives offer unique advantages over traditional ones. But at what cost? In this article we look at what they are and what kind of security risks the users face.
The cost and time of launching a crypto derivative exchange and products is drastically reduced, as lots of middle-men are cut out and generally less paperwork is needed. In addition to the fast development speed come huge price fluctuations. Bitcoin and other cryptocurrencies are known for that to lots of people by now. Professional traders love price fluctuations, as they mean more potential profit.
We look at differences of crypto derivatives and traditional ones, using the example of the popular comparison of Bitcoin and Gold.
Demand: A trader can do a study about the demand of the underlying Gold derivative contract asset (Gold itself). The trader can't do that with Bitcoin, as the demand side is less fundamentally driven and currently not well understood.
Supply: A trader also can do research of the Gold supply. Here, only estimates float around and many factors influence it. With Bitcoin, the supply is clearly known.
Marketplace: Gold derivatives can be traded on various regulated exchanges all around the world. The largest Bitcoin future exchanges mostly operate in Asian regions with fewer regulations. Trust may be a big factor, that hinders Bitcoin miners from using derivatives to reduce their operation risk (Gold miners are known to be able to do that).
Availability: Gold derivative markets are usually only available during working hours. Bitcoin derivatives on the other hand are available 24/7.
These points show that there are certain benefits of using crypto derivatives. However, the market is still young and needs time to be more mature.
The crypto derivative exchange FTX offers contracts that are basically a bet on the presidential election in 2020. Theoretically, the probability of Trump winning the reelection should be the same as the price of a TRUMP contract. So if the consensus of Trump winning the reelection is 70%, the price of TRUMP should be 0,7$ per contract.
Below you can see the weekly chart of the TRUMP contract. At the right side of the chart, you can see "0.412". This means that the people currently give Trump a 41,2% chance of getting reelected.
Once all major media outlets (The New York Times, 538, 270towin, Fox and CNN) have projected a candidate to be the winner, FTX may settle the contract. If FTX chooses to do so, users wouldn't have to wait for the official votes from the states - source.
It should also be noted: Like in any betting activity, whether it is football games, horse races or presidential elections, there is an inherent risk attached to investing - or betting money on - such activities. Committing to this is fraught with the risk of incurring losses due to factors we will go into detail on later.
Low liquidity: It is reported that a sell-order with the size of 3,645 BTC could have caused the price drop of 1.000$ on 17th May 2019 - source. With the current state of the market, players using derivatives can profit large from selling Bitcoin. On some derivative exchanges like Bitmex, it's possible to use 100x leverage.
This means that you can trade with the size of 100 Bitcoin, while owning just one. Larger players could use those derivatives to bet on the price decline of Bitcoin and then initiate the decline themselves, as demonstrated with the report mentioned. The disadvantaged smaller players face the risk of an illiquid market.
Exchange hacks: With fewer regulation often comes no protection of user funds. In the past, lots of exchanges have been hacked and funds were stolen. Here you can see a list of hacked exchanges, sorted by year and date. While there are fewer derivative exchanges and therefor less security issues versus usual crypto exchanges, it's naive to think that issues won't happen with more derivative exchanges launching.
Asset risk: As the name of derivatives comes from deriving the price of the underlying asset, the asset itself is a security risk to the derivative. If an actor finds a way to maliciously create endless units of a cryptocurrency, the cryptocurrency and the derivative may face large price declines within seconds.
Malware: Since the rise of cryptocurrencies in 2016-2017, malicious software like wallet stealer or clipboard replacer got popular. Those are a big risk to the use of crypto derivatives, as all of your money could be gone by the malware replacing your derivative exchange wallet address with a fraudulent one. To best prevent this risk, you have to be cautious and use a good antivirus software.
Fraud: The risk also can come from pure fraudulent activity by the exchange itself. In the case of the crypto exchange QuadrigaCX, a ponzi scheme fraud. The owner spent, traded and used assets the clients deposited at QuadrigaCX, according to the OSC (Ontario Securities Commission) - source.
Bitmex is a crypto derivative exchange, founded in 2014. During 2016-2018, it established itself as the place to trade a couple of popular cryptocurrencies with up to 100x leverage. To emphasize how profitable this can be: The co-founder of Bitmex, Ben Delo, became United Kingdom's first billionaire from Bitcoin.
During the recent months / years, new players entered the lucrative market.
In 2018, FTX was founded. The crypto derivative exchange offers lots of cryptocurrencies to be traded with high leverage. In addition to that, it offers options, volatility products and leveraged tokens. Overall, it offers more trading possibilities than Bitmex.
Cryptocompare's august report shows that the volume and therefore interest in crypto derivatives is positive and we believe it will continue to be so. Currently, there aren't many players offering truly innovative products, like FTX. This is possibly a reason why FTX is so successful at the moment.
With that said, the future likely offers more derivative exchanges and more unique products. Those derivative exchanges will face the risks previously mentioned. Additionally, there may be unknown risks due to unknown products. That's why it's crucial for derivative exchanges to have knowledge of It security. Those exchanges will then likely need to handle less security risks, as they prevent most of them in the first place.
Typically, crypto derivative exchanges operate in lightly regulated regions. In January 2020 for example, Deribit announced that the platform will move its quarters to Panama. This decision was made, due to the Netherlands possibly adopting very strict EU regulations, called 5AMLD.
Another very young exchange is ACDX, which is located at the Seychelles. It is founded by the former COO of OKEx, Andy Cheung.
Crypto derivative exchanges are able to innovate quicker due to less paperwork in lighter regulated areas. Customers need to give away less sensitive information as well. On the flipside, it's known that those locations have bad reputations when it comes to trustworthyness. This is why the operating persons of an exchange play a role in the users choice.
With all that being said, anyone willing to invest money in cryptocurrencies or any deriatives should be aware that they enter a high risk game. Add to that the realities of everyday cybercrime - hacked exchanges, credential-stealing malware or just plain old fraud - and you have a really serious decision to make on what to do with your money. As if this is not enough, there will be new derivative products offered, which are unique to crypto derivatives. Those will need to be audited by it security specialists to provide a safe trading environment.
In the end, you should only invest money that you can afford to lose. Playing this high-stakes / high risk game in order to "get rich quick" is likely not going to end well for the majority of investors. After all, stories of people who hit it big do not translate to everyone. Surviorship bias is a major issue here. For each person who makes the headlines for making any substantial money from dealing in these markets, there are untold numbers of people who invested everything - and ended up losing it all in a blink of an eye