A derivative is a financial contract between two or more parties that derives its value from an underlying asset ie. stocks, commodities or cryptocurrencies. An agreement to buy or sell a particular asset at a predetermined price and a specified time in the future. Derivatives do not have inherent or direct value by themselves; the value of a derivative contract is purely based on the expected future price movements of the underlying asset.
Cryptocurrency tokens are special kind of virtual currency tokens that reside on their own blockchains and represent an asset or utility. Tokenizing assets via Blockchain is maturing and explained here (Security Token Offering), here (Commodities) and here (CRE).
Adoption is happening daily - most recently with JP Morgan Coin. And so are derivative markets with physical delivery that can actually reduce volatility in the price of Bitcoin, which was the original intention of derivative markets in the 18th century.
The main forms of derivatives are:
Swaps: A swap is an arrangement between 2 parties to exchange a series of cash flows in the future, usually based on interest-bearing instruments such as loans, bonds or notes as the underlying asset. The most common form of swaps are interest swaps., which involves the exchange of a future stream of fixed interest rate payments for a stream of floating rate payments between 2 different counter-parties.
Futures: A financial contract where a buyer has an obligation for a buyer to purchase an asset or a seller to sell an asset at a fixed price and a predetermined future price.
Options: A financial contract where a buyer has the right (not an obligation) to purchase an asset or a seller to sell an asset at a predetermined price by a specific timeline.
Keep in mind crypto-derivatives represent a second layer of speculation on top of an already volatile crypto-asset. Since one of the main factor that drive the price of cryptocurrencies are news and market speculation, hence no easy way to predict any of those. Also traditional market trading/ investing strategies may not be applicable as outlined here. If we add a mathematical model (derivatives) on top of that, we are essentially adding a speculative vehicle on top of a volatile vehicle.
Exchanges for crypto-derivatives Huobi, Bitmex, CBOE, Bitozz, UDAX and others.
Are Security Tokens a Derivative?
In general, any form of security token can be considered a derivative in-and-out itself as derives its value from the performance of an underlying asset. However, traditional derivative models include other aspects such as time constraints, obligation symmetry or settlement model that don’t quite fit the profile of security tokens. Therefore, security tokens can behave like derivatives while others trade more like first-tier asset classes.
Type and Models of Security Token Derivates
As the security tokens market evolves, there are several derivative products that are likely to surface.
Derivatives that Represent Security Tokens: These are mathematical models that speculate on the price of underlying security tokens that can represent alternative assets such as real estate, art, shares, gold or others.
Security Tokens that Represent Market Derivatives: We can tokenize everything so tokens could represent market derivatives such as options or futures.
The Forward-Futures Model: Following the model of forward or futures derivatives in financial markets, smart contracts could specifies the criteria to buy or sell a security token at a specified future time and at a previously agreed price. This security token derivatives can follow the futures model if traded in centralized exchanges or the forward model if traded in decentralized exchanges.
The Options Model: The owner of the security token option will have the right but not the obligation to buy or sell the underlying security token at a specified price on a specified date.
The ETF Model: Exchange-traded-funds are viable for security tokens. ETF-like security tokens could represent the value of an underlying group of assets such as real estate leases, loans or private shares of different companies.
The Swap Model: Like swap models in financial markets, security token derivatives that exchanges the dividends or cash flow produced by two different security tokens in order to serve as a hedge or insurance against future market conditions.
The Mutual-Fund Model: The mutual-fund model is better suited for enterprises such as financial institutions that are looking to issue their own security tokens. Just like ETFs, Mutual-Fund tokens will aggregate a pool of security tokens but, unlike ETFs, they won’t be actively traded and only priced on regular intervals.
Derivative markets foremost value will be the implied risk information that can help investors make allocation decisions.