3 ways crypto derivatives could evolve and impact the market in 2023

Futures and options let traders put down only a small portion of the value of a trade and bet that prices will rise or fall at a certain point in a certain period. It can make traders’ profits bigger because they can borrow more money to add to their positions, but it can also greatly amplify their losses if the market moves against them.

Although the market for crypto derivatives is growing, the instruments and infrastructure that support it are not as developed as those in traditional financial markets.

Next year will be the year that crypto derivatives reach a new level of growth and market maturity because the infrastructure has been built and improved, and an increasing number of institutions are participating.

The growth of crypto derivatives in 2023

In 2023, the volume of crypto derivatives will continue to grow due to two factors: first, the growth of relevant infrastructure such as applications for decentralized finance (DeFi) and also because of more professional and transparent intermediaries that plan to enter the space. Eventually, this will lead to more institutions participating.

Understanding why traditional financial institutions use derivatives more than traditional spot markets is an excellent way to learn more about the market.

Some reasons for the growth are the ability to raise capital, the fact that derivative contracts in the US are treated as long-term capital gains for tax purposes, and for their use in hedging, which is the ability to protect against unexpected price swings.

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When more institutions participate, relative volatility decreases, making derivatives trading a better use of capital. Also, as more institutions add crypto assets to their balance sheets, derivative instruments will become an important tool to hedge against short-term volatility.

The industry is still in its infancy

Like 2022, 2023 is also bound to be a unique year for crypto derivatives. There will be an increase in centralized and decentralized options infrastructure and the continued development of new crypto primitives such as structured vaults, perpetual options and experiments with derivatives.

The cryptocurrency industry is moving deeper into regulated markets as it tries to gain more users and compete with existing traditional financial firms such as brokers that already let people trade stocks and other financial assets.

Most derivatives contracts happen on Binance, OKX and Bybit, which are based outside of the US and are not regulated. However, based on data from CoinGlass, CME Group is the only US regulated market that has gained traction.

In November 2022, it was responsible for approximately 10.7% of the open interest in Bitcoin (BTC) and Ether (ETH) futures.

Large buying firms continue to buy small licensed derivatives operations

It’s getting harder to tell where the retail market ends and the institutional market begins. The retail-focused businesses that crypto exchanges have bought are run by some of Wall Street’s largest and most experienced companies.

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In January 2021, Coinbase acquired FairX, a small futures exchange in Chicago. The purpose of the deal was to make it easier for traders to enter the derivatives market. A retail-focused futures exchange startup called Small Exchange has also released a crypto futures product that requires less cash upfront. Citadel Securities, Jump and Interactive Brokers all backed the company.

Related: What is crypto market capitulation and its meaning?

The growth of the decentralized derivatives market

Like centralized futures, all-time futures contain most of the volume of decentralized derivatives. First led by Perpetual Protocol and now by dYdX, the daily volume of decentralized transactions averages $3 billion per day.

Even though growth has been robust, decentralized volume all the time makes up less than 5% of all crypto derivatives volume. Over the next two years, we expect this segment to grow in a big way.

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As more projects and protocols are built on top of decentralized swap protocols all the time, the value of the platforms that support them will continue to grow. Along with decentralized futures, options and structured products, market participants will be excited to see more native crypto innovations such as perpetual options develop.

Protocols like Deri, which offer both eternal futures and eternal options, let users trade derivatives in a very authentic way, giving them the ability to hedge, speculate and arbitrage, all on-chain.

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Derivatives could lure in more traditional investors

Institutional traders like these instruments more because they can provide stable returns, similar to fixed income, and these trades are executed with strategies such as bull call spreads and covered calls. Also, institutional traders can combine call and put options to set a risk limit without risking liquidation for option trades.

Fidelity Digital Assets now offers its institutional client base the ability to borrow using crypto as collateral so large companies can add Bitcoin to their assets more easily with the help of these services.

By 2023, it is likely that cryptocurrencies will be easier to use as collateral for everyday business, which will allow companies to take more risks using cryptocurrency derivatives.

Derivatives played an instrumental role in the 2020-2021 crypto bull market for retail and institutional traders. For many investors, borrowing money and using derivatives is the easiest way to increase their bets on a variety of positions. They are available for use in stocks, currencies and commodities, but their use in cryptocurrencies has been steadily growing since 2017.