Introduction to Futures in Cryptocurrency

Futures, in the context of cryptocurrency, are financial contracts obliging the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. The asset in question can be a specific type of cryptocurrency, most commonly Bitcoin.

How Futures Work

A 'Futures Contract' includes the type and quantity of the cryptocurrency, the price per unit, as well as the transaction's delivery date. This contract essentially sets the price at which the cryptocurrency will be sold in the future, regardless of what the actual market price is at the contract execution date. This feature allows participants to hedge their positions against potential price changes.

What are Long and Short Positions?

In the Futures market, there are two positions that traders can take: Long or Short. Taking a 'Long' position means buying a Futures contract with the expectation that the price of the cryptocurrency will rise in the future. Conversely, taking a 'Short' position involves selling a Futures contract with the projection that the cryptocurrency price will decline.

Types of Futures

Futures are categorized into two main types: physically-settled and cash-settled.

Physically-settled : In physically-settled Futures, the actual cryptocurrency must be delivered on the settlement date. In the context of cryptocurrencies, delivery refers to a transfer of tokens from one digital wallet to another.
Cash-settled : As for cash-settled Futures, the difference between the contract price and the market price at the contract's end is settled in cash rather than the actual cryptocurrency.

Why are Futures Important in Cryptocurrency?

Futures have a significant place in the cryptocurrency landscape because they provide a mechanism for price discovery. By allowing investors to speculate on what the future price of a cryptocurrency will be, futures contracts reflect the market's sentiment about future pricing. They also offer investors an avenue to hedge against the extreme volatility that cryptocurrencies are known for.

How Cryptocurrency Futures Work

Cryptocurrency futures work on the principle of financial derivatives. These are contracts between two parties to buy or sell a specific type of cryptocurrency, at a predetermined price, and at a future date. The concept may seem complicated to some, yet once broken down to components it becomes quite straightforward.

Design of Cryptocurrency Futures

A typical cryptocurrency futures contract is created when one investor agrees to buy (go long) and another agrees to sell (go short) a particular cryptocurrency at a fixed price on a specified future date. The contracts are typically "standardized" to simplify trading on the futures market, which means they tend to dictate a standard quantity and quality of the underlying asset.

Cryptocurrency futures contracts usually use leverage- a financial strategy that allows investors to control large amounts of cryptocurrency with a relatively small capital outlay. The ability to leverage a substantial amount of cryptocurrency with a relatively small quantity of capital is one of the main attractions of cryptocurrency futures trading.

Trading Cryptocurrency Futures

Trading cryptocurrency futures is typically conducted through cryptocurrency exchanges with futures markets. These markets work much like traditional stock exchanges, however, they specifically deal in futures contracts instead of individual shares of companies. In these markets, investors can freely buy and sell contracts to other investors.

The price of a futures contract fluctuates throughout the trading day in response to investors' beliefs about what the price of cryptocurrency will be in the future. Cryptocurrency futures trading can be quite volatile, mainly due to the underlying cryptocurrencies themselves being quite volatile.

Settlement of Cryptocurrency Futures

The settlement of cryptocurrency futures contracts refers to the process through which the underlying cryptocurrency is delivered and the contract is closed. There are two primary forms of settlement: physical and cash. In a physical settlement, the seller passes the underlying cryptocurrency to the buyer. In contrast, cash settlements involve the transfer of cash equal to the difference between the contract price and the market price at the settlement date.

It's important to note that many cryptocurrency futures contracts tend to be cash-settled due to the digital nature of cryptocurrencies and the challenges that can arise from trying to transfer ownership.

Benefits and Risks of Cryptocurrency Futures

Cryptocurrency futures are contracts that allow investors to buy or sell digital assets at a predetermined price on a specific future date. They offer several notable rewards.

Hedging and Risk Management

One of the main purposes of futures contracts is to provide a risk management tool. This is accomplished through a process called "hedging," which involves setting a fixed price for a certain asset. By doing so, an investor can lead their operations safely, knowing that they are protected against price volatility.

High Leverage

A distinctive feature of futures trading is the possibility of leveraging, which allows traders to borrow money to invest more than they could afford with their own funds. This can lead to magnified profits if the market moves in the predicted direction.

Accessibility

Futures contract also offers greater accessibility. Crypto futures open the door for institutional investors, who can now engage with digital currencies without holding the actual asset.

Potential Hazards of Cryptocurrency Futures

Despite its various advantages, trading cryptocurrency futures also comes with its own set of risks.

Price Volatility

The inherent volatility of the cryptocurrency market can lead to significant losses. While hedging may provide some degree of protection, dramatic market swings can quickly wipe out an investor's capital.

Risk of Leverage

While leverage can boost the potential profits, it can also magnify losses. If the market moves against a trader's position significantly, they may lose more than their initial investment, ending up in a debt to the broker.

Regulatory Uncertainty

While cryptocurrency futures allow traditional investors to engage in the crypto space, they still carry regulatory uncertainty. Policies vary greatly worldwide, and legal disputes could potentially lead to lost investments.

Lack of Underlying Asset Ownership

When trading futures, investors never actually own the underlying cryptocurrency. This means they can't use it in the same way those who own the currency can, for instance, to participate in the blockchain or use in transactions.

Cryptocurrency Futures vs Spot Trading

Cryptocurrency trading involves both Futures trading and Spot trading. Both methods come with their unique advantages and risks. It is essential for traders to understand the difference between the two before entering the market.

What is Spot Trading?

In Spot trading, a buyer purchases a cryptocurrency at its current market price and becomes an immediate owner. This form of trading is known for its simplicity and immediacy.

Ownership: With spot trading, the trading parties are trading possession of actual cryptocurrency. Once the trade is finalized, the buyer is the immediate owner of the cryptocurrency.
Risk: The risk in spot trading is limited to the amount of money invested. If the value of the cryptocurrency falls to zero, the maximum loss is the initial investment.
Taking profits: Profits can be made when the value of the cryptocurrency increases. This may involve selling the cryptocurrency for a higher price than the purchase price.

What is Futures Trading?

Futures trading is a trading strategy that allows investors to speculate on the price movement of a cryptocurrency without actually owning the asset.

Ownership: In futures trading, the trader does not own the actual cryptocurrency. Instead, they own a contract that represents a specific amount of the cryptocurrency.
Risk: The risk in futures trading is potentially infinite because the price of the cryptocurrency can rise indefinitely. This exposes the trader to significant potential losses if the trade goes against their speculation.
Leverage: Futures contracts allow traders to leverage their position, which means traders can control a large amount of cryptocurrency with a relatively small amount of capital. This could result in higher potential profits but also significant losses.
Taking profits: Profits are made in futures trading by correctly speculating on the market's direction. If the market moves in favor of the trader's position, they make a profit.

Comparison Between Spot and Futures Trading

The main difference between spot and futures trading lies in the ownership and risk involved. Spot trading involves actual ownership of the cryptocurrency, and the risk is limited. On the other hand, futures traders do not own the cryptocurrency, they own a contract representing it. They can leverage their trading position, increasing both potential profits and risks.

Spot trading is suitable for individuals who want to own the cryptocurrency and are comfortable with holding on to it for long periods. Futures trading, on the other hand, is suitable for experienced traders who can accurately speculate on price movements and are comfortable with higher risk levels.

Popular Platforms for Trading Cryptocurrency Futures

Binance is one of the largest and most popular cryptocurrency trading platforms. It offers Futures trading in a variety of cryptocurrencies, and the platform is well-regarded for its user-friendly interface and comprehensive selection of trading tools.

Features: Binance Futures supports up to 125x leverage and it offers both USDT-Margined Futures and COIN-Margined Futures.
Fees: Trading fees on Binance start from 0.020% for makers and 0.040% for takers, and can be lower for traders with larger 30-day trading volumes or larger Binance Coin (BNB) holdings.
Security measures: Binance provides many security options including two-factor authentication (2FA), biometric authentication, withdrawal whitelist, and anti-phishing measures.

BitMEX

BitMEX is a peer-to-peer cryptocurrency derivatives trading platform that offers cryptocurrency futures contracts. It is particularly popular among experienced traders due to its advanced trading features.

Features: BitMEX offers up to 100x leverage on Bitcoin, and up to 50x leverage on other futures contracts.
Fees: BitMEX folows a maker-taker fee schedule. For Bitcoin futures, the maker fee is -0.025% and the taker fee is 0.075%.
Security measures: BitMEX uses technologies like multisignature deposits and withdrawals, and all BitMEX wallet addresses are multisignature for added security.

Kraken

Kraken is a reputable and diverse cryptocurrency exchange that provides futures trading for a variety of cryptocurrencies including Bitcoin, Ethereum, Ripple, Litecoin, and Bitcoin Cash.

Features: Kraken users can trade futures with up to 50x leverage, 24/7/365 on a highly liquid market.
Fees: Fees on Kraken futures range between 0.01% - 0.02% for "open" positions and 0.01% - 0.02% for "settlements".
Security measures: Kraken takes security seriously with features like two-factor authentication (2FA), a secure cold storage for cryptocurrencies and proof-of-reserves audits.

FTX

FTX is a cryptocurrency derivatives trading platform that offers futures, leveraged tokens and OTC trading. Created by traders, for traders, FTX provides a powerful platform for seasoned traders.

Features: FTX offers futures contract trading in over 150 markets with up to 101x leverage.
Fees: The trading fees for futures on FTX range between 0.020% and 0.070%, depending on the 30-days trade volume.
Security measures: FTX provides multiple security features such as two-factor authentication (2FA), withdrawal whitelist, and subaccount management.

Regulation of Cryptocurrency Futures

Cryptocurrency futures trading represents a major part of the global finance market, with regulations varying across different countries. This section explores the legal framework related to this domain, highlighting diverse approaches taken by various jurisdictions and their impact on individual traders.

United States

In the United States, the Commodity Futures Trading Commission (CFTC) has declared cryptocurrencies as commodities, leading to their legal recognition for futures trading. This regulatory approach has enabled the development of a more structured market where cryptocurrency futures contracts can be openly traded between parties. In spite of this, traders are still obliged to comply with US trading laws, a non-trivial task given the complex nature of these laws.

European Union

The European Securities and Markets Authority (ESMA) regulates digital assets like cryptocurrency futures under European Union (EU) law. Trading in such financial instruments is legal in the EU, but cryptocurrency futures are considered ‘complex products’. This means that they fall under a higher level of regulation compared to traditional futures contracts. Traders must be cautious here as they face elevated risks and challenges.

United Kingdom

In the United Kingdom, the Financial Conduct Authority (FCA) is the regulator overseeing cryptocurrency futures. As of 2021, the FCA has banned the marketing, distribution, and sale of cryptocurrency derivatives, including futures, to retail consumers. This means individuals cannot legally trade these instruments due to concerns around potential harm caused by price volatility, fraud, and a lack of reliable valuations. This ban does not extend to professional traders.

China

China has a more stringent stand towards cryptocurrency futures. As of 2021, all forms of cryptocurrency trading, including futures, are banned in mainland China. This extreme stance is rooted in the government’s concerns about financial stability, leading to its aggressive stance towards cryptocurrencies in general.

Implications for Individual Traders

Understandably, these regulatory landscapes can drastically affect how individuals trade in these markets. Depending on the residence of a trader, the laws can range from total acceptance to absolute prohibition. Given the global span of digital markets, individual traders must stay aware of their respective national regulations and any changes thereto, to ensure lawful and safe participation in cryptocurrency futures trading.

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