Cryptocurrency 101Learn

What is a Cryptocurrency Security and Derivative?

Overview

As mainstream companies start taking an interest in crypto investments there has been a marked increase in their supply. There are now many cryptocurrency securities and cryptocurrency derivatives, but what exactly are they and how can they benefit from you? Read on to find out.

What is the Difference Between Crypto Security and Crypto Derivative?

To see the difference between crypto securities and derivatives you need to know that they are financial instruments. A financial instrument is any legal contract between two parties that involves monetary value.

Financial instruments can either be liquid or illiquid. Liquidity measures how easy or hard it is to sell an asset. Cash, for example, is very liquid. On the other hand, assets like real estate, property, plant, and equipment are illiquid.

Financial securities are not just liquid, but also fungible. Fungibility is the ability to exchange an asset with another asset of the same type. It implies an equal value between assets. As such, liquid assets also tend to be fungible.

Securities can be cash or derivatives. On one hand, cash securities are directly affected by the markets, easily transferable, and can either be deposits or loans. Cash securities also include foreign currency exchange assets.

Derivatives, on the other hand, get their value from an underlying asset. The underlying asset can be a commodity, interest rate, or indices. However, derivative price shifts are not always the same as the underlying asset.

While you can own cash securities,  derivatives give you certain rights. You can even enjoy these rights without owning the underlying asset. Like, options give their holder the right, but not the obligation to buy or sell an asset.

Thus, crypto securities and derivatives work a lot like their mainstream peers.

Crypto Securities

Cryptocurrency securities are similar to cash securities. For this reason, some cryptos are the digital variant of cash. Only instead of physically carrying them, cryptos exist as digital entries on an online ledger.

In fact, coins and tokens are types of crypto securities. Also, not all crypto coins and tokens are classified as securities. Crypto coins and tokens can be currency or commodities or even securities. It is also not unheard of for some coins to even fall under more than one class.

Notably, the tech behind cryptos, blockchain, is still evolving. Satoshi Nakamoto only deployed Bitcoin, the first crypto, in 2009. The decentralized nature of blockchains also makes them hard to classify. For this reason, different governments have diverse rules for cryptos. Some governments use a blanket rule, while others prefer a case-by-case method.

The Howey Test

The US Securities Exchange Commission (SEC), for instance, has in the past ruled that Bitcoin and Ethereum are not securities. However, SEC Chairman Jay Clayton recently stated that tokens and ICOs that promise profits based on the efforts of others are securities under U.S. law.

Moreover, the SEC uses the Howey test to tell if a token is a security. The Howey Test is from a 1946 ruling that for an investment to be called a security it must meet three criteria.

  1. There is an investment of money or assets.
  2. Investors pool their resources to fund a project.
  3. Investors expect a profit from the work done by either the promoters or third parties.

In light of this test, the SEC charged Ripple for selling unregistered securities in the form of XRP tokens. Unlike Bitcoin and Ethereum that release coins through mining, Ripple minted billions of XRP tokens at once. The SEC has thus equated the tokens to company shares.

Also, Crypto coins and tokens are very different. Coins are native currency to their blockchains and often release through mining. On the other hand, blockchains mint tokens using various methods. A popular minting method is by using ERC-20 tokens and smart contracts.

Once minted developers distribute the tokens via an Initial Coin Offering (ICO) or some other way. An ICO is one-way blockchains raise funding for projects. However, as regulators start targeting ICOs it is clear it will not be easy to issue an ICO for much longer.

These blockchains ‘promise’ that ICO investors will derive future value from their tokens. Either as utility tokens with practical use on the blockchain. Or, that investors can resell the token, for a profit, once the project launches.

Types of Crypto Coins and Tokens

  • Monero closely resembles money and can be used in ‘everyday’ use. Most well-known examples include Bitcoin, Ether, Litecoin, and Bitcoin Cash. BTC and ETH have the added unique trait of being good stores of values.
  • Stablecoins’ value is pegged against another asset’s value. The pegged asset can be fiat money like US dollars or British pounds. However, the pegged asset can also be a commodity like gold or oil. In rare cases, it can also be another crypto. Examples include USDT, USDC, BUSD, PAX, DGX, TCX, SRC, and Dai.
  • CBDCs are central bank-issued cryptos that closely resemble stablecoins. For instance, China is currently testing its digital yuan, while India is exploring issuing a CBDC.
  • Privacy coins offer greater privacy compared to other cryptos. Critics have accused BTC, for example, of not being truly private. This is because if someone knows a BTC user’s key address they can track their moves and even view how much BTC they hold in their wallet. Privacy coins, however, conceal transfer values as well as sender and receiver data. Examples include Monero and Zcash.
  • Governance tokens are often associated with decentralized finance (DeFi) protocols. They entitle holders to voting rights about how the platform works. For example, Aave, Maker, SUSHI, and UNI.
  • Utility tokens give the holder some form of practical use. For example, utility tokens pay for service fees on blockchains, like BNB on Binance. Utility tokens’ practical use plus limited supply make them valuable as their block grows in popularity. Examples of utility tokens include Filecoins, Siacoins, and Civic.
  • Non-fungible tokens (NFTs) tokens are linked to a unique digital asset. NFTs are rare which makes them valuable, indivisible as they often represent whole assets like art, and are unique. Digital ‘certificate of authenticity’ records NFT uniqueness. NFTs are mostly used in gaming and digital collectibles. Examples of NFTs include ERC-721 tokens, CryptoArt, CryptoKitties, DeFi farming yields, and many more.

Cryptocurrency Derivatives

As noted earlier, derivatives are traded securities and contracts that derive their value from an underlying asset. In this case, crypto derivatives get their value from cryptos.

Derivatives are suave, high-risk financial instruments. These derivatives are useful for hedging against investment risk. Investors use hedging as a risk control strategy. Thus, the investor hedges by taking an opposite position on the same asset to offset losses.

Crypto Futures

Bitcoin futures were the first crypto derivative to be traded mainstream. Bitcoin futures remain the most traded crypto derivative in terms of volume.

However, a futures contract is a pact between two parties to buy and sell the underlying crypto or asset at a set price and at a specific future date. Some exchanges expect parties to settle in cash rather than exchanging the actual asset. However, since cryptos are fairly easy to move, exchanges that allow actual asset trading like Bakkt are growing in popularity.

Futures contracts vary in duration. Let’s say that you believe that Cardano’s (ADA) price will go up next week. You can go long on a futures contract which helps you to pay a lower price than the market price in the future. The long position is termed an unlimited profit position. A profit can be earned as long as the market price is higher than the contract purchase price.

Long position profit = (Market price – Purchase price) x Contract size.

Going short, therefore, is hoping to sell at a higher than the future market price. Short selling, however, is borrowing an asset and selling it hoping to buy it back at a lower price.

Crypto Swaps

Any sell constitutes a swap. We exchange cash for goods and before money we swapped or bartered goods. A crypto swap is the exchange of one crypto for the equal value of another. Swaps are offered on various exchanges and they help reduce the cost of switching between cryptos. Exchanges, however, charge a fee for the swapping service.

Swaps are also agreements between two parties to exchange future cash-flows. The cash-flows can be based on the rise or fall of cryptocurrencies.

Perpetual swaps, on the other hand, are like futures, but allow a longstanding open position with no set settlement date. These swaps use a funding rate to ‘force’ a price convergence. The funding rate ensures that the contract price reflects the crypto’s market price. For this reason, the perpetual swap expires once it stops being profitable for either party.

In other words, a positive funding rate means that the contract price is higher than the market price. A higher price is good for the seller, but not for the buyer which leads the buyer to exit the contract. Equally, a negative funding rate means that the contract price is lower than the market price. The lower contract price will cause the seller to exit as they can sell at a higher spot price.

Crypto Options

Options are derivatives that give the owner the right, but not the obligation to buy or sell an underlying asset. Investors use options for risk control as an option that can help reduce investment loss. Thus, if the number of option Open Interest (OI) rises, it shows a growing uncertainty in the underlying crypto’s market position. OI shows the vague total value of option contracts that are currently open.

There are two ways to use options. First, the holder can use American options at any time before the option expires. European options, on the other hand, can only be exercised on the expiry date.

In addition, the option premium is the market price of the option. Three things make up the option premium; the intrinsic value, time value, and price volatility of the underlying asset.

As the option nears expiry the time value part nears zero in value. However, the closer to expiry the more the intrinsic value shows the price difference between the underlying crypto and the option strike price. The strike price is the pre-set price the parties agree to buy or sell at.

Call and Put Options

There are two types of options; call options and put options. A call option gives the holder the right, but not the obligation to buy the underlying crypto. On the other hand, a put option gives the holder the right, but not the obligation to sell the option.

If an option holder chooses not to exercise the option they lose the premium they paid to buy the option. For instance, if the holder of a put option does not use it, it means that the strike price is lower than the market price. That is, the holder benefits more from selling on the spot market taking into account the loss on the premium.

Similarly, if the holder of a call option does not exercise their option, it means that the strike price is higher than the market price. The holder can therefore buy the crypto for less on the spot market, still including the loss from the premium.

Crypto Exchange-Traded Products

Exchange-Traded Products (ETPs) are derivatives that track an underlying asset or group of assets. Investors trade ETPs on exchanges similar to stocks, thus ETPs experience similar price shifts. As derivatives, ETP prices tend to move up and down along with their underlying asset.

The volatile nature of cryptos makes them too risky for most investors. However, cryptos add an investment variant class that’s growing harder to ignore. For instance, Bitcoin has over the last year, gained value on par with Gold. At the same time, fiat money, like the US dollar, has been falling. Thus, BTC is becoming more recognized as a good store of value, like gold. Of note, the top crypto has even recently outpaced gold in value.

Because of the crypto risk part, ETPs give their investors less risky exposure to cryptos. Price volatility is not the only crypto risk. Cryptos are also tricky assets to keep as wallets can be hacked, even on exchanges. Cryptos can also be difficult to sell due to a lack of liquidity. ETPs, however, offer high-class crypto custody, simplified trading, greater liquidity, and more trading transparency. Most ETPs even hold the underlying crypto instead of just the dollar equivalent.

More countries now allow crypto ETPs to be legally traded on exchanges. Canada, for example, recently allowed the first-ever regulated crypto ETF. Within its first hour the ETP, BTCC, sold over $80 million worth of shares and over $200 million in the first day.

In addition, the Swiss SIX Exchange surpassed $1 billion in crypto trading volume. SIX is one of the top markets for regulated crypto ETPs. The exchange offers over 34 different ETPs as of the beginning of the year (2021).

Of note, Exchange Traded Funds (ETF) is the most popular ETP type. ETFs are similar to a mutual fund in that they track a group of assets, in this case, cryptos. In fact, ETFs track an index or are linked to a group of underlying cryptos. As such ETFs give investors diversified exposure to the crypto market. Generally, investors passively trade which makes ETFs less costly to trade

Trading Tips

There are thousands of cryptocurrency securities and derivatives, and the number rises every day. Crypto use is also wide and ever-increasing. With so many options and uses, it’s only natural that some are better than others. But, how do you separate the good from the bad or the good from the great?

Separating the Good from the Bad

1. Risk:

As previously mentioned, cryptos are very volatile. They are also very young and thus are still in exploration mode. It is therefore important for you to know and respect your risk level. Investors range from risk-averse to having a high level of risk tolerance. Which are you? Cryptos also range from less risky to super risky. Thus, knowing your risk tolerance will help you steer towards ‘safer’ to more risky cryptos.

For instance, cryptos like Bitcoin, Ethereum, and Litecoin are generally seen as fairly safe. If they are still too risky for you, consider stablecoins like USDT. Although high risk often equals high returns this doesn’t always hold true in the crypto-verse. The important thing is finding a good fit for you.

2. Time:

Consider how much time you have. Are you looking to make a quick return or hold your crypto long-term? Knowing how much time you have can help you find the best crypto that will suit your needs. Many investors believe that the best time to buy Bitcoin was 10 years ago, but this attitude can blind you from good options right under your nose.

Consider cryptos that have great potential as they upgrade and scale over the next period or years to come. The market always moves in response to good and bad news. Always do your best to stay up to date with platform news and developments so you can anticipate price movements before they happen.

3. Purpose:

When choosing your crypto make sure the coin or token has a purpose. The most successful coins all have a practical use. Identify the coin’s main features and take note of how its blockchain differentiates itself. Be wary of coins that seem to be imitations or offer generic use. Generic and imitation coins rarely succeed. However, the top two coins, Bitcoin and Ether both off practical use even though they are very different.

When considering an ICO make sure that the proposed coin use is practical and makes logical sense.

4. Transparency:

Do your due diligence and ensure that the development team is competent and transparent. Check if the project website includes the names, credentials, and images of the developers. If the team details are available on the website, verify their credentials on LinkedIn and Github. Verification will help you gauge the developers’ ability to deliver on the project.

Also, check who the project partners are. Like, who is underwriting, acting as a custodian, or ensuring the project or ICO. In fact, the more reputable the partners, the more likely the project is to be legit.

Many crypto projects also disclose their source code, failure to do so can be frowned upon.

5. The whitepaper:

This part might be a bit tedious, but read the white paper. If you are going to invest your money into a coin, take time to learn what it is about. Consider, if the white paper is well written, structured, and logical? Does reading the white paper make sense or does it muddle your brain? If the white paper doesn’t make sense, this is a red flag.

Also, the white paper is meant to convey the vision, goals, and technology behind the project. As such the white paper should be able to persuade you to invest in the project. If the white paper doesn’t inspire confidence, then neither should the coin.

6. Network:

The crypto-community is robust and friendly. Crypto fans are ever eager to share insights and opinions on coins and projects. You can check discussion forums via Twitter or Reddit to gauge the general view towards a coin or project. For a more in-depth analysis, you can check for threads related to your coin of interest on BitcoinTalk. The forum allows projects to post ICO announcements and to answer questions. Based on questions and responses you will be able to tell how genuine the ICO is. Also, take note of project comments and reviews. Be wary of overly negative or positive comments as both are red flags.

Conclusion

Now that you know the ins and outs of cryptocurrency securities and derivatives, you are ready to start trading. If you have done your research and your gut tells you this is too good to be true, it probably is. Hence, you should always use caution and be ready for a bumpy ride. Crypto is very unpredictable with no guarantees and certainty. If a project offers a guaranteed return that’s another red flag.

If you feel confident about your crypto security, and if you are into it for the long haul, don’t panic. Dips will happen, oftentimes they happen for a reason. Is the asset reacting to some bad news like litigation action? Has a whale dumped a load of coins? Has the coin’s price recently set a new all-time high and is the coin possibly overbought? All these are reasons why a coin could experience a dip. Don’t panic buy or sell, always do your homework first. Happy trading!

Disclaimer:

The views and opinions expressed in this article are solely the author’s and do not necessarily reflect the views of CoinQuora. No information in this article should be interpreted as investment advice. CoinQuora encourages all users to do their own research before investing in cryptocurrencies.


Tina Mutare

Avid reader and writer with a passion for sharing crypto news and trends. Uses her background in finance to help readers better understand the crypto market and investments. Hopes to see mainstream crypto adoption in the near future, especially in Africa.

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