Though still the default way to trade cryptocurrencies, spot markets have been falling out of favor with professional traders for some time now, as a result of stiff competition from newer cryptocurrency derivatives platforms. Here’s why traders are beginning to make the switch.
The Problem with Spot Markets
Although still massively popular, cryptocurrency spot markets are gradually losing ground to derivatives as the go-to way to invest in and speculate on the price action of cryptocurrencies.
According to the May 2020 Exchange Review by CryptoCompare, cryptocurrency derivatives trading volume grew by a staggering 32% in May to reach a record high of $602 billion, while cryptocurrency spot trading volumes grew just 5% over the same period. The crypto spot market is now just twice the size of the derivatives market and has declined significantly since March.
Part of the reason behind this change may be due to mass retail investors pulling out of the spot markets as a result of the adverse market conditions seen in March — a time when Bitcoin and many other cryptocurrencies experienced one of their worst weeks in recent years. With no built-in way to easily speculate on declining markets, many holders and trade traders are forced to pull out and adopt a ‘wait and watch’ strategy when the market turns sour.
Likewise, a lack of liquidity in many spot markets, particularly those associated with less popular altcoins, has seen the market plagued by the now commonplace pump and dump scams, whereby a group of traders work to drive up the price of an asset before dumping the coins and tokens on unsuspecting traders.
Instead, many traders — often those trading with significant volume — are now beginning to turn their focus towards cryptocurrency derivatives, due to the myriad of advantages they offer over spot markets.
Why Traders Prefer Derivatives
Cryptocurrency derivatives are a type of contract formed between two parties that agree on a date and price to sell a particular cryptocurrency. These typically come in the form of cryptocurrency futures and options, but an increasing fraction of platforms now offer simpler perpetual contracts, which can be settled whenever.
This setup enables a variety of powerful trading strategies, which would be difficult, if not impossible to replicate while spot trading.
For one, cryptocurrency derivatives can frequently be traded with leverage. This essentially means traders are able to open larger positions than they would otherwise be able to afford by using their account balance as partial collateral. This can be as much as 100x leverage on some platforms, which is the equivalent of using $100 to open a $10,000 position — working to multiply the amount of profit by 100x.
Understandably, this feature makes cryptocurrency derivatives trading potentially far more lucrative than spot trading, since even those with limited trading budgets can generate sizeable returns. This also makes derivatives popular among crypto funds that are looking to the largest possible ROI for their clients.
But the real potential of derivatives is perhaps best demonstrated during a bear market, since they allow traders to easily trade in the short side — turning a profit even during a declining market, something that can be challenging with spot markets.
Finding a Suitable Derivatives Exchange
Although derivatives exchanges are rapidly gaining popularity in 2020, they’re not all built equal. Some are better than others, and certain features can only be found on particular platforms. As such, it’s important to do your research before deciding on a platform.
The first thing to look out for is regulatory compliance. Bityard, for example, has obtained licenses in four different countries, whereas PrimeXBT isn’t regulated at all. Generally, regulatory compliance ensures a higher standard of service and accountability, making it a favorable trait for exchanges.
Beyond this, you’ll also want to look out for the security options on offer. Platforms like BitMEX, Bityard, and Deribit all bode well in this department and use a combination of cold storage and two-factor authentication options, but not all exchanges are so careful — don’t put your funds at risk by using an insecure platform, regardless of the claims it makes.
These two major factors, combined with the simplicity, accessibility, and speed of the derivatives exchange should be considered before making a deposit.