From Olives to Bitcoin: Evolution of Derivatives
Financial derivatives are not exclusive to cryptocurrencies and date back to ancient Greece! Speculation on an underlying asset got a new twist with the rise of digital assets known for their volatility and opportunities to profit.
In traditional finance, derivatives refer to a group of instruments, that derives its value from an underlying commodity or market. There are forwards, futures, swaps, and options among derivatives contracts, that are traded over-the-counter (OTC) or on an exchange. The most common underlying assets for derivatives today are stocks, bonds, commodities, currencies, interest rates, and market indexes. Derivatives can be used for a number of purposes, including insuring against price movements (hedging) or speculation an asset’s future price.
The earliest evidence of trading derivatives can be traced back to ancient Greece. Aristotle related a story about how the Greek philosopher Thales of Miletus profited from an option-type agreement, speculating on olives around the 6th century BC. According to the story, one-year ahead, Thales forecast the next olive harvest would be an exceptionally good one. As a poor philosopher, he did not have many financial resources, but he used what he had to place a deposit on the local olive presses.
As nobody knew for certain whether the harvest would be good or bad, Thales secured the rights to the presses at a relatively low rate. When the harvest proved to be bountiful, and so the demand for the presses was high, Thales profited from charging a high price for their use. Had the olive harvest been poor, Thales would only have been out his small deposit. In other words, he had a call option. The first call option in history.
Under Roman law, forwards are identified in the form of a promise for future delivery of goods at the delivery date. In the Middle Ages, derivatives continued to facilitate trade. Italian merchants used several types of commercial partnership contracts, that could be considered as commodity forward contracts. At the dawn of the modern world, Antwerp became the trading and financial center where the first exchange was opened.
In 1585, after the sacking of Antwerp by Spanish troops, international trade moved to Amsterdam. One of the most significant developments in derivatives that may be accredited to Amsterdam was the emergence during the 17th century of stock derivatives trading. It’s not a surprise that the first economic bubble, known as Tulip Mania, occurred in Holland.
In 1848, a first derivatives exchange was created in Chicago, United States. The oldest futures market – the Chicago Board of Trade – is still operating in the world. It merged with the Chicago Mercantile Exchange in 2007 to become the CME Group. From the 1970s on, the USA has been the cradle of innovation in derivatives. In the second half of the eighties, the first collateralized debt obligations were issued by a Wall Street investment bank. The mortgage-backed securities issued by investment banks were a major issue in the financial crisis of 2006–2008.
The early development of crypto derivatives dates to 2011. Back then, the only product available to traders was Bitcoin futures, with the average daily volume of about 1,500 BTC a day. Derivatives in digital assets flourished fast as higher volatility in the crypto markets allows for a higher return. Drastic price swings enabled an opportunity for arbitrage based on future prices of cryptocurrency on different exchanges. Many derivative instruments, including cryptocurrency trading, are leveraged. That means a small amount of capital is required to have an interest in a large amount of value in the underlying asset. Instruments, like leveraged Perpetual Contracts, evolved exclusively for cryptocurrency markets.
The derivatives market has rapidly expanded, especially in the years since the crypto bull run of December 2017. Crypto derivatives hit a record high volume of $602 billion in May 2020.