Real Bitcoin vs. Bitcoin Derivatives

4 min read

Bitcoin Markets

When Bitcoin was created in 2008, it was only known to a small group of early adopters. There were no formal exchanges, so the easiest way to get bitcoin was to mine it on your computer. As Bitcoin grew, exchanges were created to facilitate the transfer of the currency. Over time, these exchanges were joined by increasingly efficient financial institutions that offered improved functionality to their clients.

Currently, the Bitcoin market has sufficient liquidity for almost all traders, and new Bitcoin products are constantly being added to product offerings. Investors who are involved in the market need to understand the products they are buying in order to understand the potential risks and rewards.

Learn more about the actors in Bitcoin markets.

Owning Bitcoin

The simplest way to get exposure to Bitcoin’s price is to own bitcoin directly. This means you own some portion of the actual 21 million bitcoin that will ever exist. Surprisingly, its not always immediately clear if you actually own bitcoin directly. An easy way to check if you have actual bitcoin is to see if you can transfer the currency. If you can send bitcoin, then you own bitcoin.

Even when you own bitcoin, if your wallet is controlled by a third party such as an exchange, you are sacrificing some degree of autonomy over your bitcoin. In order to take full control of your bitcoin, you must send your bitcoin from your exchange account to a wallet you control. This transaction will be recorded on the Bitcoin blockchain, which serves as the ultimate authority on ownership of bitcoin.

Key Fact: Companies that custody Bitcoin for their clients may pool the funds into the same address.
Companies that custody Bitcoin for their clients may pool the funds into the same address.

Bitcoin Derivatives

An alternative way to gain exposure to Bitcoin’s price is by owning derivative, or synthetic, products. These derivative products change price based on the price of their underlying asset: Bitcoin. However, there are several important differences between owning a Bitcoin derivative and owning real Bitcoin.

Since the derivative is not real Bitcoin, the owner will not be able to spend or transfer funds on the blockchain. Importantly, this means that the derivatives must remain in the control of the company that issued them. For many people, part of the appeal of Bitcoin is the autonomy from legacy financial institutions. This autonomy is lost with Bitcoin derivatives.

Additionally, derivative products have a greater degree of counterparty risk because they are tied to a specific company. If the company becomes insolvent or dishonest, your investment may be lost even if the price of Bitcoin indicates that they should be valuable. The company offering the derivatives is almost certainly hedging their position to limit their risk as the Bitcoin price fluctuates. However, this hedging may be imperfect, or the company could simply fail for other reasons.

Owning Bitcoin derivatives may not always carry the ability to redeem those derivatives for their worth in real bitcoin.
Owning Bitcoin derivatives may not always carry the ability to redeem those derivatives for their worth in real bitcoin.

Despite these drawbacks, Bitcoin derivatives do offer some compelling benefits. Some Bitcoin derivatives trade on stock exchanges, along with more traditional equities. This can be extremely beneficial for traders who are better positioned to interact with these markets than traditional Bitcoin markets. Additionally, many institutional investors have restrictions on where they can allocate their investments, and financial derivatives may be more accessible than direct ownership of bitcoin.

Derivative products can also give investors the ability to leverage or hedge their position in ways that are not possible with direct Bitcoin ownership. Derivatives with very high liquidity may be well suited for high-frequency traders looking to minimize slippage.

Which Method Is Right for You?

The answer to this question depends on the users’ individual investment needs. If Bitcoin derivatives are the only option for an investor based on their restrictions, then they may be a good choice. A trader who intends to spend or transfer their funds will need to own actual bitcoin. An investment is a personal decision that individuals must make for themselves, but generally, the simplest way to get exposure to Bitcoin’s price is by owning bitcoin directly.

Learn more about brokerages and exchanges.

Key Takeaways

  • As the Bitcoin market matures, financial institutions are finding new ways to package Bitcoin.
  • Unlike Bitcoin, Bitcoin derivatives cannot be transferred or spent on-chain.
  • Bitcoin derivatives carry unique risks associated with the issuing company.