What are Crypto Derivative & Futures Contracts (and How are they Taxed)?

If you're interested in learning about crypto derivatives (including crypto futures), you’ve come to the right place. Here we delve deep into the background around derivatives as a financial concept, and then show you how it has now been applied to crypto. At the end, we'll discuss how crypto futures and derivatives are taxed.

What is a derivative?

Derivatives are financial contracts set between multiple parties that ‘derive’ their value from an underlying asset or benchmark. 

The contract is signed between two or more parties that want to buy or sell a particular asset for a specific price in the future. The value of the contract is therefore determined by fluctuations in the price of the benchmark it derives its value from. Often these underlying assets used in derivatives are currencies (or cryptocurrencies), commodities, bonds, stocks, market indexes and interest rates. 

Derivatives are often used when investors want to protect themselves from price fluctuations. With this in mind, you can see how signing a contract to buy an asset for a fixed price in future helps mitigate risks. 

Another way some investors make use of derivative trading is speculation, whereby traders are trying to predict how the asset’s price might change over time.

What are the most common types of derivative contracts?

Futures

A futures contract is an agreement between two parties, or people, to purchase or sell an underlying asset at a specified price and date in the future.

Futures oblige the buyer to purchase the asset at a previously agreed-upon price on a specific date in the future, even if it has lost value relative to their agreed fee. Likewise, the seller must also sell the asset at the agreed price, even if it’s value has gone up. These futures are traded on exchanges, making the contracts similar and standardized. 

Options

Options are like futures, but rather than having an obligation, they have a choice. In other words, options grant the buyer the right, but not the duty, to purchase or sell the underlying asset at a certain price. According to the terms of the contract, the trader is not forced to buy anything they don’t want. This is a key difference between options and futures.

Swaps

Swaps are derivative contracts that are used between two parties to exchange one type of cash flow for another. The most popular types of swaps are related to interest rates, commodities and currencies. They are OTC (over-the-counter) contracts.

What is a crypto derivative?

A crypto derivative uses the same format as traditional derivatives, but applies them to crypto assets.

Crypto derivatives are contracts that derive their value from a primary underlying asset. In the case of crypto derivatives, the primary asset would be a cryptocurrency such as Bitcoin.

What is a crypto futures contract?

As we discussed earlier, futures contracts obligate the buyer to purchase an underlying asset (in this case, a cryptocurrency such as Bitcoin) at a previously agreed-upon price on a specific date in the future, even if it has lost value relative to their agreed fee. Likewise, the seller must also sell the asset at the agreed price, even if its value has gone up. This can be very advantageous to investors looking to make use of volatile markets.

What is crypto futures & derivative trading?

Crypto futures trading was launched by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) during a crypto bull market in December 2017. It involves creating derivative contracts, such as futures, but using crypto as the underlying asset.

This was a big deal for people looking to invest into crypto, but was scared of its volatility. This is because futures contracts allow investors to hedge positions and reduce the risk of the unknown, which is quite relevant for cryptocurrencies. 

In other words, trading Bitcoin and altcoin futures allows serious traders to mitigate their risks.

How do people make profit from crypto futures & derivative trading? 

To make a profit from a sudden change in the underlying asset’s price, the trader can buy a cryptocurrency at a low price and sell it at a higher price later. However, this strategy is only relevant when a bull market has a lot of risk, as with all other attempts to speculate on the price of the underlying asset. It’s risky, but could pay off big if you speculate correctly.

So, when it comes to crypto derivatives, the biggest risk that traders face is volatility. Prices can rise and fall at speeds that make you dizzy, and losses can be amplified whenever someone is trading on margin.

What is the best crypto futures exchange?

Derivatives in cryptocurrency can be traded on both centralized and decentralized exchange platforms, such as Binance or Gate.io. There are also exchanges such as ByBit, OKX and Bitget that you can do crypto derivatives trading on.

 Cryptocurrency derivatives exchange can be used by exchange owners to reach out to additional investors. A crypto derivative trading platform is more flexible than crypto margin trading and gives you access to markets that would otherwise be inaccessible to you.

How are crypto futures & derivatives taxed?

At the moment crypto futures and derivatives are unregulated. This means the specific tax treatment on them is pretty unclear and it will depend on your country of residence, as well as the amount you're trading.

If you're trading at a similar scale as a day trader it's likely that this would be viewed as business activity and subjected to the relevant Business Income Tax.

However, if you're seen to be trading as an individual investor your trades are more likely to be taxed the same way traditional margin trades and contracts are in your country. For the most part, this means you'll be paying Capital Gains Tax on profits from crypto futures. The taxable event arrives when you close your position.

Crypto derivatives tax rules are different in each country

As mentioned, the rules may change per country. For example, in the UK, if the cryptocurrency provider is authorized by FCA to perform regulated activities in the UK, and the activities amount to non-trade, then the proceeds will be taxed under Capital Tax. But if it is unregulated, it is taxed under Miscellaneous income and thus Income tax.

For reference, please checkout our range of crypto tax guides which give specific and detailed advice around your own nation's rules and regulations. We have guides for the US, the UK, Canada, Australia and many more.

How can Koinly help you with crypto futures

Koinly is a crypto tax tool that calculates your crypto taxes for you, meaning you don’t have to go through the hassle of doing it yourself.

Not only does the software integrate with your exchanges' transaction history, but it calculates your taxes in a format that makes sense for your country’s tax authority. Essentially, Koinly does all the boring tasks that would cost your hours and hours sitting at a computer.

As a quick breakdown, here’s a short summary of what Koinly does:

• Imports all your trades including trades, sales, swaps, and rewards.
• Converts your transactions into your country’s currency at fair market value (this in itself is a massive time saver).
• Decipher which of your transactions are taxable and which are not (you may sometimes need to do some fiddling, but for the most part the software organizes it for you).
• Allows you to submit a clean and accurate report to your tax office.