What is a derivative

A derivative is a financial contract whose value is derived from the price of something else. That something else is called the underlying.

It can be a stock, a bond, a commodity, an interest rate, a currency, or a crypto token. The contract doesn't contain the asset. It references it.

If wheat costs $7 a bushel at planting, a contract that pays the difference between $7 and whatever wheat costs in six months is a derivative.

The wheat itself is the underlying. The contract is the derivative. They trade separately, often at very different volumes.

The global derivatives market dwarfs the underlying markets it references, with notional outstanding above $700 trillion as of mid-2024 according to the Bank for International Settlements. That's roughly seven times global GDP.

Most of that activity isn't speculation. It's risk transfer between counterparties who'd rather not hold the underlying themselves.

How they actually work

Derivatives do two jobs: they transfer risk, and they let participants take a position on a price without owning the underlying asset. Both jobs run on the same machinery.

Three contract types cover most of the market.

Futures and forwards lock in a price now for settlement later. A jet fuel buyer who needs delivery in March can lock in today's price through a futures contract.

If fuel rallies, the contract gains value and offsets the higher cash cost. If fuel falls, the contract loses, but the buyer pays less in the spot market. Either way, the budget is fixed.

Options give one side a right, not an obligation. A put option lets the holder sell at a fixed price; a call lets them buy at a fixed price.

The holder pays a premium up front for that right, and walks away if it isn't worth using. Options are the standard tool for downside protection, because the loss is capped at the premium.

Swaps exchange one cashflow stream for another. The most common version swaps a floating interest rate for a fixed one, used by corporates that borrowed at floating rates but want fixed-rate exposure.

Currency swaps, total return swaps, and credit default swaps work on the same logic: two parties trade payment streams that fit their respective risk profiles.

Why they matter

Without derivatives, the only way to hedge a price exposure is to hold an offsetting amount of the underlying asset. That's expensive, often impossible, and locks capital up.

With derivatives, a participant can pay a small premium or post a fraction of the notional as margin, and get the same protection. That's why airlines hedge fuel, exporters hedge currency, pension funds hedge interest rates, and crypto lenders hedge collateral. The alternative is carrying the full price risk on the balance sheet.

The same machinery enables speculation, which is why derivatives have a reputation for blowing things up. Borrowed exposure works in both directions: a small position can produce a large gain, or a large loss.

Most of the famous financial disasters of the last fifty years, including Barings in 1995, LTCM in 1998, and AIG in 2008, involved derivative positions sized far beyond the underlying capital that supposedly backed them. The contracts themselves aren't the problem. The sizing usually is.

Where this shows up in Rekord

Rekord uses options to hedge the volatility of crypto collateral. When a pledger borrows stablecoins against crypto, the platform layers protective options on top of the position so a sharp drawdown doesn't force liquidation.

The pledger keeps their crypto exposure, the lender is protected against the downside, and the option premium is funded from yield. For the mechanics, see What is hedging? Options, puts, calls, and why lenders use them.