DeFi Explained: Derivatives

The world of decentralized finance, as innovative as it is, has brought on a number of new words and concepts. Having to navigate through such unfamiliar and often incomprehensible ideas can be confusing, which is why we are here to do the heavy lifting for you. This week’s edition of DeFi Explained will cover the concept of derivatives, a type of financial security contract that relies on another asset or group of assets, like stocks or bonds, for its value- but in a decentralized form. How does this work? Why is it important? What are the benefits and risks associated with trading derivatives? These are all questions that will be answered in this article.

What Are Derivatives?

Derivatives may seem like a novel concept. However, from the Sumerians using clay tokens stored in a clay vessel to represent commodities 6000 years ago, to the 1848 establishment of the Chicago Board of Trade, derivatives have been around for centuries.

In traditional finance, derivatives are financial contracts that are set between two or more parties whose value is derived from an underlying asset, index (set of assets), or security. These underlying assets can be bonds, commodities, currencies, interest rates, or stocks. Simply put, it is trading something that represents the price movements of something else. With derivatives, investors are both given exposure to the asset without actually acquiring it, and can transfer risk from one party to another.

Why Derivatives Are Important

The market of derivatives is the single largest financial market in the world, estimated to be 10 times larger than the global GDP. Derivatives are not just a technique used by traders but are an essential part of many of our everyday financial services and applications. WIthout derivatives, personal checking accounts, insurance plans, and mortgage contracts, all cannot exist as we know it! But what exactly makes derivatives so critical to our financial systems?

The main reason why derivatives are so attractive is because of the way our financial markets are set up. In financial markets, every transaction, every trade, has an element of risk attached to it. This risk is what banks, traders, investment firms are looking to minimize every day because the wrong move will result in financial chaos. With derivatives, those participating in the market can manage their risks so that unforeseen loss is prevented.

Benefits of Derivatives in DeFi

Accessibility

Like all DeFi services, DeFi derivatives do not require any interested party to provide their personal information or register formally with any entity. Information such as proof of identity, personal bank statements, social security numbers, and national insurance need not be provided to begin trading DeFi derivatives. This is in stark contrast to traditional derivatives trading in the financial markets, where both proofs of eligibility and identity are usually the first step.

No Central Body

DeFi derivatives are decentralized in nature, which means that there is no single governing body overseeing the transactions and decisions being taken by both parties. This allows virtually any person to create contracts that are pegged to other assets.

Transparency

With DeFi derivatives, all trading information and contract creation are managed by blockchain and smart contract technology. This information can be viewed and assessed by anyone, making it an incredibly transparent process.

Use Cases of Derivatives

Hedging

In essence, hedging is a technique or strategy that tries to limit risks in financial assets. It works like insurance as it acts as a preventative measure against unforeseen circumstances in the market. As the name suggests, hedging acts as a fence or barrier against risk exposure. An investor can use this strategy by purchasing a derivative contract whose value is projected to move with an opposite trajectory than the asset they already own. This can be better explained with an example.

Let’s say there is a farmer who is known for growing a large grain crop such as wheat. Now, depending on supply and demand, the price of wheat fluctuates throughout the year. It is possible that when the time comes to harvest, the price of wheat is low. The farmer’s entire year’s worth of hard work may result in a loss.

To reduce this risk, the farmer can instead sell short contracts on a predicted harvest amount. This way, the current price of wheat is locked down, and the farmer can avoid the possibility of going into a total loss at the time of harvest.

Speculation

Speculation is similar to hedging, but there are some differences. Speculation is defined as the purchase of any asset with the expectation that it will become more valuable in the near future. Speculation is a more high-risk trading technique, done to take maximum advantage of market fluctuations. It is most commonly done in markets where the price movement of securities is very volatile. With speculation, investors can gain exposure even with less on-hand capital.

Leading DeFi Derivatives Platforms

Synthetix

Synthetix is a protocol that allows the issuance of synthetic assets, referred to as Synths, on the Ethereum blockchain. Synths are managed by community voting and track the price of their underlying assets. These assets can be anything, including cryptocurrencies, fiat currencies, stocks, or commodities. To track the prices of these assets, decentralized oracles are used, and the platform enables its users to hold or exchange Synths. The platform provides benefits of infinite liquidity, zero slippage, all while allowing users to act as if they own their underlying assets,

dYdX

dYdX is a hybrid platform that offers permissionless derivatives, decentralized exchange (DEX), and lending. It is one of the most powerful open trading platforms for crypto-assets and derivatives. Built on the Starkware layer 2 network, dYdX is different from other automated market makers such as Uniswap and Sushiswap in that it follows an order book architecture. The native token DYDX is used for the governance and utility of the platform.

UMA

Based on the Ethereum blockchain, UMA (Universal Market Access) is an open-source protocol for the permissionless creation of synthetic assets and financial contracts. What is unique about this platform is that it allows anyone to create a synthetic token, which will then track any specified asset or index. In addition, users can contribute liquidity to a synthetic token, as well as earn fees on a trade.

Conclusion

Although they are somewhat of a novel concept in the world of decentralized finance, they are rapidly gaining traction and garnering public interest. Just in 2020 alone, the market for derivatives experienced a 34% increase and is estimated to be worth a huge $15.8 trillion in gross market value in 2021. At this rate, this market is only going to get bigger and grow faster. Soon, no asset will be out of reach for DeFi derivatives to be created upon.