What are DeFi derivatives?
Derivatives are one of the key signs of a mature, traditional financial market. Some analysts estimate the global derivatives market at more than $1 quadrillion on the high end! This completely dwarfs all other financial markets including stocks and bonds.
Derivatives are financial contracts, set between two or more parties, that derives its value from the performance of an underlying asset, group of assets, or a benchmark. The underlying asset can be a stock, commodity, index, or cryptocurrencies. The common types of derivatives are forwards, futures, options and swaps.
At its core, derivatives have primarily been used as a risk management tool. For example, airlines have long used derivative contracts to hedge against potential price changes. By locking in prices, airlines could operate their businesses with a degree of certainty. This same hedging strategy has long been used in the agriculture business. For instance, farmers that plant wheat are committed to delivering a certain amount of wheat at the end of the growing season. However, this presents the farmers with significant pricing risk as its price can flutcuate throughout the year. To manage this risk, farmers will sell short wheat futures and incur a profit or loss depending on the price of wheat at time of delivery. No matter where the price ends up, its important to note that the wheat farmer has a predictable income.
Another common use case for derivatives is asset speculation. The reason for this is derivatives offer a simple way to gain exposure to particular assets instead of owning the actual assets itself. They also provide easy access to leverage where traders can gain exposure to a significant amount of the underlying asset. Speculators are just as important for the derivatives market as they provide liquidity and allow people to easily enter and exit their positions.
Given the importance of derivatives in traditional markets, it is no surprise that derivatives are also emerging in DeFi markets. “Yield farmers” in DeFi use derivatives for the same reason as traditional ones: hedging price risk and speculating on crypto assets. The difference is that DeFi derivatives utilize smart contracts that live on a blockchain, offering greater transparency and cost-efficiency.
Types of DeFi derivatives
Derivatives in DeFi come in many different forms:
- Futures contracts. These are financial agreements that allow traders to benefit from the future price movement of an underlying asset. It is essentially an agreement to buy or sell an asset at a predetermined price and date in the future. Decentralized futures can be either perpetual (no maturity date) or have a fixed expiration date. Perpetual futures have emerged as the most popular DeFi derivative to date as they mimic the trading experience of traditional futures contracts but without an expiration or settlement date.
- Options. These are financial contracts that gives the holder the right – but not the obligation – to buy or sell an underlying asset at a specified price and date (expiration date). Options are typically used to hedge against an asset’s price volatility or to speculate on its future price movements.
- Synthetics. These are assets that are digital representations of a wide range of assets, including stocks, commodities, crypto assets, etc. While they represent the value of the underlying asset closely, they are not directly backed by them.
Where does the yield come from in DeFi derivatives?
The yield or income that derivatives traders or creators earn or pay comes from various sources, such as:
- Trader profits: This is the trading profits that derivatives traders make when they buy or sell their contracts at a favorable price. For example, if a trader buys a perpetual future contract on ETH with a price of 4000 USDC and sells it later at 5000 USDC, they will make a profit of 1000 USDC.
- Trader losses: This is the trading losses that derivatives traders lose when they buy or sell their contracts at an unfavorable price. For example, if a trader buys a perpetual future contract on ETH with a price of 4000 USDC and sells it later at 3000 USDC, they will lose 1000 USDC.
- Platform fees: This is the fees that derivatives traders pay to the platform or protocol for using their service. For example, if a trader uses GMX to trade perpetual futures, they will pay a fee of 0.05% on every trade.
- Token rewards: This is the token rewards that derivatives traders or creators receive for participating in a platform or protocol. For example, if a trader or creator uses Synthetix to trade or create synthetic assets, they will receive rewards in the form of SNX tokens.
Are DeFi derivatives safe?
Derivatives are considered a riskier financial instrument in both traditional and crypto markets. This is because derivatives are complex, volatile financial products. As such, the potential gains or losses are magnified as a result. Liquidity is another concern for derivatives as it can make it difficult to enter or exit positions. There is also potential for liquidation for certain financial contracts like perpetual futures. In the absence of an expiration date, traders must maintain a sufficient margin in their accounts to cover potential losses. If a trading position moves against you, and your margin balance falls below the required threshold, your position will be liquidated.
What are the advantages of DeFi derivatives?
Derivatives in DeFi can offer several benefits including:
- Risk management: DeFi derivatives allow users to hedge against price volatility. For example, a cryptocurrency trader can use DeFi derivatives to protect their portfolio against potential losses by taking a short position when they anticipate a market downturn.
- Leverage: DeFi derivatives often allow users to trade with leverage, meaning they can control a larger position with a smaller amount of capital. This can amplify potential gains when markets move in the desired direction. While leverage can enhance profits, it also increases the potential for losses. Users must be aware of the risks and manage their positions accordingly.
- Synthetic exposure: DeFi derivatives enable users to gain exposure to assets or markets that may be difficult to access directly. For instance, users can obtain synthetic exposure to traditional financial assets like stocks, commodities, or even real estate without owning the underlying assets.
Top Derivatives protocols in DeFi
To learn more about DeFi derivatives, you can check out some of these derivatives protocols: