What Are DeFi Derivatives?

A Primer on High-Risk Instruments Used in Decentralized Finance

By: Rahul Nambiampurath Loading...

What Are DeFi Derivatives?

As their name suggests, derivatives are financial instruments that enable investors to bet on the behavior of underlying assets, whether they are stocks, bonds, commodities, or cryptocurrencies.

They are often called “synthetic” instruments because investors may not have to hold the underlying asset to trade them. Investors in tokenized stocks, for example, do not hold the actual shares in a listed company but a tokenized version of the stock.

Why Do Derivatives Exist?

In their purest form, derivatives are all about managing risks. Farmers and investors in agriculture have long used derivative contracts to hedge potential losses from the possibility of crop failures. By locking in prices, producers and farmers could operate their businesses with a degree of certainty. The same type of preemptive risk mitigation has long been a staple in the energy industry. Airlines, for instance, have long set future prices for jet fuel to protect themselves from sudden price spikes in a volatile industry.

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So how do derivatives work? At a fundamental level, they are contracts between a buyer and a seller. These instruments can be divided into option and lock contracts. Options allow contract-holders to trade the underlying asset, either sell or buy it, before the expiry date. In contrast, lock derivatives bound trading parties to the set underlying price until the agreed-upon expiry date. And remember, investors don’t necessarily have to hold the underlying security or asset.

For example, an exchange-traded fund (ETF) called ProShares Bitcoin Strategy (BITO) doesn’t hold actual Bitcoin on the Bitcoin network. Instead, the fund tracks the price of BTC, while charging a fee. In turn, the investors don’t have to worry about the custodial issues of holding BTC in a wallet.

BITO pegs the price of its BTC futures contracts to Chicago Mercantile Exchange (CME). Source: ProShares

What BITO does instead is to hold futures contracts with expiry dates, settled in cash. Investors buy these contracts just like they would buy stock shares, including placing limit orders. Nonetheless, as the futures contracts expire monthly, they have to be repurchased.

Although this increases the monthly administration fees, investors who don’t want to deal with the hassle of moving BTC around prefer this BTC-exposure trading solution.

DeFi Derivatives

DeFi derivatives serve the same purpose as traditional ones: hedging price risk and gaining exposure to the asset’s value without actually owning the asset. The difference is that DeFi derivatives are smart contracts hosted on a blockchain, offering greater transparency and cost-efficiency.

Because smart contracts automate the execution of derivatives’ terms, there is no need for any mediators except for the protocol itself. More importantly, such derivatives can be tokenized as synthetic assets.

Let’s take the example of Synthetix, a derivatives protocol that tracks the value of commodities, fiat currencies, cryptocurrencies, and stocks. The protocol tokenizes the value of these underlying assets as “synths,” adding the prefix “s” to their ticker symbols.

Source: Synthetic

Transformed into synth tokens, these derivatives can then be exchanged on a spot market just like one would exchange assets from a wallet, but without actually owning them. This could be applied to precious metals like gold, stocks, or fiat currencies.

In essence, Synthetix protocol makes it possible to have an agnostic derivatives exchange because all underlying assets can be tokenized into synths. The critical link in making that happen is Chainlink oracle network. This decentralized network feeds real-world data, such as prices, to on-chain protocols like Synthetix or UMA.

Other DeFi Derivatives Protocols

For traders who don’t want to buy Ethereum, but want to trade its value, Opyn is the solution. Opyn protocol allows traders to have either long (betting ETH price will rise) or short (betting ETH price will fall) positions.

Moreover, they can keep funding those positions perpetually, without an expiry date. These derivatives are called perpetual futures. Depending on whether ETH price falls or rises, both short and long sellers fund each other’s positions.

As the cherry on top, traders can even leverage their positions. Typically, leveraging is extremely risky, but Opyn’s Squeeth perpetual trading offers a protected downside with no liquidations.

Source: Opyn

Nonetheless, traders still have to pay premiums when they fall out of their short/long positions. For example, if ETH price goes sideways for a long time, long position holders constantly have to pay premiums because of the lack of ETH upward price momentum.

Another DeFi derivatives platform to offer perpetuals trading is dYdX, but without the liquidation protection. Although dYdX is a decentralized exchange, it employs off-chain trade matching with order books, while settlements occur on-chain. Such hybrid combo makes for a fast trading experience on par with traditional finance.

Most Common DeFi Derivatives

Anyone who has been in the crypto space must have seen familiar token names, but with a “w” prefix. These are wrapped tokens. For example, wBTC is wrapped Bitcoin. Its whole purpose is to bridge the incompatibility gap between the Bitcoin network and Ethereum, by making BTC into an ERC-20 token, which is the smart contract standard for the Ethereum ecosystem.

Technically, this makes wBTC a derivative because it is tied to the underlying asset — Bitcoin. One wBTC equals 1 BTC, just like $1 equals 1 USDC stablecoin. Each wBTC, or other wrapped tokens, can only be minted when the original token is deposited, so they can be redeemed without risk.

wBTC tokens are widely used in DeFi as a collateral for loans. This makes sense because Bitcoin is the largest cryptocurrency, making it the least volatile asset. Otherwise, a loan collateral would be prone to liquidation. Moreover, wrapping BTC extends its use cases beyond store of value.

Series Disclaimer:

This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.