Last updated on July 11th, 2023 at 10:37 pm
The DeFi space has grown immensely in the past few years. The growth of DeFi has led to the launch of many DeFi protocols offering different financial services like lending/borrowing, derivatives, and payments.
While lending platforms like Maker are the ones that started it all, the one category in DeFi that has tremendous growth potential is Derivatives. Currently, DeFi derivative platforms account for $2.7B of the Total Value Locked in DeFi out of a cumulative $69B in TVL.
In this article, we will talk about what derivatives are and why they are important in DeFi. We will also talk about some of the most popular DeFi derivatives’ protocols.
Let’s dive in.
What Are Derivatives?
Derivatives are one of the most sophisticated instruments in the financial market. As the name suggests, they derive their value from an underlying entity’s performance. Usually, the underlying assets are stocks, bonds, commodities, interest rates, or cryptocurrency.
The derivatives contract specifies the exact conditions within which the involved parties can transact with each other. These conditions include the following:
- Predetermined time period
- The resulting value of the entity
- Definition of the underlying variables
- Contractual obligations of each party
- The notional amount
Futures, forwards, swaps, warrants, and options are some of the most commonly used derivatives in DeFi.
Derivatives Use Cases In DeFi
The use cases of derivatives can be divided into two categories: hedging and speculation. Let’s take a look at these two use cases in detail.
Investors who speculate using derivatives are essentially trying to make personal profits from the inefficiencies and the fluctuations in the market. Using derivatives, investors can get more exposure even with less capital up-front.
When it comes to derivatives in DeFi, just like any other financial instrument, speculation represents a large amount of the total trade volume across the ecosystem. This is large because of the easy exposure offered by derivatives. Derivatives enable investors to invest in assets that may be hard to access otherwise.
Moreover, derivatives are the favorite instrument of traders as they can use them to leverage funds. By only providing enough funds to cover the options premium, traders can purchase a call and put option and gain a significant amount of exposure to the underlying asset.
Furthermore, speculators provide much-needed liquidity in the market. They allow investors to easily enter and exit the market and allows them to buy derivatives to hedge their risks.
Purchasing derivatives allows them to manage their financial risks more efficiently. By purchasing a derivative contract whose value moves in the direction opposite to the original asset owned by them, investors can hedge their risks.
Let’s try to understand hedging with the help of an example.
Imagine a farmer whose farmland consists of a large amount of wheat. It can be said that the farmer is overexposed to the price fluctuations of wheat. To hedge their risks, the farmer can make use of derivatives and take a short position by selling futures contracts for the amount they predict to harvest. This effectively locks down the current price and as the time of harvest approaches, the farmer can close their position. Depending on the price of wheat at the time of closing, the farmer can incur a profit or a loss.
If the price of wheat is lower than the predicted price, the short position makes a profit. This profit would then offset the loss from selling wheat at a lower price.
If the price of wheat is higher than the predicted price, the short position will be at a loss. This loss can be offset by selling the actual wheat at a higher price.
Thus, regardless of the price, the farmer will end up with a predictable amount of income.
Derivatives In DeFi: The Opportunity
Derivatives are arguably one of the most exciting investment opportunities in DeFi today. Here are some reasons why:
- Large addressable target market – Derivatives is one of the largest financial markets in the world. Without derivatives, many everyday products such as checking accounts, insurances, mortgages will not be possible. Thus, there is a large market opportunity that derivatives in DeFi can potentially utilize
- The importance of derivatives in any financial market – Financial market is all about risks. Where there is a risk, there is a need for hedging and that is exactly what derivatives offer. In any important financial system, the general market ratio between money/debt/derivatives is 1/10/100. This is not even nearly the case in DeFi at the moment.
- Potential to disrupt the centralized derivatives market – With the inherent benefits of DeFi like accessibility, automation, and flexibility, many traditional derivatives markets will be incentivized to decentralize their offerings.
The Protocols Bringing Derivatives To DeFi
Now that we have a better understanding of derivatives, let’s take a look at some of the protocols bringing derivatives to DeFi.
One cannot talk about derivatives in DeFi without mentioning Synthetix. It is a DeFi protocol built on the Ethereum blockchain that enables users to develop and issue synthetic assets or Synths on the blockchain. These Synths track the price of their underlying asset and like a truly decentralized protocol, they are voted into existence by the community. Currently, Synthetix dominates the derivatives market in terms of TVL with the protocol accounting for around $1.47B, which is over 53% of the total TVL in derivatives.
UMA is another popular DeFi protocol that allows the creation of synthetic assets. UMA is different from Synthetix in the sense that it does not highly overcollateralize the protocol and instead offers incentives to liquidity providers to find inadequately collateralized positions and liquidate them. Moreover, unlike Synthetix, anyone can create a synthetic token on UMA as long as there is a reliable way to track the data. Currently, UMA has over $99M in TVL on the platform.
BarnBridge is a fluctuations derivatives protocol that allows for hedging yield sensitivity and market price. Through the protocol’s Structured Market Adjusted Risk Tranches (SMART) products, It allows investors to risk their positions according to their own risk appetite rather than have to opt for generalized hedging options. Currently, BarnBridge has over $260M in TVL on the platform.
dYdX is a unique addition to this list. This is because it is a hybrid platform that operates as a DEX and at the same time offers lending and leverage services. It provides unique opportunities for traders to use permissionless derivatives for speculation. On dYdX, traders can open positions with up to 5x leverage on some assets like ETH. Currently, dYdX has over $179M in TVL on the platform.
Opyn is a relatively new DeFi project that launched in 2020. It is a DeFi platform that allows users to trade options in the European options style which means that options can only be exercised at the time of expiry. Currently, Opyn has over $76M in TVL on the platform.
- Derivatives are a crucial product in any financial infrastructure. They are needed to support the long-term growth of any asset class. Similarly, when it comes to the world of cryptocurrencies, the introduction of derivative products like futures, forwards, options, and swaps offer a unique opportunity for investors. Investors can use these financial instruments to shorten and hedge their risk against their inherently volatile cryptocurrency holdings.
So, what are views on derivatives in DeFi? Do you think they have great potential to grow in the future? What are some of your favorite DeFi derivatives platforms?