As the cryptocurrency ecosystem expands, so do the ways to interact with digital assets. DeFi derivatives are a relatively new way to interact indirectly with cryptocurrency and other assets on the blockchain. Investors and enthusiasts worldwide have begun engaging with DeFi derivatives, so if you are interested in cryptocurrency it's worth understanding this market.
What are derivatives?
Derivatives are contracts with values derived from underlying assets. They were initially used to balance exchange rates for international swaps in the foreign exchange, or currencies, market. The concept has moved into other financial markets. Options, prediction markets, futures, and collateralized loans are examples of derivatives. These securitized contracts give investors a way to interact with an asset without holding it. Additionally, derivatives let investors hedge positions, speculate on directional movement, leverage their holdings, and transfer risk to other parties.
The two classes of derivatives are lock and option derivatives. With lock derivatives, the parties are bound to the agreed-upon terms throughout the contract’s life. Option derivatives allow the holder to buy or sell the underlying asset before expiration.
Although the derivative's value is based on an underlying asset, a contract’s owner doesn’t necessarily own the underlying asset. For example, an option derivative on US Steel stock gives the holder the right to buy or sell US Steel at the strike price until expiration. That stock is the underlying asset.
Derivative traders often are, in essence, betting on what direction an asset will go, rather than buying the asset as an investment. For example, a trader thinks a company stock price, now $60 a share, will go up. He could simply buy 1,000 shares of stock, wait for it to rise and then sell it for a profit. Instead, he buys a call option derivative, for a relatively nominal fee, that gives the option of buying 1,000 shares at $60 a share in 60 days. If he's right, and in 60 days the stock has risen to, say, $80 a share, he can buy that $80 stock for $60 a share. Or, if the stock has dropped to, say, $40 a share, he chooses not to buy the stock and gives up that fee.
Due to the wide variety of derivatives available, the value of the derivatives market is estimated at anywhere from $15 trillion to $1 quadrillion.
The International Swaps and Derivatives Association is in charge of creating legal guidelines for traditional derivatives. The ISDA also makes guidelines for smart derivatives.
How do DeFi derivatives work?
Like the derivatives found in traditional finance, the motivations behind crypto derivatives and other decentralized derivatives are hedging price risk and gaining exposure to a particular asset or market without being directly involved. DeFi derivatives’ values are often tied to cryptocurrency markets, although, in some cases, they track the value of fiat, commodities, and other traditional assets. Like many other elements of decentralized finance, DeFi derivatives often rely on the use of smart contract technology and other technology-enabled solutions.
Using automated market makers for derivatives trading can be challenging, but several technology solutions exist to deal with this issue. For example, a virtual liquidity machine can use a smart contract to create a constant product, supplying long and short liquidity. Virtual liquidity machines mitigate liquidity provider risks by eliminating the liquidity provider role and transferring the risk to the protocol.
Many DeFi derivatives protocols allow users to create synthetic assets with values tied to underlying real-world assets. Sites like Synthetix let traders buy and sell derivatives with values tied to cryptocurrencies, commodities, fiat currencies, stocks, indexes, and more.
Most exchanges offering Defi derivatives allow traders to use leverage, which is an essential part of derivatives. Leverage allows traders to increase their risk-to-reward ratio by committing a relatively small amount of capital up front for potentially large gains. For example, if an investor speculates that a specific cryptocurrency will increase in price, they could simply acquire a certain amount of that cryptocurrency at the current market price. Instead, the investor can leverage a much smaller amount in derivatives to generate big gains. Of course, if they’re wrong they could get hit with big losses.
It’s important to understand that regulatory issues may arise for certain DeFi derivatives. The U.S. Securities and Exchange Commission has sent subpoenas to numerous cryptocurrency projects and is engaged in several high-profile lawsuits that may spell bad news for decentralized finance.
The SEC uses the Howey Test to determine whether or not an investment contract exists. According to the Howey Test, if market participants invest money in a common enterprise with the expectation of profits based on others’ efforts, the asset is an investment contract. If a cryptocurrency project or exchange offers any asset or service that resembles an investment contract, they have to register with the SEC or suffer penalties.
Key concepts for DeFi derivatives
To gain a better understanding of DeFi derivatives, let's review some important terms and concepts.
ISDA master agreement: The master service agreement for international OTC derivatives transactions.
Fx market: A global market for trading currencies and determining foreign exchange rates.
Derivatives market: The financial market for instruments tied to the values of underlying assets — these include options, futures, interest rate derivatives, and more.
Derivatives contract: A contract between two or more individuals or organizations where the contract’s value is based on an underlying financial asset or market.
Futures contracts: A derivative with value tied to the performance of an underlying asset.
Equity options: A derivative with value derived from an underlying stock. Options can be either calls or puts. Calls allow the holder to buy the underlying stock at a predetermined date and price outlined in the contract. Puts enable the holder to sell the stock at the predetermined date and price.
Smart derivatives contract: A derivatives contract operating on a distributed ledger that uses smart contract code to automate most aspects of the transaction.
Credit derivatives: Any instrument created to transfer the credit risk or risk of default.
Crypto derivatives: Derivatives contracts where the underlying asset is a cryptocurrency token.
Synthetic assets: Tokenized derivatives that mimic the value of an underlying asset.
Underlying asset: The asset or group of assets to which the value of a derivative is tied.
Underlying market: The market tied to a derivative’s value.
Crypto assets: Tokenized digital assets on the blockchain.
Real-world asset: Any physical asset such as gold, real estate, or commodities that can be tokenized and represented on-chain.
DeFi derivative protocols: A marketplace or tool that uses smart contracts to offer decentralized derivatives.
Structured products: Pre-packaged investments including assets and one or more derivatives.
OTC Transactions: Derivatives trades carried out over-the-counter between individuals, brokers, or banks instead of using a formal exchange.
DeFi derivatives allow investors to limit their exposure to risk and benefit from underlying assets’ price movement in a trustless environment. As blockchain technology continues to evolve, we’ll likely see new types of derivatives and new technology solutions to accommodate derivatives trading on the blockchain. Both decentralized finance and derivatives are complex worlds. Putting them together is not for the faint of heart. It’s essential to only interact with derivatives offered by trusted exchanges.