An In-Depth Look at DeFi Derivatives

paul faecks
Summary:
  • Traditional derivatives are a type of financial contract whose value depends on an underlying asset, a basket of assets, or a benchmark.
  • DeFi derivatives are similar to traditional derivatives, except that blockchain-based protocols issue them without intermediaries.
  • Investors can utilize several types of derivatives in DeFi, with more likely to emerge as blockchain infrastructure evolves to accommodate new protocols.
DeFi Derivative Regulations

Now that we've reviewed some of the most popular DeFi derivatives protocols, it's worth touching on the regulatory environment surrounding these blockchain-based financial products. For example, The U.S. Securities Exchange and Commission (SEC) uses the Howey Test to determine if a cryptocurrency projector exchange offers any asset or service that resembles an investment product.

The Howey Test stipulates that "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 project issues derivatives that align with this definition, it must register with the SEC or face penalties for non-compliance. Unfortunately, the SEC has sent subpoenas to several cryptocurrency projects and is even engaged in high-profile lawsuits, bringing uncertainty to the ecosystem. However, given the global reach of DeFi, it's impossible to determine how governments will apply such regulations worldwide.

The Future of DeFi Derivative

Despite regulatory uncertainty, it's apparent that DeFi derivatives continue to proliferate. Like their traditional cousins, these unique financial instruments allow investors to limit their risk exposure while benefitting from underlying asset price movement. However, DeFi derivatives deliver this functionality without the need for intermediaries. As blockchain technology evolves and protocols become even more complex, we'll likely see DeFi derivatives products and new infrastructure to support their use.

As crypto awareness grows worldwide, more investors and enthusiasts are looking for ways to interact with the digital asset class. As a result, DeFi derivatives have begun to gain momentum, providing a novel way to gain exposure to the ecosystem. However, before we explore DeFi derivatives in more detail, it's important to define their traditional counterpart.

Derivatives are a type of financial contract whose value depends on an underlying asset, a basket of assets, or a benchmark. In traditional financial markets, derivative contracts are made between two parties that can trade on secondary markets or over-the-counter (OTC). Both of these options require an intermediary to execute the contract.

What Are DeFi Derivatives?

In contrast to traditional derivatives, those offered on DeFi platforms often utilize smart contracts to automate transactions, eliminating the need for intermediaries. However, the motivation for purchasing derivatives remains the same across both markets—derivatives hedge price risk, giving investors exposure to a particular asset or market without direct involvement. And while DeFi derivative values are often tied to crypto markets, they also track the value of fiat, commodities, and other traditional assets.

How Do DeFi Derivatives Work?

Like many DeFi protocols, DeFi derivatives often utilize automated market makers (AMM) to facilitate trading. Unlike traditional exchanges, AMMs don't use order books to match buyers and sellers, making it more challenging to issue derivative products. However, several emerging solutions aim to overcome such hurdles. For instance, virtual liquidity machines can use smart contracts to create a constant product (x*y=k), supplying long and short liquidity to keep the pool balanced. In addition, these virtual liquidity machines eliminate the liquidity provider role, transferring risk to the protocol instead. Notably, most platforms offering DeFi derivatives also allow traders to use leverage, a crucial component of derivatives trading in traditional markets. Using leverage, or borrowing money from the protocol, enables traders to amplify their gains by committing a relatively small amount of their capital upfront.

For example, if a trader believes that a specific digital asset will increase in price, they could buy it at the current market price. Alternatively, the same investors can leverage a much smaller amount in derivatives to generate substantial gains. However, the latter approach could also cause significant losses if the investor is wrong—which is why derivatives are often seen as risky, especially when using leverage.

Despite the risks, DeFi derivatives eliminate barriers to entry, making financial products accessible to anyone with adequate collateral and a non-custodial crypto wallet. For example, most derivatives can be traded directly on the protocol's native exchange or a decentralized exchange (DEX) like Uniswap, making interacting with these unique financial instruments easy. With the basics of DeFi derivatives covered, we can begin exploring the ecosystem more closely.

The DeFi Derivative Ecosystem

In general, investors will need stablecoins like DAI, USDC, or sUSD (in the case of Synthetix) to interact with derivatives protocols. Similarly, most derivatives can be purchased and issued using ether (ETH) as collateral. Below, we’ll break down some of the most popular DeFi derivatives protocols.

GMX

According to DeFiLlama, GMX is the largest derivatives platform based on total value locked (TVL). This decentralized spot and perpetual exchange allows users to trade BTC, ETH, and other cryptocurrencies directly from their wallets. That means investors keep custody of their digital assets at all times. Specifically, traders can use GMX to execute swaps and trade perpetual futures (futures without an expiration date) using up to 30x leverage, similar to centralized exchanges.

dYdX

dYdX is the second largest provider of permissionless derivatives based on TVL. The hybrid protocol serves as a DEX for cross-margin perpetual trading while offering lending and leverage. In cross-margin trading, investors can repurpose their available balance to provide liquidity to existing trades—a widespread practice to avoid liquidation during extreme market volatility. In addition, dYdX users can open positions with up to 5x leverage using ETH, with other digital assets to come.

Keep3r Network

Keep3r is the third largest derivatives provider based on TVL, serving as a task-based network that connects decentralized development teams with outside talent. Keep3r Liquidity Provider Tokens (kLP) are native digital assets issued to users that provide liquidity to the network's liquidity pools. Job owners can bind kLP, which periodically generates KP3R credits. These KP3R tokens facilitate payments and collateralize job contracts.

UMA

The Ethereum-based Universal Market Access (UMA) protocol tracks real-world commodities like gold and tokenizes them into synthetic on-chain assets. For example, a trader might use UMA to create a futures contract for gold as the underlying asset. Like traditional futures, these contracts are binding agreements to buy or sell commodities or securities at a given price in the future. However, unlike perpetual contracts, regular futures have expiration dates, meaning investors use them to hedge against price depreciation or appreciation, depending on if the trader locked in the price for buying or selling.

Opyn

Opyn is a DeFi derivatives protocol that supports options infrastructure. Like traditional options, traders can buy long or short positions. However, these positions are identified and tokenized as "Long Squeeth" or "Short Squeeth." Specifically, Long Squeeth gives traders a leveraged position with unlimited ETH² upside, protected downside, and no liquidations. Long Squeeth holders pay a funding rate for this position. In addition, as the name suggests, Short Squeeth is short an ETH² position. Traders earn a funding rate for taking on this position, which Long Squeeth holder pays.

Perpetual

Perpetual is an on-chain perpetual futures DEX for every asset, made possible by a Virtual Automated Market Maker (VAMM). Similar to other DEXs, traders can use VAMMs without intermediaries. These VAMMs are designed to be market neutral, are fully collateralized, and provide guaranteed on-chain liquidity with predictable pricing set by constant product (x*y=k) curves.

Synthentix

The popular Synthetix protocol allows users to create synthetic assets (Synths) with values tied to underlying real-world assets. Specifically, the protocol enables traders to buy and sell derivatives with values tied to cryptocurrencies, commodities, fiat currencies, stocks, and indexes with zero slippage.

BarnBridge

The BarnBridge protocol aims to tokenize risk by aggregating exposure across the DeFi ecosystem via unique financial instruments. Specifically, the protocol gives investors more control over their risk profile by allowing them to purchase tokens that represent investment and participation in various DeFi products. The ability to tokenize risk exposure generates more volatility for speculative traders and less volatility for long-term investors and institutions. This mechanism is critical to attracting more risk-averse investors to the DeFi ecosystem.

DeFi Derivative Regulations

Now that we've reviewed some of the most popular DeFi derivatives protocols, it's worth touching on the regulatory environment surrounding these blockchain-based financial products. For example, The U.S. Securities Exchange and Commission (SEC) uses the Howey Test to determine if a cryptocurrency projector exchange offers any asset or service that resembles an investment product.

The Howey Test stipulates that "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 project issues derivatives that align with this definition, it must register with the SEC or face penalties for non-compliance. Unfortunately, the SEC has sent subpoenas to several cryptocurrency projects and is even engaged in high-profile lawsuits, bringing uncertainty to the ecosystem. However, given the global reach of DeFi, it's impossible to determine how governments will apply such regulations worldwide.

The Future of DeFi Derivatives

Despite regulatory uncertainty, it's apparent that DeFi derivatives continue to proliferate. Like their traditional cousins, these unique financial instruments allow investors to limit their risk exposure while benefitting from underlying asset price movement. However, DeFi derivatives deliver this functionality without the need for intermediaries. As blockchain technology evolves and protocols become even more complex, we'll likely see DeFi derivatives products and new infrastructure to support their use.

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