Derivatives in DeFi | OpenPad DeFi
Decentralized Finance Applications Demystified | Walkthrough of derivatives and their part in the Web3 space
TL;DR:
Derivative is a contract that derives its value from the performance of an underlying entity/asset.
Futures, Options, and Swaps are examples of the derivative products in DeFi.
The Definition
Let’s start with an intuitive definition. Derivatives derive their value from something, as the name implies. The price of another underlying financial asset, such as a stock, a bond, a commodity, an interest rate, a currency, or in our case, a cryptocurrency, is generally this “something.” They can be used for several reasons like insuring against price movements, i.e. hedging, speculation etc.
If investors know they intend to buy an asset, they may sign a derivatives contract promising to acquire it at a certain price. This helps them hedge against potential fluctuations in the asset’s value.
However, derivatives markets are also very popular as a subject of speculation. Instead of ever owning the asset in question, traders simply bet on its future value.
Hedging: a contract entered into or asset held as a protection against possible financial loss: inflation hedges such as real estate and gold.
Why does derivative trading exist?
To put things into perspective, derivatives are traded in higher volumes in crypto exchanges than in the underlying spot markets. This means there is more buying and selling of Bitcoin futures than actual Bitcoin. To understand its inevitable existence, let’s look at its inception.
Taking a tour through the history of Derivatives
Derivatives in the form of forwards and futures contracts were introduced for hedging. Historically the agricultural and commodities market has been highly volatile and difficult to predict. Natural calamities, wars and trade restrictions would drive the commodities markets up/down depending on the situation. This gave rise to the futures contract among the farmers and the merchants, ensuring that each participant got a fair price regardless of the market situation. Futures contracts for agricultural commodities were traded for a long time in the United States before they were regulated in the early 20th century.
The oldest organized derivative market appears to be the Dojima Rice Exchange in Japan in the early 18th century. You can read about it here - Forwards and futures in tokugawa-period Japan: A new perspective on the Dōjima rice market.
The tale of a philosopher named Thales, who utilized his wisdom to anticipate a prosperous olive crop, is one such fascinating narrative. He took his limited funds and went to the owners of olive presses, which were used to turn olives into oil. Having rented these pressers for exclusive use during the harvest time earlier than others for relatively less money, he made a fortune by renting these out after the bumper harvest when there was high demand for the olive pressers.
So, in short, derivatives in one form or another started out as humble mechanisms to protect against substantial price movements in agricultural produce and other commodities. They have been around for a long time.
Why is it essential?
Essentially, the motives for developing and using DeFi derivatives are similar to those applied to TradFi markets — either to hedge price risk associated with exposure to a crypto asset, exploit speculative opportunities, or access leverage.
Many financial markets carry risk and, with it, a need for hedging. But, in addition to these needs, there are also opportunities for speculation in those markets. Derivatives are designed to serve the needs of these market participants.
Every growing market naturally develops its own derivatives market that can end up being an order of magnitude bigger than its underlying market.
This is also why many people in the decentralized finance space are extremely bullish on the potential of decentralized derivatives that, in contrast to traditional finance, can be created by anyone in a completely permissionless and open way. This, in turn, increases the rate of innovation that has been stagnating in traditional finance already for a while.
Now that we have an intuition on the purpose and structure of derivatives let’s outline the most prevalent derivatives instruments in crypto markets: futures and options.
Futures
Futures are a form of derivative that tracks the price of an underlying asset. The contract allows traders to bet on the price going up (long) or to bet on it going down (short). The most popular form of futures contracts in crypto markets is perpetual futures products, which means they don’t expire at a certain date. As with our Bitcoin example, these contracts are traded at higher volumes than the underlying base assets.
Examples of DeFi derivatives protocols include dYdX (clever math pun), Mirror Protocol, and Synthetix.
Options
An option is a contract that allows its holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. Each contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price.
Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset at a stated price within a specific timeframe. Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
While options are predominantly used by banks and investment firms in traditional finance, several options protocols have sprouted in the past two years as DeFi products that use smart contracts for financial services – gained steam in the broader crypto market. DeFi options are pretty similar to futures contracts. The difference between the two is there is no mandatory condition for buying or selling an underlying asset as a stakeholder.
Derivatives are financial instruments that have been around and will probably be around for a long time. They are tools that have naturally evolved as necessary fail-safe mechanisms against the ever-fluctuating market currents.
Resources to Learn & Invest with OpenPad
🕸 Home: openpad.app
📖 Docs: docs.openpad.app
🧢 Twitter: twitter.com/OpenPadCitizens
📒 Web3 Newsletter: openpad.substack.com
🔊 Announcement Channel: t.me/openpad
🗣 Community Channel: t.me/OpenPadTG
🔗 Official Links: linktr.ee/openpad