Derivatives

DeFi has been an emerging market for the past three years in the Web3 world. Protocols have tried to bridge the gap and bring traditional financial instruments to the Web3world, offering users decentralization, full custody, and favorable conditions to make their own choices with minimum intermediation. 

So far, we (Web3 users) have been successful in creating decentralized: 

• Exchanges
• Applications
• Lending & Borrowing
• Stablecoins and Stableassets 
• Insurance
• Prediction Markets
• Indices 
• Derivatives

Disclaimer: These categories are still broad as the markets are still segmenting, and niches are coming up, so you will forgive us if I missed any.

Even though the DeFi space is broad, in this blog post, we will focus specifically on one of its emerging markets, Derivatives.

Let’s start simple and explain what derivatives are. Derivatives are financial instruments whose value mainly depends on the underlying asset’s price. They allow users to manipulate their assets. Users can expose themselves to more risk or hedge against it. Derivatives are traded over the counter (OTC) or through exchanges. 

How does this translate to DeFi? Decentralized Derivatives, aka DeFi Derivatives, are blockchain-native financial instruments that remove the need for centralized intermediaries, such as brokers and banks, through smart contracts. Smart contracts automate and facilitate the whole process while maintaining transparency. 

2021 was a boom year for the market. Still, due to recent events, such as FTX bankruptcy and increasing risk and uncertainty, TVL decreased significantly. In the graph below, you can see the Total Value Locked in all segments of the DeFi Derivatives market. 

Source: DeFi Llama 

Types of Derivatives

There are many different derivatives. Still, here we will discuss the most common ones in TradFi, and DeFi: 

• Options
• Futures
• Perpetual Swaps
• Synthetics

Options

Options are the most widely used financial instruments since they offer the buyer the right to buy or sell the underlying asset without the obligation of actually doing so. 

There are two types of options Call and Put. The Call gives you the right to buy, while Puts give you the right to sell. All options have maturity dates, dates at which the option expires. 

Depending on when the option can be exercised, there are two types of options, American and European. American options can be exercised at any date before expiration, while European options can be exercised only on the maturity date.

More on options here. 

Futures

Contrary to options, futures require the person to buy or sell an underlying at the specified date regardless of whether market conditions are favorable. In other words, parties agree on the price of an asset paid which will be delivered in the future. They are used for hedging or speculation, just like options.

Futures carry greater risk for investors than options since they must be exercised at the maturity date, which can result in potential losses from the drop in value of the underlying asset. This risk is almost negligible with options since the investors can opt not to exercise the option and only lose the premium they paid for acquiring it. 

Perpetual Swaps

Perpetual Swaps are very similar to futures contracts. However, what distinguishes them is that they do not have an expiration date. This implies that investors can open positions and close them as they please without waiting for the maturity date.

Just like futures, perpetual swaps offer investors trading opportunities without directly owning the underlying asset (i.e., Bitcoin) while allowing them to open positions bigger than their trading capital. This is also known as leverage, and while you are set for higher gain, you risk losing more and being liquidated.

Synthetics

These derivatives are new to crypto but not necessarily unique in Traditional Finance. Synthetics are assets that track the value or performance of the underlying asset or combinations of assets. In the DeFi sense, synthetics can also be considered tokenized representations of physical goods. 

Users can bet for or against these assets by entering long or short positions. We will explore a few examples later in the post.

TradFi vs. DeFi

The concept of Derivatives is the same in both TradFi and DeFi. However, there are several critical differences in providing this solution: 

Intermediation - In TradFi, financial intermediaries are banks and brokerage firms, which are centralized systems that also use human capital to conduct these services. While in DeFi, Code is Law, and smart contracts are the intermediaries and the ones automating the process.

Custody - Centralized platforms act as custodians of your assets, making it hard to manipulate them as you wish. Here is where DeFi comes into play, your assets are stored in your wallet at all times, giving you complete control over them, and allowing you to act as you please.

Market efficiency - New technology gives access to more people, increases choice, and decreases market friction, aka transaction costs. In colloquial terms, banks require good credit scores, proofs of income, and so forth when you want to borrow money, denying access to many users. Moreover, every transaction involves high fees, so DeFi is more focused on Economies of Scale to reduce them.

Collateralization - In DeFi, anyone can access a particular service provided he has enough assets to offer as collateral. In Borrowing and Lending platforms, this is usually around 150%. Banks do not require high collateral, but the lower your credit score, the higher collateral you will have to provide. 

We are all set to explore the top five DeFi derivatives platforms, and we will proceed.

Largest DeFi Derivatives Protocols

Opyn

Opyn is a DeFi options trading platform operating on Ethereum, Polygon, and Avalanche with $56.8M in Total Value Locked. It allows users to create, buy and sell options. It is also the first options trading platform in DeFi.

Its primary token is OSQTH (OpynSqueeth) which acts as the index that follows the price of ETH-squared (ETH^2). Generally, DeFi platforms require collateral for entering the position. The cool thing about Opyn is that their collateral ratio is 0% for the Long Squeeth position, which means that the investors have downside protection with unlimited upside. However, shorting Squeeth requires a collateral ratio of 150%, which is an average in DeFi.

Aside from Long and Short Squeeth, Opyn offers a ‘Crab’ strategy: A position betting on the ETH price moving inside a proposed interval. This is an excellent way of short-term investing during market stagnation since this is a delta-neutral position. Something between Bull and Bear, as it seems. 

Source: Squeeth

dYdX

We covered perpetual swaps and are now covering one of the first protocols to offer them. dYdX has $437.16M in Total Value locked, making it the second biggest Derivatives platform.

Aside from perpetuals, dYdX is an Order Book DEX that offers borrowing, lending, and spot trading with 0% fees for trade volume under $100K, making them one of the biggest competitors in the industry. The collateral ratio for borrowing is 125%; however, the deposited collateral earns interest. Perpetuals can be 20x leveraged.

Aside from that, they operate on Ethereum and have their own token, DYDX, which is used for governance. Users with X amount of DYDX have voting rights and can participate in the protocol’s decision-making. 

GMX

The largest Decentralized Perpetuals platform, operating on Arbitrum and Avalanche with over $466M TVL, is GMX. Unlike dYdX, GMX is an AMM that offers its users 50x leveraged trading. 

What also makes this platform competitive is its low fees, pool transparency, and native tokens GMX and GLP. GMX is used for governance, and holders earn 30% of protocol fees. GLP is the liquidity provider token, generating lenders 70% of protocol fees. It is also an index of pooled assets that serve as the protocol’s Proof of Reserves.

Synthetix

Synthetix is a decentralized platform where users can mint and trade synthetic assets. These assets are called Synths and can be either Regular Synths (long position - sSynth) or Inverse Synths (short position - iSynth). As previously mentioned, users can tokenize real-world assets such as fiat, crypto, indices, commodities, etc. Each tokenized asset is ERC20. 

The protocol has a collateralization ratio of 750%, which is exceptionally high. Stakers get flagged for liquidation when the CR falls below 200% giving them three days to rebalance it. The native token is SNX which is also used for governance purposes. The governance scheme is very delicate; however, it all comes down to community members staking SNX and choosing the next steps for the protocol, such as target collateral, liquidation ratio, and staking rewards.

Synthetic is available on both Ethereum and Optimism, but users are encouraged to use Optimism since the fees are significantly lower. As of now, the Total Value locked is at $308.93M.

Current state of DeFi Derivatives

Every project or protocol tries to distinguish itself on the market and bring something new and liberating. However, while doing this lite research, I noticed a pattern of resemblance in most of them. Here are five things all leading DeFi protocols have in common:

Governance - They all have native tokens that can be staked for voting rights and/or liquidity, providing rewards. These voting rights are put to use when the community proposes protocol improvements (IP). Those improvements usually target LP rewards, collateralization ratio, availability of different asset pairs, etc. 

Overcollateralization - Speaking of collateral, most borrowing and lending protocols like to keep safe at around 150% of CR. Derivatives, in general, are riskier and should be handled by more seasoned investors/traders. Still, DeFi is all about accessibility, so the middle ground for everyone is found at high CRs, such as 750% in Synthetix’s case. As time progresses and we progress in space, these ratios will decrease.

Transparency - This has been a relatively common topic lately, with many (centralized) crypto exchanges failing and people wanting to know what is happening with their money. More and more DeFi protocols know this is a differentiating factor. Even though they may not be custodial, they are nevertheless setting up their Proofs of Reserve to provide full transparency to the user. The PoRs are essential (especially to AMM-based protocols) in preventing the now very famous ‘Chapter 11’ (Bankruptcy - if you lived under the rock), lowering uncertainty and volatility in the crypto market.

Transaction-related costs - You know what I’m talking about, slippage and protocol fees. As everyone ever said: ‘Good lawd, I hate transaction fees’. Protocols are trying hard to reduce them to a bare minimum to lure us, spicy investors, into using their platforms, increasing their trading volumes, and creating a frictionless market. Looking at GMX and dYdX, I would say it is working. (GMX - 0.1% trading fee, dYdX - 0% fees under $100k trading volume)

Leverage - Finally, and most importantly, everybody loves a good gamble, and if it is not a gamble for you, you love it even more. Using more capital than you have does result in potentially more significant losses, which also means more enormous profits. By now, it is a standard for the protocol to have at least 20x leverage. GMX is doing 50x, which is what separates them from others.

How do these commonalities reflect in a current situation? Let’s use FTX as an example.

As we previously discussed, to borrow crypto and trade with leverage, you must post collateral a couple of times higher than your initial capital. In our case, Alameda (FTX’s hedge fund) borrowed money from FTX while posting FTT (FTX’s token) as collateral which was not even over 100% of the initial capital. 

To add fuel to the fire, Alameda was trading with leverage and losing money on those trades, creating more reason not to disclose their and FTX’s financials with the investors. So, in essence, Alameda was losing FTX money while it provided imaginary money as safety.

These events (Celsius, 3 Arrows, Terra) created massive distrust in the DeFi market, forcing people to withdraw money from all segments, including Derivatives platforms. 

Luckily, the bad actors are slowly being exposed and are disappearing from the market as DAOs introduce transparency through their Proofs of Reserve. Here is a neat example by DeFi Llama.

Conclusion

Crypto derivatives are a fun ride and a topic that yet has to be explored and perfected. There are quality platforms offering exposure to literally anything to savvy investors. If you made it to this point, here are some key takeaways from the blog:

• Do your Due Diligence (like Binance did :D) before using DeFi Derivatives.
• Good DeFi protocols capitalize on: governance, decreasing over-collateralization, transparency, low transaction fees, and high leverage.
• There are many projects to be discovered and new ideas to be implemented, but at least the space is moving on despite all the big platforms failing.

If you have insights or feedback on the DeFi space, don’t be shy and reach out. The space is broad, and everyone profits from knowledge-sharing. At least 3327 believes in that.