The DeFi ecosystem enables multiple use cases and is striving to become a direct and reliable solution for financial transactions. One of the primary DeFi use cases is the concept of blockchain-based derivatives. DeFi Derivatives replicate practices of financial derivatives and provides more efficient tools than conventional centralized systems.
Financial Derivatives
In order to understand the concept of DeFi Derivatives, let’s first examine the use of derivatives in traditional finance.
Financial Derivatives are contracts whose value depends on an underlying financial asset, group of assets, or benchmark. Derivatives are tradeable on exchanges and OTC networks (which come with a counterparty risk). The value of financial derivatives depends on the price fluctuation of other assets. However, they do not require the consent of the issuer for trading activities. The underlying assets usually include bonds, currencies, stocks, commodities, interest rates, and more.
Common examples of financial derivatives are futures and forwards contracts as well as options. A forward contract refers to an agreement between two parties to buy or sell an asset at a certain time in the future for a specific price. Futures are traded on exchanges instead of OTC. On exchanges, prices are settled on a daily basis until the end of the contract. With options, a participant has the right, but not the obligation to buy or sell an underlying asset in the future. On many occasions, contracts change ownership or are sold before the settlement date.
The most common use of financial derivatives is to hedge against risk due to price fluctuations and other circumstances that might shift the value of an asset in the future. For instance, farmers can enter into a short forward position to buy a certain quantity of wheat at a specific price in the future. They do this to eliminate the risk of increased wheat prices from possible bad weather conditions.
In addition, the financial derivative is an optimal method to speculate on future prices and access otherwise unavailable markets.
DeFi Derivatives
Synthetic assets represent the primary example of DeFi Derivatives. They use smart contracts to represent on-chain and off-chain assets via blockchain tokens. A blockchain transaction facilitates this relationship between the asset and the token. This transaction is reflected by tokenization. Participants can trade synthetic assets on the blockchain. Trading of synthetic assets comes with all blockchain benefits including fast execution, decentralization, transparency, fractionalization of ownership, etc.
Tokenization can embrace any asset such as securities, property, stocks, art, fiat currencies, cryptocurrencies, trading strategies, etc. The use of oracles to feed smart contracts with fluctuations of real asset prices is essential. Participants tend to overcollateralize synthetic assets by locking a higher value of collateral than the value of the asset.
You may have heard the terms “wrapped Bitcoin” (wBTC), “wrapped ETH” (wETH), etc. A wrapped form of a cryptocurrency refers to a new cryptocurrency that represents the value of an underlying asset i.e. 1 BTC = 1 wBTC. The smart contract holds the original asset and mints an equal value of the wrapped asset to give it back to the user. Users can redeem the original asset by burning the wrapped asset in the future.
Wrapped cryptocurrencies can be useful to mimic the price of Bitcoin in smart contract executions as wBTC is an ERC-20 token. Similarly, wrapped versions of other cryptocurrencies can facilitate cross-chain interaction with other blockchains. Users also need wETH to interact with certain Ethereum dapps which are compatible with ERC-20 tokens. ETH is not actually an ERC-2O token so it may need to be wrapped in these cases!
DeFi Derivatives Protocols
Synthetix is one of the most popular protocols enabling the creation of synthetic assets. These synthetic assets track the assets of their underlying assets, thereby providing exposure to real-world assets through blockchain technology. Synthetix tracks the price fluctuations of popular fiat currencies, cryptocurrencies, stocks, and commodities. Users provide SNX as collateral to a Debt Pool in order to issue a synthetic asset. Positions in Synthetix are overcollateralized at a ratio of 5:1, and transaction fees from the trading of synthetic assets are rewarded to minters and SNX holders.
UMA is an alternative DeFi Derivatives protocol that, unlike Synthetix, does not rely on over-collateralization. It relies on liquidators by rewarding them to liquidate improperly collateralized positions. These liquidators use their own price feeds and therefore do not rely on oracles. They pay back the debt and reclaim the collateral. The role of disputers is to identify which liquidations are valid. In case of a dispute, UMA holders have a monetary incentive to vote on the price of the asset, according to their own price feeds.
Perpetual Contracts
Perpetual contracts attracted the attention of the DeFi community as they mimic the role of forward and future contracts. Their difference from traditional financial tools is that they do not have a settlement or expiration date. Therefore, a user can hold a perpetual contract until he/she wants to close the position.
Perpetual Protocol is a project that enables the trading of on-chain perpetual contracts and offers up to 10x leverage for makers and takers. USDT is the settlement token for the trading of 15+ pairs. The protocol enhances a Virtual AMM which does not rely on liquidity providers. xDAI (or Gnosis) chain processes all the transactions of the network. It is a Layer 2 scaling solution and enhances low gas fees (the protocol subsidizes a portion of the fees).
dydX is another DeFi Derivatives exchange that offers perpetual trading. It also allows decentralized spot and margin trading as well as lending and borrowing. dydX relies on an off-chain matching mechanism with order books. This facilitates faster settlement which ultimately occurs on-chain. Perpetual trading happens on StarkEx, a Layer 2 solution.
Just like many DeFi applications, decentralized derivatives can be subject to dangers like hacks, protocol risks, low liquidity, and oracle failures. Furthermore, since speculation and leverage are aspects of DeFi Derivatives, they include their own risks which may lead to significant losses for traders.
