Decentralized derivatives are financial instruments that are traded on decentralized exchanges (DEXs). They are becoming increasingly popular in decentralized finance (DeFi).
Like traditional derivatives, decentralized derivatives derive their value from underlying assets, which are usually cryptocurrencies.
They are powered by smart contracts that can automatically facilitate and execute the terms of the contracts.
What Are Derivatives?
Derivatives are financial contracts that derive value from an underlying asset, such as a stock, cryptocurrency, fiat currency, or commodity. Think of a derivative as a contract between two parties based on the future price or value of an underlying asset.
There are several types of derivatives, including options, futures, and swaps. Nevertheless, they all share the same basic principle of allowing investors to benefit from the future price movements of assets without actually owning them.
Derivatives can help to hedge against potential risks and increase returns through leverage. For example, a trader can use leverage on a small amount of capital to purchase a futures contract that controls a larger amount of the underlying asset.
Some traders also use derivatives to gain exposure to different asset classes and markets to diversify their portfolios. In contrast, hedging involves taking an opposite position on a derivative to offset potential losses on an existing investment.
However, it's important to note that due to their complex nature and leverage possibilities, derivatives also carry inherent risks that can magnify losses. As a result, it's essential to understand the risks and potential consequences of trading derivatives before getting involved.
What Are Decentralized Derivatives in Crypto?
Decentralized derivatives also derive value from underlying assets but are traded on blockchain-based protocols. While cryptocurrency-based derivatives are most common in DeFi, it's also possible to create decentralized derivatives tied to other types of assets, such as stocks.
Crypto derivative contracts allow anyone to benefit from the future price movements of an asset or hedge their positions in a transparent, trustless environment. The protocols that create decentralized derivatives often have low barriers to entry because anyone can connect to them with their crypto wallet.
Crypto derivative protocols typically allow users to retain control of their assets and keys, so they aren't required to transfer these to a centralized platform or third-party custodian. This also means users can easily move their assets between different protocols for their DeFi strategies without going through lengthy withdrawal processes.
How Do Derivative DEXs Work?
Derivative DEXs operate on a blockchain to facilitate transactions without intermediaries. The blockchain serves as an immutable, tamper-proof ledger that records all transactions and contract executions in a decentralized way. This ensures that a transaction cannot be altered or removed once validated and added to the blockchain.
Decentralized derivative protocols can be built on different blockchains, such as Ethereum, BNB Chain, Solana, or even Layer 2s. However, blockchains have different levels of security, scalability, and transaction costs, which can affect a derivative protocol's user experience and overall performance.
Some derivative DEXs focus on enabling cross-chain compatibility and interoperability, allowing users to trade derivatives across multiple blockchains.
Another key technology is smart contracts, which can complete transactions without intermediaries. These are self-executing contracts with terms and conditions written directly into their code. They automatically execute and settle transactions and other possible functions (e.g., staking and governance) when pre-defined conditions are met.
Protocols often rely on blockchain oracles to perform accurate price tracking and maintain a link to real-world assets. These oracles may have different levels of decentralization, data accuracy, and update frequency, all of which affect the platform’s overall reliability.
Decentralized derivative protocols are often based on decentralized governance models that allow users to participate in decision-making to varying degrees. However, some protocols may have more decentralized governance structures, while others may rely on more centralized decision-making.
Native tokens can also play a critical role in decentralized derivative protocols. For instance, through their decentralized autonomous organizations (DAOs), some platforms allow token holders to participate in their governance and vote on proposals related to protocol upgrades and other changes.
Tokens can sometimes be used as an alternative to stablecoins to provide collateral for trades, or a DEX could use its native token to incentivize market makers. For example, it could collect exchange fees and distribute them to market makers who help bring liquidity to the platform.
Types of Decentralized Derivatives in Crypto
Futures contracts are financial agreements that allow traders to benefit from the future price movements of underlying assets. A futures contract is essentially an agreement to buy or sell an asset at a predetermined price and date in the future.
In traditional finance, futures contracts are typically traded on centralized exchanges (CEXs). With DeFi, traders can access futures contracts in a decentralized, permissionless environment and trade directly with one another on a blockchain network without the need for intermediaries.
Decentralized futures can be either perpetual or have a fixed expiration date. Perpetual futures contracts are designed to mimic the trading experience of traditional futures contracts but without an expiration date or settlement. They are the most common type of DeFi derivative contract.
Perpetual futures contracts are designed to be more flexible and accessible than regular futures contracts. However, they come with their own risks, including high leverage and the potential for high funding fees.
An options contract is a type of financial contract that gives the holder the right — but not the obligation — to buy or sell an underlying asset at a specified price by a specified date (expiration date); the same applies to cryptocurrency. An options contract can be used to hedge against a digital asset’s price fluctuations or to trade its future price movements.
For example, if an investor owns ETH and is concerned about potential downside risk in future, they could buy a put option that allows them to sell ETH at a predetermined price, regardless of its spot price. This way, they could limit potential losses if the price of ETH falls below the predetermined price.
On the other hand, options can also be used to benefit from the future price movements of a cryptocurrency. In this case, the investor would buy a call option, which gives them the right to buy the underlying asset at a predetermined price if its price rises above the strike price.
Synthetic assets — also called “synths” — are digital representations of various assets designed to provide an accessible way to hold and trade those assets. Synthetic assets are essentially tokenized derivatives that use blockchain technology to replicate their underlying assets’ value and even some characteristics, such as inflation.
While synthetic assets share similarities with stablecoins, they’re more diverse because they can represent a wide range of assets, including stocks, precious metals, altcoins, options, and futures. In addition, while they attempt to represent the value of the underlying assets closely, they are not directly backed by them.
Therefore, the goal of synthetic assets is to leverage blockchain technology’s transparency and openness to allow anyone anywhere to access various assets without jumping through numerous hoops. They are part of the creation of a permissionless investment environment that is also linked to traditional assets.
What Are the Challenges of Derivatives in DeFi?
It's important to understand the risks of trading DeFi derivatives before committing to it. Doing so is generally riskier than simply trading cryptocurrencies as DeFi derivatives are complex, volatile financial instruments. As such, the potential gains or losses can be much greater than with crypto trading.
Liquidity is also a concern. DEXs are still relatively new, and their potentially lower trading volume may make it harder to trade derivatives instantly. On a practical level, DEXs aren't as user-friendly as traditional crypto exchanges yet. For newcomers unfamiliar with non-custodial wallets, connecting their wallets to a DEX, forgetting their passwords, and even losing their seed phrases are some of the problems they may face.
In addition, most centralized platforms offer real-time trading unaffected by block times. However, using a DEX's on-chain order book can sometimes be problematic, as a congested network can lead to increased fees.
Security risk is another consideration to keep in mind when trading DeFi derivatives. DEXs aren't completely immune to hacking and have their own vulnerabilities. For example, as smart contracts control DeFi protocols, a single bug in their code could cause derivative contracts to fail.
There have already been numerous instances of DeFi platforms suffering significant losses due to smart contract vulnerabilities. To minimize your risk, always do your own research (DYOR) to investigate the platform’s team, derivative types, and smart contract security.
With the rise of DeFi derivatives, investors can benefit from underlying assets’ price movements in a trustless environment. As blockchain technology continues to develop, we can expect more types of DeFi derivatives to emerge. Nevertheless, before trading any financial instruments, consider your trading experience and risk appetite carefully and evaluate the potential loss you can afford to bear.