Brew Money

Chapter 8

Crypto Derivatives in DeFi

Derivatives are contracts between two parties that derive their value from an underlying entity. This entity could be stocks, bonds, commodities, or crypto tokens.

Typically, buyers and sellers complete a trade on an exchange or market once they have reached an agreement on the price of the underlying asset. With derivatives, two parties exchange capital or assets basis the price of the underlying entity, a date or a period of time, and other parameters.

Types of derivatives

Futures

Derivative contract allows the holder to buy or sell the asset at an agreed price on a specific later date. Both the parties are obliged to buy/sell the asset on the date mentioned on the contract. A Futures contract can be settled by accepting the delivery of the underlying asset or cash settled where the seller transfers the equivalent cash position.

Options

Similar to Futures contracts, Options are contracts between two parties where the buyer of the option can choose to buy or sell an underlying asset on or before the expiry date. The difference between a futures and options contract is that the buyer does not have an obligation to execute the trade. A call option gives the holder the right to buy an asset, and a put option gives the holder the right to sell the underlying asset.

Swaps

Swaps are derivative contracts where two parties exchange the cash flows or liabilities from two different financial instruments. There are different types of swaps, such as:

Interest Rate Swaps where an entity with a floating interest rate loan enters into a contract with another entity to swap it for a fixed interest loan.
Credit Default Swaps where the buyer pays a premium to another entity in exchange for protection against a default on a loan they have made.
Debt Equity Swap where the debts of an entity are swapped for equity of the entity.

Application of Derivatives

Derivatives were created as tools to manage financial risks. Traders use them to speculate on future price movements of the underlying asset.

A real-world example of derivatives used to manage risks is for locking in a price. For example, an Olive Oil manufacturer might be worried that changing climate conditions may lead to a supply crunch and higher prices. So, they can get into a futures contract with Olive Farmers to purchase a set amount of olives for an agreed price. Then, if the prices actually rose due to failing crops, the manufacturer would have protected themselves from it.

Similarly, in crypto, a use case can be, let's say an investor holds an asset A and expects the price to go up. But they would like to hedge your risk in case markets start crashing. So they can buy a Put Option (an option to sell the stock) expiring on a certain date. If the market doesn’t crash, they can skip exercising the option. But if it does, they were able to limit your losses.

Derivatives DeFi Protocols

Futures in Decentralized Finance

dYdX is a leading Derivatives protocol with billions of dollars of trades happening every day. On dYdX, traders can buy and sell special kinds of futures contracts called Perpetual Futures with no expiry date. Since there is no expiry date involved, instead of a cash settlement, every pre-defined time interval, based on the price difference between the futures contract and the spot price of the underlying asset, buyers and sellers of the contract exchange capital called funding cost.

While Perpetuals are available on centralized exchanges, decentralized exchanges such as dYdX enable perpetually trading in perpetuals in a non-custodial ways.

Options in Decentralized Finance

Opyn and Ribbon Finance are the leading protocols that offer Options. Similar to DeFi Futures, DeFi Options offered by Opyn do not have an expiry date or a strike price. Instead, they use a funding mechanism to track the value of ETH^{^2} called SQUEETH. Ribbon Finance builds on top of Opyn to provide structured products such as covered calls.

Covered calls are derivatives transactions where an investor sells call options (i.e., the buyer of the option can choose to purchase the underlying asset from the investor) while holding the underlying asset.

In traditional finance, the derivatives market is typically much larger than the spot market and is primarily used by massive firms and large hedge funds. Derivatives bring in liquidity and provide risk management tooling that encourages institutions to participate in the markets.

On the other hand, the derivative market in DeFi has limited applications and fairly minimal volume.