Derivatives

Derivatives Explained 

Derivatives are financial instruments that reference an underlying asset. The price movements of derivatives are, in large-part, a function of the movement of the underlying asset. Derivatives are designed to expose market participants to alternative risks, or propositions – associated with the underlying. Derivative markets typically dwarf the size of the markets of the underlying asset they reference. They are widely used for hedging purposes, leveraged exposure and other important risk strategies.   

Derivatives run the gamut of being highly standardized and exchange-tradeable, to esoteric and complicated contracts that require heavy legal involvement in order to trade and settle. Given the variance in standardization, some derivatives are proving easier to implement than others in a DeFi setting. The requirements to create derivatives will be informed by DeFi coin trading and lending platforms that ingeniously solved the issues of sourcing liquidity, margining and other protocol parameters. 

What to Know

In DeFi, derivatives offer flexibility across multiple DEXes and tokenized assets. Smart contracts enable tokenized derivatives which are executed automatically based on the terms of the smart contract. Oracles play a large role in derivatives based on off-chain assets. In order for parametric pay-out of a derivative based on an off-chain asset, oracles are introduced as a pricing source for the underlying asset. Oracles like Link and Band are widely used in derivative contracts, in addition to other use-cases that require oracles. 

In traditional finance, derivatives often contain embedded options or other structural leverage to express specific risk exposure. DeFi derivatives, by necessity, will share many of these structural characteristics. It’s important for traders to know and understand what risks they are being exposed to when engaging with DeFi derivative protocols. 

Why it Matters

In centralized finance, the size of derivatives markets dwarfs that of underlying assets they are based on. We anticipate DeFi will be no different as the ecosystem proliferates and matures. Derivatives introduce a new level of potential participation, as non-financial market participants often enter derivatives markets in order to hedge business line processes or risk exposures. Derivatives will be key drivers of smoothing out volatile crypto markets, as new market entrants beget more liquidity. In addition, derivatives enable more ways of expressing a risk view, or hedging risk, which tends to have the effect of optimizing prices. 

UMA Protocol and Synthetix have been some of the early movers in the derivatives space. As DeFi protocols implement methods for liquidity sourcing and insurance pools, we expect a cambrian explosion of protocols that offer unique risk exposure to myriad underlying assets.