For today’s article I am going to take a look at what derivatives are and how they handled in the Decentralized Finance (DeFi) world. These are relatively the same as their centralized counterparts, but of course with all of the perks of being decentralized.
For the usual disclosure, I am not a financial advisor, I don’t even work in finance at all. My day job is as a telecommunications software engineer. Treat everything you read here as some educational resources and not financial advice.
What Are Derivatives
Derivatives are, quite simply, something that get their value from something else. Generally speaking, this something else is the price of some underlying asset. In the real world this could be commodities like gold or produce, the price of a stock on the exchange, a fiat or crypto currency, or really anything that exists that has a value associated to it.
There are a number of different types of derivatives, such as futures, options and swaps. They are very useful, as they can give you exposure to the underlying asset, without actually needing to hold the asset itself, and allows for things such as shorting the price of something in order to hedge against the price, or for doing price speculation type trading.
Without the derivatives, these types of actions would be impossible. You couldn’t, for example, make any profit off an asset whose price has gone down, as you would only realize profits/losses from an asset you own directly. In that setup, if the price goes down, your assets would be worth less when you sold it.
Let’s dive into hedging a little more, as it should help make things a little more clear. We’ll use a common example of a farmer that grows potatoes.
Throughout the year, the wholesale price of potatoes will fluctuate based on supply and demand, as prices are known to do. But the farmer basically locks themselves into that commodity when they plant their fields. Since a harvest takes the full growing season, they can’t see the price of potatoes drop, while the price of corn skyrockets, and decide to just change mid-season.
This of course exposes the farmer to a lot of risk, as his revenue will be based on the price of potatoes when he harvests and sells it, so he is at the mercy of the market. This is where our friend, the derivative, can step in and help our farmer out.
The farmer can take out a sell short position in a futures contract, against the price of potatoes, and essentially bet against himself. This is really just a form of mitigating his risk.
If the price of potatoes is down when the harvest comes around, the crop itself would be worth less than it should have been, but the short position would have a profit to be cashed in. This helps to offset the lower revenue that would have been realized if the farmer only had the potatoes themselves to sell.
Conversely, if the price goes up, the short position would actually be at a loss, and the profits the farmer would get from the sale of the potatoes, would be impacted and lowered by the losses on that future contract position. While impacting the profit and loss on both sides of his entry price (the price he sold short at), what it really does is help shave off some of the volatility of the price, and make the revenue stream from the crops more predictable.
He doesn’t have to worry about a really bad price drop causing him to lose a lot of money, but it also prevents him from having a runaway year where he makes serious bank, so it’s a measured approach to stabilize an income stream, rather than something to help ensure that he becomes rich.
Now, if we take this same idea, and we apply it to a Decentralized Finance (DeFi) scenario, picture a liquidity pool powering an automated market maker, that has a stablecoin and a volatile crypto paired up. This type of situation is just a prime place for you to suffer impermanent loss, so you could take out a position with a derivate to help offset those losses (and gains), just like the farmer did. It would stabilize your value within the pool, while allowing you to reap the benefits such as trading fees and other rewards,
The other big way derivatives are used is in speculation trading, which actually makes up a pretty significant portion of the trading that occurs. This is for a number of reasons, especially when we look at the real world.
One big way speculation trading is used, is for trading assets that you couldn’t easily get your hands on. A big example I’ve always used is the price of oil. It’s not so easy for you to just go buy yourself 1000 drums of oil and sit on it for a few months until the price is where you want it, and then go sell it to an oil company. But you could take out a position in a derivate of the price of oil like a futures contract.
Derivates are also the only way to take out a short position, so even if you are not doing it to hedge against an asset you hold, they can still be very useful in this regards if you think the price of something is about to drop off and you want to catch some profits from it.
And of course, derivates are what give traders access to the tool to get you rekt, leverage. I’ll admit, I do a little leverage trading, but with very small amounts, because they always go to zero. Sure, I’ve won a few plays, but then the next ones generally drain me back out. Leverage is fun, but it’s definitely very high risk, and generally just a bad idea. But a tempting one I fall for, so I can’t fault anyone for it, but just, know your limits and know what you are doing if you are going to get into that game.
Speculation traders are a very important piece to the derivatives market, regardless of what reason they are using them. They make the markets happen, and they are what gives the people that actually need to use them to hedge their positions, the ability to do so. A derivate trade is a bet, and there has to be someone on the other side to win or lose against you.
DeFi Derivative Protocols
Now that we have covered what derivates are, and why they are useful beyond leverage trading and losing your shirt, it’s time to take a look at some of the bigger players we have in the DeFi space that are doing them.
Synthetix – This protocol let you create synthetic assets that peg themselves to the price of the underlying asset, which can be a fiat or crypto currency, or a standard commodity. These synthetic assets can then be traded on certain Decentralized Exchanges (DEXs). To create the assets, you have to stake up liquidity in the form of the Synthetix (SNX) token in a highly overcollateralized fashion.
Uma – This protocol is similar to Synthetix in that it allows you to create the synthetic assets, but they do not do it in a overly collateralized fashion. Instead, the rely on liquidators to go about finding positions that are not properly collateralized, and liquidate them.
Hegic – This protocol is a DeFi options platform that lets you buy put and call options, or be the liquidity provider for them and sell the options. They were one of the first DeFi protocols to offer options trading.
There are of course plenty of other protocols out there, offering various derivates services and products, so there is lots of places for you to be able to trade them.
Derivatives make up a very significant potion of the entire global trade system. Estimates put the market cap of all derivates somewhere in the realm of 1 quadrillion dollars. Yes, that’s with a Q. If we take a look at the other major markets, the bond market has a cap of about 130 trillion, the stock market has 70 trillion, and the crypto market of course is current under 1 trillion, but before the May crash, we were up over that line. That puts derivates at about 5 times the other 3 all combined, so a very significant portion.
Derivates are a very useful trading tool, especially when used properly. Using them to hedge your positions and helping to stabilize your gains can be very good. Using them to trade on leverage can be good or bad, depending on how skilled a trader you are, and if you win more than you lose. And of course, being able to create synthetic assets that allow trading real world commodities in a DeFi protocol, is something that can be very useful later on.
Like everything in the crypto game, there is of course the risk of a hacker attacking a protocol and draining it, or the prices to be so volatile that no amount of hedging is going to save you, so always do your own research and make sure you know what you’re getting into.
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