DeFi’s explosive growth has led to the launch of numerous protocols that bring lending, exchanges, and payments to the globe, without the need for financial intermediaries. And while lending platforms are still the most common, there’s a category with the potential to become a serious contender: derivatives.
Right now, derivatives represent approximately $3B out of a total of over $64B locked in DeFi. While this may seem like a respectable amount, consider that even the most conservative estimates put the value of the total derivatives market in traditional finance in the tens of trillions. Compound this with the fact that the total value locked (TVL) in DeFi is more than 75x what it was at the same time last year, and it seems very possible that things are just getting started.
What are Derivatives?
Derivatives are products including options, futures, collateralized loans, and prediction markets, where an arrangement or instrument has a value derived from the underlying asset. The underlying asset could be anything: a stock, bond, interest rate, commodity, or currency. Ultimately, it gives investors exposure without actually having to hold the asset, and the ability to easily transfer risk from one party to another.
Derivatives are not new to the scene—in fact, they have a captivating history that dates back as far as Ancient Greece.
As a society, we have always liked the idea of certainty, and this desire for certainty drove the evolution of contracts. In Politics, Aristotle recounted the story of Thales of Miletus, a philosopher who was knowledgeable about meteorology. Thales was so confident in the success of the coming olive crop that he paid deposits to rent all of the olive presses in the region during harvest time—a move that many believe is the first recorded options trade.
Fast forward to 19th century America, where rural farmers often found it challenging to find buyers for their commodities. The Chicago Board of Trade led to the first derivatives market and what would eventually become the Chicago Mercantile Exchange. This completely changed the game: buyers and sellers no longer had to negotiate directly; instead, contracts listed on the exchange could be bought or sold by anyone.
Derivatives in TradFi
Within the more recent past, derivatives have been a crucial component in modern finance. In fact, some estimates put the derivatives market at an incredible $1 quadrillion—significantly more than global real estate, global debt, or global stock markets. While this seems like an unbelievably large number, it’s based on the notional value of all available derivatives contracts—the amount of value controlled by the position or obligation. Lower estimates base the value of the derivatives market on its market value, which goes by the price of a security set by buyers and sellers via supply and demand. However, even the lowest estimates put the worth of the derivatives market at more than $15 trillion as of last year. While the actual worth of the derivatives market is debatable, the outcome is the same: derivatives absolutely dwarf any other market.
Why Derivatives are So Appealing
Derivatives could be divided into two categories: hedging and speculation. To hedge risk exposure, an investor might purchase a derivative contract whose value moves in the opposite direction to the asset they own. For example, a farmer with a large grain crop might choose to take a short position by selling futures contracts, effectively locking down the current price. A livestock farmer that will need grain down the road may do the opposite—locking in a purchase price by buying futures contracts and selling them later when they’re ready to purchase.
Speculation, on the other hand, involves trying to profit from fluctuations in the market, based on an educated guess. This allows investors to gain more exposure with less up-front capital.
Even beyond an investors' point of view, derivatives have numerous advantages: they support global diversification, hedge against inflation and deflation, and lead to more efficient financial markets. Yet, while this space has been a fundamental part of traditional finance, their use has been largely limited to institutional investors, or at the very least, required a broker.
Derivatives in DeFi
Derivatives aren’t new to the crypto world—BitMex, founded in 2014, is a peer-to-peer trading platform with perpetual contracts and futures bought and sold in Bitcoin. Since then, various other centralized exchanges have launched, ultimately taking on the role of both broker and exchange.
In DeFi, there is no broker required. Instead, settlement automatically takes place on-chain, where the terms of the contract are fulfilled. The intersection of DeFi and derivatives is a gamechanger, bringing yet another borderless, low-barrier, financial instrument to the world.
The Protocols Bringing Derivatives to DeFi
Every growing market naturally develops its own derivatives market, which is magnitudes larger than its underlying market. While derivatives are already considered to be more complex financial instruments, decentralized derivatives have the potential for even more innovation. Unlike traditional finance, derivatives in DeFi can be created and used by anyone. And, with the ability to create instruments on virtually any underlying asset, this opens the door to more unique and sophisticated products.
Here are some of the incredible protocols bringing derivatives to DeFi:
Synthetix is an Ethereum-based protocol that enables the issuance of synthetic assets, or Synths—on the blockchain. Voted into existence by the community, these Synths track the price of their underlying assets, including cryptocurrencies, fiat currencies, stocks, or commodities. Synths use decentralized oracles to track the prices of these assets, letting users hold or exchange Synths just as if they owned the underlying assets—along with the added benefit of infinite liquidity and zero slippage.
The Synthetix model is based on a debt pool. To issue a certain asset, collateral is provided in the form of $SNX tokens. Positions are highly over-collateralized; for each $500 of $SNX put in, only $100 worth of synthetic assets are issued. These synthetic assets can then be swapped for others, being repriced through an oracle.
Synthetix is bringing non-blockchain asset exposure to DeFi, providing more options for users and helping the crypto ecosystem mature. Because Synths are issued on Ethereum, investors can bring them over to other protocols—for example, to provide liquidity on Uniswap or earn interest from Curve.
With the highest TVL across all DeFi derivative protocols, Synthetix has been one of the first to lead the way in L2, having recently launched on Optimism.
Barnbridge is a risk tokenizing protocol for hedging yield sensitivity and market price.
Given that everyone has a different appetite for risk, Barnbridge is creating derivatives for risk mitigation. An institutional investor looking for steady, fixed-income opportunities will have different needs than an experienced DeFi user investing their own funds. Through Barnbridge’s Structured Market Adjusted Risk Tranches (SMART) products, users can choose a risk profile and the protocol redistributes risk via tokenized, liquid tranches.
By offering users risk-adjusted exposure to various assets, Barnbridge is helping to capture an underserved subset of DeFi users, further driving its growth.
Siren is a decentralized protocol for creating and trading fully collateralized options contracts for ERC20 tokens. Via Siren’s AMM, options can be traded without the need for third-party settlement or order matching to complete option settlement on chain. While the Siren protocol is currently run by an anonymous team, they have plans to eventually transfer the power to a DAO.
Siren intends to cater to more sophisticated options traders that are familiar with traditional finance and also want to leverage the benefits of DeFi: composability, autonomy, and self-custody. Using Siren, users can swap American-style options in and out to build complex positions.
With options trading in traditional finance experiencing massive growth, it is not a stretch to think that on-chain options could also play an increasingly larger role as DeFi goes mainstream. Protocols like Siren are bringing a crucially important piece of legacy finance to DeFi, unlocking an incredible toolset for its users. As the Siren team describes, “Decentralized options trading is like a raging ocean. Few land dwellers are aware of the vast opportunities hidden below.”
Cover Protocol is a peer-to-peer coverage marketplace that lets DeFi users buy protection against smart contract risk. Rather than a bonding curve, the market sets coverage prices.
Using the protocol, market makers deposit collateral to cover a given product and receive two types of fungible tokens: CLAIM tokens, which are redeemable if an exploit occurs, and NOCLAIM tokens, redeemable if no exploit occurs. From here, they can either sell the tokens and earn a premium, or use them to provide liquidity. Users seeking coverage are then free to purchase what they need.
The protocol’s vision is that anyone can buy coverage on anything. By giving DeFi users access to permissionless and non-KYC coverage, Cover Protocol is helping grow the space, protect users, and build confidence in some of DeFi’s most innovative protocols.
MCDEX is a decentralized perpetual swap exchange where anyone can create a perpetual market. Perpetuals are a swap product for traders to be able to hold exposure indefinitely, rather than having to roll their futures positions. With decentralized perpetuals, users can trade a larger position through leverage, giving them the potential to earn more profit (or incur more loss) based on how the market moves.
Intending to make investing in perpetual contracts easier, MCDEX’s first product is a decentralized perpetual contract (ETH-PERP) with up to 10x leverage. With the protocol, traders can long or short ETH with ETH—no other currencies required.
Ribbon Finance is “DeFi’s first structured products protocol.” In the continuous quest for higher returns, sophisticated traders may be comfortable leveraging multiple tools and complex strategies to accomplish their goals. While DeFi’s composability lends itself to methods like this, many people are still uncomfortable using derivatives to bolster their yield potential while also managing risk. To meet this need, Ribbon bundles multiple derivative products into a package that meets certain risk-return goals.
Ribbon’s products are focused on four buckets: volatility, yield enhancement, principal protection, and accumulation. Like with so many other derivatives products, structured products have historically been limited to institutional players or wealthy accredited investors. Ribbon Finance is changing this, making structured products a possibility for anyone.
Terra ecosystem's growth has been impressive, largely driven by Mirror (synthetic assets) and Anchor (a savings protocol). Mirror Protocol allows the creation of synthetic assets—called Mirrored Assets—that track the price of real-world assets.
Mirrored Assets (mAssets) track the prices of US-based equities in the stock market, being confirmed every few seconds by an oracle. When the price of the mAsset drifts away from the primary market, traders are then incentivized to either purchase or sell the asset by minting or claiming their collateral.
With Mirror Protocol, anyone with internet access can mint crypto assets that mimic the value of shares in publicly traded companies like Apple, Twitter, or Coinbase. Tokenizing assets on permissionless blockchain networks has the potential to reduce barriers to entry and let retail investors around the world tap into the US Equities Market. Given that one of the main value propositions of DeFi is that it increases access to financial systems, Terra’s ecosystem growth has been inspiring.
Derivatives were already a gamechanger in the legacy finance world, so bringing these powerful financial instruments to a permissionless, open finance system has incredible potential.
Ideal for both risk averse and risk loving investors, derivatives are a powerful tool to hedge or speculate, and an essential part of any mature financial system.
With the continued growth and evolution of the DeFi space, it will be interesting to see how the market share of decentralized derivatives changes over time, what new instruments are created, and which underlying assets generate the most demand. The cryptocurrency derivatives market has the potential to have trading volume in the trillions—so while there are new and innovative protocols coming out all the time, we are still very early.
With decentralized derivatives, anyone with a smartphone and internet can access these markets. These bleeding edge protocols are unlocking yet another class of financial products to the masses and reimagining an ancient financial instrument for a more equitable, decentralized financial system.