How do derivatives work in DeFi?

In traditional finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying ‘thing’ can be an asset, commodity, index, or interest rate or even another derivative.

Given the importance of derivative contracts in mature, traditional financial systems, it should be no surprise that derivatives are emerging in cryptofinance markets. DeFi derivatives and protocols are attracting significant interest and are emerging as equally important in cryptofinance. It is a fair observation that every growing financial market that carries risk, and with it a need for hedging as well as opportunities for speculation, will develop companion derivatives markets to service those needs. Further, the rate of innovation and development in the derivative market tends to reflect the pace of development in the underlying market. While CeFi Markets and their derivatives are highly regulated and have taken many, many decades to evolve, crypto derivatives can be created by almost anyone in an open and permissionless way and in DeFi, derivatives are evolving at a pace commensurate with the incredibly rapid pace of development of other crypto assets.

In very fundamental terms, the motives for developing and using DeFi derivatives are the same as in traditional markets, either to hedge price risk associated with an exposure to a crypto asset, exploit speculative opportunities and/or access leverage.

Understanding how DeFi derivatives operate in comparison with CeFi is best understood by looking at examples of where they are being used. Some of the more popular DeFi derivative protocols including Synthetix, UMA, Hegic, Opyn, Perpetual, dYdX and BarnBridge. Some of these DeFi derivative protocols are still in the very early stages of their development. The risks associated with creating, buying and selling these derivatives is (so far) difficult to quantify.

Watch the following video for an overview of these more popular DeFi derivatives protocols:

Source: Finematics 2021, Derivatives in DeFi explained (Synthetix, UMA, Hegic, Opyn, Perpetual, DydX, BarnBridge), 31 January, Finematics

For a closer look, let’s examine Synthetix, which (at the time of writing) is one of the largest and most significant early protocols in DeFi derivatives. It allows users to create synthetic assets that track the value of a range of tradeable things – fiat currencies, cryptocurrencies like BTC and ETH, even commodities (e.g., oil, gold and silver). Synthetix allows traders in DeFi to trade synthetics (“synths”) which are overcollateralised derivatives on cryptocurrencies, fiat currencies, commodities and stock market indices like the Nikkei 225 Index. Synthetix allows users to create synthetic tokens that track the price of underlying assets using smart contracts and Chainlink oracles. The synthetic tokens provide exposure to the underlying assets without having to buy them directly. Traders can create “inverse synths” to effectively take a short position on an asset. The following video explains how:

Source: Exodus 2020, What is Synthetix? SNX coin explained, 10 December, Exodus

After you watch the video, go to Synthetix Exchange (Links to an external site) to explore the many types of synthetics that have already been created on the Synthetix exchange. If you’d like a more technical understanding, you can also read the Synthetix Litepaper (Links to an external site) to learn more about the role of Synth tokens in staking the debt pool that collateralises synthetic tokens.

Futures contracts

Futures contracts are one of the simplest forms of CeFi derivative. One of the key characteristics of CeFi futures is that they are finite, meaning they have a specified maturity date and the expire on that date. An important new development in DeFi is Perpetual Futures, or ‘Perps’ that are traded on a number of (DEX) and centralised exchanges (CEX) including dYdX and Binance.

Watch the following short video explainer on perpetual futures and how they relate to and differ from ‘traditional’ futures contracts.

Source: Binance Academy 2019, Perpetual futures contracts explained, 28 August, Binance Academy