In this modern world of traditional finances, derivates can be said to be the fastest moving wheel while drawing massive amounts of capital and dwarfing all other markets including stocks, and bonds, and of course, the cryptocurrency market. Some financial experts estimate the global derivatives market to be as high as 1000 trillion, which is a thousand times higher than the cryptocurrency market (1 trillion).
As the title suggests, today, we’ll be talking about derivatives in the world of decentralized finance. However, to understand the DeFi derivatives market, we first need to break it down and figure out the history and working of derivatives. So, let’s start with – what are derivatives?
What are Derivatives?
As per the definition, derivatives can be explained as types of financial assets that derive their value from other underlying assets. These underlying assets or groups of assets include stocks, bonds, commodities, interest rates, and currencies. Some of the most commonly known derivatives are futures, options, forwards, and swaps.
Now, the question arises, why do we need derivatives in the first place? Well, derivatives, in essence, serves two purposes – hedging and speculating.
Hedging represents an investment strategy to minimize the potential losses in a market. Let’s understand the concept of hedging in derivatives with an example.
Let’s imagine a derivate of apples called $APL whose value is derived from the price of apples in the market. Now, an apple farmer Tarun wants to hedge against the potential fluctuations of prices of apples when the crop will be ready. To offset his loss in case the price of apples falls downwards when his crop is ready, Tarun can bet against the derivative $APL.
Now fast forward to the time of harvest. If the price of apples falls downwards, the $APL derivative will fall as well and vice versa. Now, in case the price falls, Tarun can offset his loss of apple harvest by making a profit from short-selling $APL. Similarly, if the price goes upwards, Tarun can offset his loss of short-selling $APL with his apple harvest. Thus, setting a path for a predictable income.
Now, let’s head to another major purpose of derivatives – speculations.
Speculators are a major force behind any financial market, providing enough liquidity for the market, thus enabling traders to easily buy or sell any asset. Especially, when it comes to derivate markets, speculators can easily get exposure to assets such as commodities that are hard to trade without derivatives.
For example, a trader can easily trade oil futures contracts without the need for physically handling the custody of oil barrels. With a futures contract, a trader can speculate on an asset at an agreed-upon price at a future date. Therefore, if the trader expects the price of a commodity to rise/ fall in the coming months, she can bet for/against the commodity’s future price with a futures contract.
Now, let’s head to DeFi Derivatives.
Now, that we got a basic understanding of derivatives, let’s jump into the concept of DeFi derivatives. As we discussed in our earlier blogs, the rise of decentralized finance has jump-started massive innovations in the world of finance. From the decentralized currencies to smart contracts, tokens, governance, DAOs, stablecoins, and even derivatives and insurance.
When it comes to DeFi derivatives, there are only a handful of projects working in this direction such as Synthetix, Mirror Protocol, Opyn, Hegic, etc. As of now, Synthetix is the biggest DeFi derivative protocol with over one billion in total locked value. The protocol allows users to mint synthetic assets and capture the price movements of popular cryptocurrencies, fiat currencies, stocks, commodities by providing collateral.
Mirror Protocol is another DeFi derivative protocol allowing the creation of fungible synthetic assets tracking the prices of real-world assets such as stocks. Users can mint a mirror asset (a derivative) by providing collateral in stablecoins or other mAssets. It’s worth noting, both of these protocols, need the collateral to be higher than the value of synthetic assets.
In the coming blog posts, we’ll delve deeper into the working of both of these protocols, their collateral ratio, and the process to mint a derivative on-chain asset.