A derivative is a financial instrument whose value is linked to its underlying assets. Derivatives can be used as a means to obtain leveraged returns on related assets, or simply to hedge positions. In essence, they provide traders with greater choice, allowing them to adjust the risk of the relevant spot position, whether it is increased leverage or a hedge of downside risks .
These financial products are common in traditional financial and cryptocurrency asset classes. From futures contracts, options, mortgage debt and perpetual swap contracts, which are popular products in cryptocurrency transactions, there are a wide variety of derivatives. These financial products are provided by centralized exchanges and are usually supervised by regulatory agencies to ensure the safety of traders’ funds and to ensure that they understand the risks that arise.
Cryptocurrency derivatives market
In its early days, the cryptocurrency asset class only provided spot exposure to basic crypto assets such as Bitcoin, Litecoin, and Ethereum. However, as the asset class began to mature around 2016-2017, BitMex and other exchanges launched Bitcoin derivatives in the form of perpetual swaps and futures contracts. Traders can obtain volatility through these derivatives. The leveraged exposure of the asset.
Cryptocurrency derivatives are becoming more and more popular . This can be seen from the sharp increase in trading volume in May 2020, reaching 602 million US dollars, which accounted for 32% of the market, and the rest was spot trading volume, reaching 1.27 billion US dollars. In addition to perpetual swaps and futures, the trading volume of options offered by Deribit Exchange also set a new record in May 2020, totaling US$196 million.
Comparison of monthly trading volume of spot and derivatives (November 2018 to May 2020)
DeFi (decentralized finance) is eating away at CeFi (centralized finance)
2020 has shown the power of DeFi to replace centralized financial services with permissionless smart contracts. The success of automated market makers (AMM) such as Uniswap on the centralized exchange and its order book model illustrates this point. In September 2020, Uniswap became the fourth largest cryptocurrency exchange by trading volume. People cannot use DEXs (decentralized exchanges) like Uniswap because the transaction fees on the Ethereum blockchain make it impossible to falsify transaction volumes .
Uniswap and centralized exchanges ranking of monthly trading volume
In view of the fact that the rise of DEX is eroding the spot market of centralized exchanges, it is reasonable to infer that financial instruments such as options, futures, and perpetual contracts can also be implemented with DeFi in the cryptocurrency asset class, and it makes sense to erode the CeFi derivatives market. Driven by speculators seeking to profit from volatility, the cryptocurrency derivatives market is growing rapidly , which means that agreements aimed at disrupting CeFi derivatives are likely to receive huge trading volumes in the next few years .
Benefits of decentralized finance
Harsh regulation
The British Financial Conduct Authority (FCA) recently banned the sale of cryptocurrency derivatives to retail investors and was enforced on January 6, 2021. This decision is because the financial authorities believe that these products are too volatile and risky, and retail investors cannot continue to make profits.
In many cases, British cryptocurrency traders, like American traders, will look for exchanges that do not require KYC and use a VPN to reroute their Internet activities from UK/US IP addresses. If traders are willing to go to this point in order to trade these products, then there is a great demand for decentralized derivatives solutions.
If the state and financial authorities continue to crack down on centralized exchanges that provide derivatives, decentralized derivatives driven by unauthorised and censorship-resistant smart contracts will become the only viable option for residents of these jurisdictions.
Identity Information (KYC)
In order to trade derivatives on a centralized exchange, many people need your identity information, such as official ID (passport, driving license) and the source of income used to fund the account. As Nick Szabo said, “A trusted third party is a security breach”, which means that private information stored on these exchanges may be leaked, as shown in the Binance KYC leak in 2019. The decentralized derivatives agreement does not require KYC, and traders can start interacting with the agreement’s smart contract .
Capture derivatives trading activity
Similar to how Uniswap allows liquidity providers to obtain transaction fees incurred by transactions in the liquidity pool, the decentralized derivatives agreement will allow users to obtain transaction fees incurred in derivatives transactions .
Many models have emerged, such as the Perpetual Protocols governance token PERP, which will allow token holders to bet on PERP tokens to participate in protocol governance, and obtain 50% of the transaction fee generated by PERP inflation and derivative transactions.
Perpetual agreement governance incentive model
Variety of derivatives
The diversity of derivatives here refers to allowing traders to specify the contracts they want to trade. For example, if a trader wants to create an ETHUSD perpetual contract, use WBTC as collateral, and also use WBTC instead of a stable currency pegged to the US dollar for settlement. The composability of DeFi will promote a wide range of possible derivative products that traders can use to execute transactions of their choice .
The following is a practical example of the diversity of derivatives. The Deribit centralized exchange provides BTC and ETH call and put options, which are settled at a specified exercise price on various days.
Hegic is a decentralized options trading platform that provides users with additional products by allowing traders to specify specific exercise prices and holding periods.
Some disadvantages of decentralized finance today
Transaction delay
If transactions are carried out on the chain, the delay of waiting for transaction packaging on the Ethereum blockchain will cause slow transaction execution time. For traders, this is catastrophic, because execution time is the most important to take advantage of market volatility. Therefore, decentralized derivative protocols will need to implement L2 extension schemes, such as optimistic rollup or zk rollup, where transaction execution time can be instantaneous .
Layer2 technology is undoubtedly progressing rapidly, Synthetix and Uniswap are actively integrating Optimism’s Optimistic rollup. However, it may take some time for these emerging agreements , which are mainly focused on derivatives, to integrate this technology to meet transaction needs .
fluidity
Another transaction requirement is liquidity, especially for large-scale transactions. When large transactions are executed, slippage occurs, which means the difference between the expected execution price and the actual execution price. In centralized exchanges, market makers ensure sufficient liquidity for transactions, allowing traders to execute low slippage transactions, thereby minimizing slippage.
In DeFi, automated market makers have obtained sufficient liquidity to perform low slippage transactions, or in the case of stablecoin-to-stable currency swaps, use the new AMM equation implemented by Curve to minimize slippage. Uniswap and Curve’s low slippage transactions, and part of their success in 2020, are driven by their incentive structure that allows liquidity providers to obtain transaction fees.
In order for decentralized derivatives platforms to be adopted, they must first resolve the issue of transaction execution delays and maintain sufficient liquidity in AMM or off-chain order books to execute low slippage transactions .
in conclusion
After the success of automated market makers such as Uniswap began to cannibalize the spot market of centralized exchanges, it is very reasonable to deduce that the same situation will also occur in the cryptocurrency derivatives market. Strengthened supervision of centralized exchanges, coupled with third-party security loopholes in private identity information, once transaction delays and liquidity are resolved, will lead to the outflow of decentralized derivatives agreements .
Three Arrows Capital, a well-known cryptocurrency hedge fund operated by Su Zhu and Kyle Davies, has invested in decentralized derivative protocols.
As you can see, investments in DerivaDEX, Perpetual Protocol, Futureswap, and Synthetix are all aimed at penetrating the cryptocurrency derivatives market and grabbing share with products provided by centralized exchanges .
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