Derivatives in DeFi: Reminiscence of the 2008 financial crisis?
Summary: Collateralized financial derivatives can actually help prevent financial crises, do not require risk management, and are ideally settled on-chain. Undercollateralized derivatives, however, do need risk management, margin calls, and introduce systemic tail risks.
A history lesson
Opium Team recently launched the very first Credit Default Swap (CDS) on Opium Exchange, based on Aave's Credit Delegation feature. We received a ton of positive feedback from the DeFi community, but at the same time we noticed a lot of people voicing concerns of such decentralized derivatives causing a financial crisis similar to what happened in 2008. Let's look at some examples from Twitter and try to mitigate these concerns through a brief history lesson.
People often blame derivative financial products as the main cause of the 2008 financial crisis, but in the process we are renouncing an entire asset class which is essential to financial markets! Let's not throw the baby out with the bathwater, but instead let's talk collateralization.
The 2008 financial crisis was caused by a multitude of factors, but one large factor was the use of undercollateralized derivatives. Many outstanding Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) were collateralized using real estate—the market that was expected to never come down. When the US housing bubble did collapse, it simultaneously caused a lot of these outstanding derivative contracts to become undercollateralized and become subject to margin calls and liquidations. When too few market participants were left to pay for the huge margin gaps, it caused a domino effect of liquidations which ended up in a systemic failure. This all could have been prevent through proper collateralization of financial derivative products.
“Almost every financial blow-up is because of leverage.” Seth Klarman
Looking at today's DeFi space, we are observing how yield farmers are taking on infinite risk by using unaudited protocols and undercollateralized products. I will make a statement here by saying that DeFi actually needs more collateralized derivatives, in order to allow for proper risk management!
The first CDS ever launched in DeFi—fully collateralized!
The decentralized Credit Default Swap launched on Opium Protocol is fully collateralized by a fixed margin, visibly locked on the Ethereum blockchain— which acts as Opium's settlement layer. Anyone can verify the collateral backing a financial instrument built on Opium Protocol.
In the case of the CDS for DeversiFi's 20 wBTC credit line using Aave Credit Delegation, the product is actually 100% collateralized—which means that the CDS can cover the whole credit risk of the borrower.
Collaterized derivatives are the best vaccines against systemic tail risks and financial crises
About Opium
Opium is a universal and robust DeFi protocol that allows for creating, settling, and trading decentralized derivatives. Use our products today to speculate on opportunities inside and outside of DeFi, or hedge yourself against trading risks.
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About Aave
Headquartered in London, Aave is made out of a team of innovators with the focus on creating a transparent and open financial infrastructure. Aave is an open source and non-custodial protocol enabling the creation of money markets.
Check out Aave website and read up on Aave latest Credit Delegation feature.
