Five reasons why derivatives are the most promising opportunity in DeFi today
This article was exclusively published by our friends at deFi.cx
2020 is still in full effect but it seems fair to say that this year’s landmark event will be the ongoing COVID-19 pandemic, which has also exposed the fragility of our financial and monetary systems.
However, look closer and we will see that 2020 has also been the year in which DeFi has broken all records and caught a lot of attention. Over the past few months, the Decentralized Finance ecosystem has grown into a vibrant and fascinating sandbox for financial innovation. Even though we are seeing new all-time highs for total value locked in DeFi, trading volumes, daily active users and online engagement, DeFi still has a lot of growth ahead of itself.
But which subsection of the DeFi space will see the most explosive growth? We believe decentralized derivatives is currently the single most promising investment opportunity in DeFi today, and here are five reasons why:
The market for derivatives is the largest market in the world
Did you know that the derivatives market is the single largest financial market in the world? In fact, the derivatives market is about 10 times larger compared to the credit market and 20 times larger than the global GDP. Derivatives aren’t only used by professional traders, but they are an important component of financial services that we use every day. Personal checking accounts, insurances, and mortgages all cannot exist without the use of derivatives!
Derivatives are crucial to every mature financial system
Let’s consider why derivatives are used this often and why they are critical to any financial system. It’s because financial systems are made up of financial markets, and financial markets are all about risks — every single transaction comes with a degree of risk. Professional market participants, such as traders, banks and investment firms will want to offset or “hedge” these risks in order to prevent financial disaster in case of unforeseen events such as high price volatility. This is where derivatives such as options and futures are used. Derivatives allow for market participants to manage their risks by limiting the potential returns and losses. Simply said, derivatives smooth out returns and losses and therefore prevent financial crises.
DeFi won’t mature unless derivatives grow
In any significant financial system, the typical market size ratio between money/debt/derivatives is 1/10/100. In DeFi today, this is not even nearly the case. Let’s consider these market sizes in the illustration below, just to get a feeling for the numbers.
Where will this growth in the derivatives market come from? It will come from multiple sources, all explained in this article. Let’s start with the growth from within the current DeFi user base!
Today’s DeFi users are exposed to significant risks and most of them are not yet aware, until another systemic failure occurs and people lose their funds. Those that are aware of the risks are already seeking to hedge their risks using derivatives (example: buying insurance on Nexus Mutual or buying “put options” on exchanges). The market for derivatives in DeFi will grow exponentially with the total growth of DeFi as the space matures, thus making derivatives an incredible opportunity for both builders and investors.
DeFi will cannibalize a part of the centralized derivatives market
In traditional financial systems, most derivative markets are already very large and liquid, especially those related to important commodities (e.g. gold, oil, corn) and equities (e.g. Dow Jones index).
However, derivatives built on DeFi have some inherent benefits which will incentivize a share of the traditional derivatives market to decentralized derivatives:
- Decentralized derivative markets are inherently more accessible. They can be used by anyone with an internet connection and an Ethereum wallet — no matter their location or social status. This contrasts with the traditional financial sector, which mostly serves those who reside in rich and powerful countries. Creating a custom derivative on DeFi is easy, cheap, and can be done by anyone.
- Creating a custom derivative on DeFi is easy, cheap and can be done by anyone. In the traditional financial system, the process for creating and listing a new derivative is very complex and costs involved are close to a million USD. Because of this, most derivatives are created by big banks which potentially can make it an unfair and inefficient market relative to DeFi. On Opium Protocol for example, creating a derivative contract from scratch can be achieved in mere minutes by combining an on-chain derivative recipe with a price oracle recipe. We are already seeing this in effect, as four independent external companies are currently working to build their derivatives on Opium Protocol and bring them to market fast and at near-zero cost.
Based on the above, market dynamics will cause an organic move from derivative markets to DeFi which will increase volumes.
Institutional players will start participating in DeFi
Over the past few years we have seen an increase of interest by institutional players in cryptocurrencies. But this is not where their participation will end. These large professionals will also start participating in this internet-native financial system, which will bring increased liquidity, volume and competitiveness to the space.These players will probably not participate in yield farming because of the exposure to catastrophic tail risks, but instead will participate in arbitration and provide liquidity to the most stable and safe strategies.
Regardless of how they will participate, they WILL demand tools for risk management. They will require advanced derivatives for hedging their risks. They will require financial primitives with limited upside and downside potential. This is where it gets interesting.
Professional-grade derivatives as a new market in DeFi
Let one thing be clear: The DeFi space has incredible upside potential. Both relative to the total crypto market, but especially relative to traditional derivative markets, the total value of DeFi is absolutely tiny. New users entering the space will bring in liquidity that will drive exponential growth of the derivative market in DeFi.
But where can investors find alpha? Which market will grow faster in relation to the total growth of crypto and DeFi? We believe that the increased participation of institutional players in DeFi money markets and fixed income instruments will create a strong need for professional derivatives suitable for institutional investors and professional traders. This new space within DeFi will see the largest relative growth.
Opium Protocol as a platform for professional derivatives
- Opium Protocol is unique because it is designed to be composable with both DeFi markets and professional markets. Most derivative protocols in DeFi today introduce theoretical uncapped risks through use of on-chain liquidity pools, or introduce AMMs which are actually a step back from traditional finance. At Opium we believe in robust and simple on-chain (layer 1) financial infrastructure, which can be further leveraged off-chain (layer 2).
- Opium Protocol provides robust financial primitives on layer one. More complex features (eg. order books, advanced derivatives, market making strategies, arbitrage, combined orders, dynamic pricing, automated hedge fund strategies) are implemented on layer 2. This makes for a universal and robust protocol which allows for the creation of decentralized derivatives with a risk profile more similar to traditional financial products, which are needed by professional market participants.
- Opium was founded in 2017 and was working on infrastructure for decentralized derivatives even before “DeFi” came into existence! The team behind Opium has professional experience in the traditional financial sector and has deep knowledge on financial primitives, risk management and DeFi. The Opium Protocol is live on Ethereum mainnet and audited by SmartDec. So far we have launched three working products built on Opium Exchange, and we are assisting four external independent organizations on bringing their derivatives to market using Opium Protocol.
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