Decentralized Derivatives: The Place Where You Can Trade Anything From Anywhere
In a previous article, we mentioned one argument in favor of derivative DEXes — the possibility to trade anything from anywhere. And now is the right time to describe it in detail. So, how is it possible, where are successful cases and how will derivative DEXes look after several years?
It’s important to note that we are still at the very beginning of DeFi. Not like in 2020, but still, there is so much space for development, especially in derivatives. And many people underestimate the potential of this field, especially the possibility of trading anything from anywhere. Let’s look through some advantages of DeFi to understand better why it is better.
Let’s take a look at this scenario. There is one farmer who grows some oilseeds; let’s say he’s growing corn, and he sees that the weather is good, so other farmers start growing the same corn, and our farmer is afraid that prices at the time of maturation might decrease. In that case, he would like to hedge future harvests. Now our farmer goes to a brokerage firm, agrees with the broker, then goes through KYC/AML procedures, and finally, he can deposit assets to his account and sell futures.
But users have to pay fees because exchanges, brokers, and other intermediaries have a lot of employees and expensive infrastructure. Usually, the user pays for the contract plus a monthly fee, including regulatory fees, exchange fees, clearing fees, pass-through fees and others. The diagram below shows the approximate process of how exchanges work worldwide.
There are several intermediaries (exchange, broker, clearing center and depositary), and every one of them has to be paid. For example, CME alone has about 4500 employees now, that’s without counting broker-workers, etc., and Uniswap now has 53 staffers.
Let’s come back to the farmer. If he has a big farm and lives in the USA or Europe, hedging his harvest is affordable. Suppose he’s from a different country, especially if it was poor. In that case, weak farming conditions become worse, and they just don’t have the opportunity to interact with CME or other exchanges.
And here, anybody can see the advantages of DeFi. If derivative DEX with agricultural trading had existed, then any farmer in the world would have had the opportunity to hedge their corn harvest! So, we mentioned two advantages of DeFii — permissionless and affordability. Of course, trading on Ethereum is not cheap, but there are so many other chains, like NEAR protocol, for example :)
So how does someone trade corn on a Derivative DEX? Futures on CME are deliverable, which means that any asset from the seller after expiration should be delivered to the hub, where the buyer can take it. While in reality, just a small part of all futures “lives out” till expiration, most of them are offset (close) or rolled forward (close position before expiration and buy or sell a new one with a future expiration date).
And here, cash-settlement futures enter the stage! This type of future exists in TradFi and Crypto, and they imply transferring only the difference in the price of assets between buyers and sellers. So if you bought futures for corn at $755, and it expires at $799, then you will get 799–755=$44.
But crypto comes forward and creates Perpetual, or futures contracts without an expiration date, where convergence is maintained through the funding rate, and of course, they are also cash settlements. If you want to discover how perpetual works better, just google it ;) There is tons of information about it on the internet.
So, futures for corn might exist in DeFi as a cash settlement and probably, perpetual, because people prefer simple things to difficult ones; they don’t want to monitor expiration dates, and the fantastic popularity of perps against traditional futures is proof of that.
2 necessary constituents for perp trading, let’s revise them:
- Liquidity — produced by liquidity providers on AMM exchanges and by market-makers on order book exchanges
In the case of AMM liquidity is supplied by liquidity providers, who will put, for example, corn futures and stablecoin together in a liquidity pool. So, we need to incentivize them to underwrite corn futures and keep some collateral for it. It’s not easy because they will suffer from impermanent loss and want to be compensated for it. Usually, platforms incentivize liquidity providers with distributing fees, and these fees are high compared to CEXes, especially the derivative section on the CEXes. And the second source of income is an incentive program — distributing native tokens to people who provide liquidity. An example of a platform that does it — is the Mirror platform, where anybody can trade derivatives to different stocks.
If an exchange uses an order book, it needs market-makers who will provide liquidity to the order book. Usually, an institutional market participant who uses comprehensive software has a contract with the exchanges and is paid by the exchanges for their work. But it doesn’t sound decentralized, isn’t it? The better possibility to move this process on a decentralized track is to make on-chain incentivization for market-makers. Now only two platforms have managed to do it — dYdX and Mango Markets, but both of them have some problems with MM incentivization. Market-makers will probably use traditional exchanges to reduce their risk regarding asset prices. For example, if MM’s position on DEX is -10 contracts of corn, then he buys 10 contracts on CME to avoid price-changing risks.
Infographics below show how a market-maker might hedge his position on CME against his position on derivative DEX:
if MM position on DEX has some skew, then the maker goes to CME and hedges it
An essential service for any derivatives DEX is an oracle because any derivative needs to take the price of the underlying assets for perpetual. For example, if you have BTC-Perp, you need reliable information about BTC’s price on the spot and how much BTC costs.
In our example above — about corn trading — we need to have the price of corn because it’s necessary for calculating pnl, funding, etc. Without the price feed, you can’t launch the market because Oracle might have some problems like the absence of prices, or they may send wrong information about prices, and this might lead to terrible consequences as many users can be liquidated, and protocol would need to compensate for their losses.
The image below shows in a nutshell how an oracle works. Data providers catch information from the world and translate it into oracle nodes, and after, the information goes to the blockchain.
So, with these two elements, it’s become possible to create any derivative market, but what would you recommend in today’s crypto market?
Derivative trading in DeFi
Mirror Protocol is one of the first dApps on Terra blockchain. It allows users to trade derivatives to stocks, such as Twitter, Microsoft, Google, Alibaba, Tesla, etc.
Mirror uses the AMM system and incentivizes liquidity providers.
The main disadvantage of Mirror is a “soft peg” system for keeping peg to the real asset. Because of that, prices for many m-assets are very different from their underlying; for example, mTSLA has a premium of 15%, i.e., when usual TSLA costs $1091, mTSLA costs 1232 UST! Mirror TVL gradually decreased since May of 2021, and now it’s at $751 mln.
Synthetix is a platform for trading collateralized derivatives called Synths. A unique feature of the platform is a pool of SNX stakers as counterparties in any trade. So, the liquidity for any trade is almost endless (limited only by the value of SNX stakers) and doesn’t have a slippage. TVL is $1,22 bln.
Synthetics used to support trading in Gold, Oil, Tesla, and other synths, but now there are no commodities and equities on the platform. Due to low demand, the assets were delisted, and oracles also did not do very well. The price was often different from the underlying price. But this was an issue on Ethereum; maybe they will come back with more Synths in the future!
Polymarket is a platform for making bets on any event. Not the obvious case, but still an example of derivatives in DeFi, where you can bet on some events, such as Ethereum price on a particular date or the next US president. Polymarket is based on UMA — protocol for creating derivatives on crypto. It was popular at the beginning of 2021, but now not that many people use it.
Cypher is a protocol for trading pre-IPO assets and now works only on DevNet and with only one asset — SpaceX derivative.
Besides DeFi, several CEX exchanges give the chance to trade tokenized stocks, such as FTX, Bittrex, etc.
As you can see, there are only a few DeFi protocols that provide trading assets from TradFi to DeFi. It means that this field is still empty, but the question is not only about developers; the question is also about adoption. How many farmers understand how DeFi works? How many will hedge their harvest through crypto, which is still unregulated? It’s an adoption question. When more people know about crypto and DeFi, it becomes easy to deposit your money when you’re not just speculators, but real users will come to the market for their needs.
Variety of assets in TradFi derivatives
The scheme below shows the structure of possible trading assets for derivative DEX, more precisely, only the smart part of it :
Hedging oil for oil traders, gold for gold miners, the possibility to trade silver or US treasuries for any person in the world, disregarding the country they live in and the amount of money in their account, lower fees than on TradFi exchanges and many other possibilities are being opened for the people with smart-contracts!
As we said before, DeFi is still taking its first steps on this amazing journey. Such an obvious sphere as derivatives from TradFi isn’t widespread in crypto. But we predict that more and more new dApps will find their way to users’ hearts in the near future. It’s not easy to attract people to crypto, but with an attractive design, simple and understandable interface with an easy way to swap fiat into crypto, adoption will become much easier. The examples above are a small part of possible trading cases for crypto derivatives, and for any asset, you still need only an oracle and market-maker. So, with DeFi, everything is fair game.