What is a Derivative?
Derivatives are agreements where each person’s payoff is tied to the observation of something else (called the underlier). Usually, the observation is the price of the underlier, but occasionally can be other characteristics like volatility or volume. Derivatives are traded on all sorts of underliers, like credit agreements ($8 trillion notional), foreign exchange rates ($90T), and interest rates ($437T).¹ The market is huge, in part because derivatives are so flexible.
What is a Synthetic Derivative?
At UMA, we’re focused on synthetic derivatives. We use “synthetic” to refer to the way that a derivative is settled. Below is an example of a “physically settled” derivative and why on the blockchain, it must be “synthetic.” We also discuss the other benefits that synthetic risk enable.
Let’s go through an example of Alice, a wheat producer and Bob, a cereal manufacturer. Alice is currently planting 100 bushels of wheat, and won’t be able to sell it until her next harvest in May 2020. She’s concerned that the price of wheat will fall, hurting her profitability. Bob needs to purchase 100 bushels of wheat to produce cereal. He is concerned that the price of wheat will rise next year. Alice and Bob want to lock in the price of wheat at $5, and structure a derivative to enable them to do this.
In physical settlement, Alice would deliver 100 bushels of physical wheat to Bob in return for a cash payment of $500.
Of course, physical wheat doesn’t exist on the blockchain. In fact, nothing exists on blockchain besides crypto-native assets that were mined or minted. As a result, bringing derivatives like this to the blockchain means they cannot be physically settled.
Alice and Bob could instead agree to synthetic settlement using UMA’s smart contract templates. Alice would make a cash payment in Dai to Bob as the price of wheat rises, and vice versa if the price of wheat falls. Exactly how much Dai exchanges hands is determined by the NPV, or net present value, of each counterparty’s position. This way, Alice doesn’t need to keep 100 bushels of wheat ready for delivery. Bob doesn’t need to keep $500 on hand to pay for delivery. Instead, they can both get exposure to the price of wheat by only putting up a small amount of margin, and they only exchange money if the NPV of the trade moves. They both attain leverage.
NPV functions can be complex or simple, can reference different assets, and can be customized to whatever Alice and Bob agree upon. One simple function could be
NPV_Alice = -NPV_Bob = 100 * (5 -price_wheat). This means that Alice’s NPV increases if the price of wheat < 5, and Bob’s NPV increases if the price of wheat > 5.
There are several open source libraries, like OpenGamma, that specialize in standardized NPV models for different types of financial derivatives.
The flexibility of synthetic derivatives means that you can create pretty much any kind of financial risk just by plugging different NPV functions into UMA’s smart contract templates!
OK, but there’s a catch. Defining a contract is only part one. Finding a counterparty to take the other side can be challenging. In the example above, Alice and Bob had offsetting risk and were able to identify each other. That’s not always the case. I’d personally love to get the returns of a global emerging markets real estate index without buying physical property in 50 different countries — but is anyone out there willing to get short facing me? (Seriously, contact me if you do!).
In our next post, we’ll cover different models for cultivating liquidity in synthetic derivatives. Futures exchanges are one of the well-known ways, but other mechanisms have historically been orders of magnitude bigger. You can read it here.
Over the next few weeks, we’ll also share more content about:
- An optimistic framework for writing secure blockchain-based financial contracts
- The financial contract infrastructure that we’re building here at UMA — and how you can access our testnet later this quarter
- Cool things you can create using our infrastructure
- Heavy financial engineering theory on topics like timelocking margin, loss socialization, and price stability mechanisms
To stay updated:
- Follow me on Twitter
- Follow UMA on Medium and Twitter
- Read our financial contract whitepaper and decentralized oracle whitepaper
- Check our our GitHub and bug bounty program
¹ Bank for International Settlements, statistics as of 2018 H2