The DeFi Blue Ocean of 2021? Analyzing the Category and Potential of Decentralized Derivatives

This article was published in WebX Lab Daily.

After a year of accumulation and sedimentation, decentralized exchanges like Uniswap and lending protocols like Compound have achieved breakthroughs at different levels with the development of DeFi last year. However, in the derivatives field, they have not been widely used. It is important to note that in traditional finance, the volume of derivatives is 40 to 60 times that of spot trading, while in the crypto market, the trading market value of derivatives accounts for less than half of the entire digital asset market. In contrast, there is still enormous room for imagination in the development of derivatives. This situation has seen a glimmer of hope this year. A simple example is that with the surge in Bitcoin's price this year, many institutions have begun to try using derivatives to hedge risks, discover prices, and arbitrage to capture more value due to the instability of value. It can be confidently said that as crypto assets and DeFi heat up, the demand for derivatives will become increasingly strong, and the speed of market penetration and transmission will continue to accelerate, thereby stimulating the emergence of new market species to fill the existing market gaps and demands.

The definition of financial derivatives generally refers to a bilateral contract that has a trading swap relationship between two parties or is used by traders to transfer risk. It gives the holder an obligation or an option to buy or sell a certain financial asset, and its value is determined by the price of the financial asset being traded. Options, futures, and swap contracts fall into this category. In the DeFi field, the definition of derivatives is roughly similar to the above. Currently, from a relatively fair perspective, the main types include trading options and futures, synthetic assets, while decentralized insurance and oracle tools still constitute a significant separate sector. Below, we will explore this track through mainstream derivative types.

Trading Derivatives

The first category is Bitcoin futures products. According to data from the crypto market data aggregation service provider Glassnode, since last November, Bitcoin futures trading volume has been steadily increasing, with the daily trading volume of Bitcoin futures now exceeding $180 billion. In addition, Bitcoin options trading has also surged, and new record levels are expected this year. Currently, some exchanges have achieved regular custody of over $1 billion in daily trading volume. The continuously growing trading volume has also encouraged more institutional units to begin experimenting with such products. According to public news reports, in early March, Goldman Sachs announced that it had restarted its cryptocurrency trading desk and began offering Bitcoin futures and non-deliverable forward (NDF) trading services to clients. Subsequently, Giant Steps Capital, the largest quantitative asset management company in Latin America, also announced that it would launch a fund focused on investing in Bitcoin and other digital asset futures, using machine learning strategies to trade Bitcoin and similar asset futures. The trading of Bitcoin options and futures is entering an incremental market, and the good news is that, in addition to Bitcoin, other derivatives trading for various cryptocurrencies are also continuously developing.

In addition to centralized exchanges and financial institutions, another category is the development of decentralized derivatives protocols. Projects like dYdX, Kine, and Injective are all engaged in futures trading. dYdX was born in 2017 and is one of the earliest DeFi derivatives protocols. It adopts an off-chain order book and on-chain settlement trading method, and besides perpetual contracts, it also includes lending, leveraged trading, and other functions. Currently, the perpetual contracts of this project are running on Ethereum's Layer 1, and Layer 2 mainnet testing is also underway. Kine operates in a model similar to centralized exchanges, using "on-chain trading" and the "Peer to Pool" trading method promoted by Synthetix, allowing trading users to have unlimited liquidity and zero slippage. Since trading on Kine occurs off-chain, it is not significantly affected by public chain performance, ensuring trading speed. The downside is that Kine cannot be considered a fully decentralized protocol, posing certain security risks.

Representative projects in the options category include Opyn and Hegic. The Opyn protocol allows users to create call or put options, enabling users to buy and sell options with predetermined products, delivery times, and strike prices. In terms of the trading time for options, Opyn adopts European-style cash-settled options, meaning that option holders do not need to take any action on or before the expiration date; the settlement will be executed automatically upon expiration, and all products are priced in USDC. Option sellers must have 100% collateral as a guarantee to manage market risk. Hegic addresses the liquidity issue of options products through liquidity pools, currently including options for BTC and ETH. Users can provide funds in Hegic to form a liquidity pool, and these funds will be used to automatically sell call and put options, becoming the counterparty for buyers. Liquidity providers bear the risk of options while simultaneously enjoying the profits from selling options.

In the realm of perpetual contract derivatives, dFuture can be considered an innovative protocol. This protocol does not adopt a traditional order book trading model but instead uses an innovative "constant product formula" to solve issues of trading depth, liquidity, and control. It also introduces multiple external oracles and decentralized exchanges to obtain current quotes for trading categories, forming an index price through weighted averages. This maximizes the guarantee of risk-free profits for liquidity providers. Currently, the platform has been deployed on the HECO chain and BSC chain and has stabilized initially. Due to its reliance on the traffic attributes of public trading chains, it has also absorbed a large portion of the customer traffic driven away by Ethereum congestion, so overall development has been quite smooth.

Synthetic Assets

Synthetic assets are built through asset protocols that map almost all priced assets, achieving a simulated expression of the original assets. However, this does not represent the original assets themselves, nor does it imply ownership of these assets in the real world; it merely anchors the price of the asset, serving as an alternative expression of existing assets in a parallel world on-chain. Currently, it is possible to synthesize stocks, fiat currencies, gold, BTC, and other assets. The most representative project in the synthetic asset track is undoubtedly the synthetic asset issuance protocol Synthetix based on Ethereum. It supports synthetic assets including fiat currencies, cryptocurrencies, and commodities, primarily based on a debt pool model that tracks the underlying assets and allows users to provide collateral in the form of SNX tokens to mint synthetic assets. In just over two years since its inception, the total locked value has exceeded $3.2 billion, placing it at the top of synthetic assets and creating a significant gap with other projects.

Data Source: Debank

Another rapidly growing synthetic asset is Mirror. Last month, after several U.S. brokerage firms announced restrictions on opening positions for GME and AMC stocks on the brokerage platform Robinhood, this synthetic asset platform took the opportunity to initiate a vote and launched synthetic asset trading corresponding to GME stocks, providing investors with trading opportunities that are not subject to restrictions from centralized platforms. As a newcomer, Mirror has developed rapidly and has become the largest synthetic U.S. stock trading platform, already listing over 20 synthetic assets covering U.S. stocks, crypto assets, commodities, and more. Overall, Mirror, which is quick to gain insights into market demand, is continuously seizing opportunities.

Another decentralized synthetic derivatives platform, Supercash, claims to have cash capabilities, allowing users to freely add and trade various digital asset derivatives pairs with a single token. It supports trading pairs including BTC, ETH, ERC-20s, gold, stocks, etc., and the oracle service has evolved from initially relying on external sources to now being independently developed. The platform's standout feature is its ability to synthesize automated market makers, allowing liquidity providers (LPs) to provide just one type of asset, while another type of asset will be automatically synthesized by smart contracts. This means that half of the assets provided will automatically create futures positions through the contract, significantly lowering the participation threshold for users. Additionally, the introduction of automated liquidator smart contracts to assist in liquidation represents a passive market maker model similar to AMM, allowing anyone to provide liquidity through the protocol to become an automated liquidator. Based on a large customer base of liquidators, the platform has further developed its liquidation pool business into a standalone product, providing liquidation services to other DeFi projects.

By leveraging the borderless nature of the crypto market and the innovative combination of market elements, ordinary people are empowered to participate in asset trading. The synthetic asset derivatives track holds immense imagination. Specifically, it utilizes the characteristics of decentralized trading platform operators and permissionless access to simulate popular investment scenarios on-chain, providing ordinary investors with an excellent way to trade diversified asset categories such as U.S. stocks and gold with low barriers to entry. Moreover, synthetic assets are almost unconstrained in terms of asset richness, covering gold, crude oil, U.S. stocks, and even the foreign exchange market, with no restrictions on trading varieties; any asset with public pricing can be traded. This aligns very well with the development of traditional finance and the existing DeFi market.

In addition to the aforementioned futures, options, and synthetic assets, there are also other types of derivatives such as Augur-like prediction markets, Nexus Mutual insurance, and interest rate swaps. In fact, we find that DeFi derivatives are no longer just serving on-chain native crypto assets; they are continuously exploring unknown possibilities, aiming to simplify the trading of on-chain assets and all assets anchored to real-world assets with more open and transparent infrastructure and more diverse and equitable financial distribution models, while truly ensuring the safety of user transactions. Compared to the substantial promotional costs of most derivatives in traditional finance, DeFi derivatives can be created at almost zero cost and quickly pushed to the trading market. This is because the DeFi ecosystem includes oracle services, asset protocols, trading layers, data layers, clearing layers, insurance layers, and derivatives trading layer ecological components, enabling highly flexible financial Lego-style innovative drives. Derivative creators can leverage fewer resources to unlock more market opportunities, and the unilateral innovation and improvement in the derivatives field further strengthen the network effects of the entire DeFi ecosystem, providing a distinctly different experience for the entire ecosystem's construction and user awakening. In the future, the derivatives market will flourish, and the coexistence of multiple strong players will be an inevitable trend in the industry's development. In summary, the future of DeFi derivatives will exceed the developmental potential seen from the perspective of traditional finance, releasing infinite possibilities.