Decentralized finance (DeFi) is one of the most dynamic sectors of the global economy to date and its growing with increased interest in various derivative assets.
According to analytical agency Messari, trading volumes on decentralized exchanges (DEXs) in the second quarter of 2021 have shown a 117 times increase. This is in comparison to the same period last year and 83% growth over the first quarter.
Trading volumes on decentralized exchanges exceeded 10% of the volumes of centralized exchanges for the first time since October 2020. In essence, DEXs are slowly but surely occupying the market share of their centralized counterparts.
However, quantitative indicators are not the only factors to consider. There are also qualitative changes to take into account. Crypto market economics started off with the simplest of financial transactions like buying, selling, and storing assets.
Replicating TradFi in digital assets
Still, the tools available to crypto investors have expanded dramatically over the past two years. The trend is obvious as crypto market players are trying to replicate the full scope of traditional financial services in the digital assets economy.
For the cryptocurrency market, which has traditionally been characterized by high volatility rates, such instruments are becoming especially important. Cryptocurrency derivatives allow market participants to simultaneously reduce investment risks and make money on changes in the exchange rates of traded tokens.
Equally important is how derivatives provide easy access to earnings on trading assets that can be difficult to acquire on real markets. In the last century, oil futures have opened up wealth to millions of traders who had only seen oil rigs or tankers in photographs in newspapers and television.
The launch of Bitcoin and Ethereum futures trading on leading U.S. exchanges has made it possible for many speculators to make money on such digital assets. Despite the disapproval of almost all central banks towards decentralized cryptocurrencies.
Derivatives attract speculators and institutional investors who provide the market with liquidity. That is why derivatives have become the largest market in traditional finance. According to some estimates, the volume of this segment is at least twice as high as the volume of the world’s money supply.
Bitcoin futures, options, and structured products
Although in DeFi space, the situation is still the opposite. Since the derivatives segment accounts for only a small fraction of it, the situation is changing rapidly. Messari estimates that perpetual digital asset trading volumes reached nearly $20 billion in Q2 of 2021. Up 155% from Q1 and up about 300% from Q4 of 2020.
“Decentralized derivative protocols are starting to see strong signs of adoption among DeFi users,” they explain.
The most common cryptocurrency derivatives today are Bitcoin futures. The volume of trading on the main markets of Bitcoin futures has already reached $1.7 trillion.
The reason is simple, these kinds of instruments trade on large traditional exchanges. Such as the Chicago Board Options Exchange and the Chicago Mercantile Exchange.
Options are another common form of a derivative contract. They, like futures, allow the parties to the contract to determine the terms of future trade in the present and also to get out if prices do not move as expected.
One of the most popular options trading platforms is Deribit. This is where users can buy and sell derivatives for Bitcoin and Ethereum.
Selling contracts, not crypto
Many crypto brokers provide investors with services for buying or selling CFD contracts (contracts for difference). These are derivatives that act on the difference in the price of the underlying asset.
At the same time, the trader does not buy or sell the underlying cryptocurrency. They only open contracts for the difference in prices, earning on their forecast, regarding how the exchange rate will behave in the future.
If the asset has risen in price during the CFD period, the seller pays the difference. If the cryptocurrency has fallen in price – the buyer pays up.
Surprisingly, currency swaps – a very popular form of derivatives on traditional financial markets – have not yet become widespread in the crypto industry.
Although these are futures contracts with no specific expiration dates that foresee the ability to close the contract at any time. The high volatility of digital assets makes such instruments too risky.
The next step in the development of hedging investment risks was the emergence of the so-called structured deposits. The profitability of such products depends on the degree of capital protection.
The smaller it is, the higher profitability is. In general, structured products always provide higher income levels than conservative instruments. Meanwhile, the associated risks are much lower than with direct exchange speculations.
A new era of crypto derivatives
The development of new segments of the cryptocurrency economy is leading to the emergence of new derivative products. The best confirmation of this observation is decentralized lending services that connect borrowers with lenders.
In the past couple of years, this sector has been developing very rapidly. This has been facilitated by the anti-crisis monetary policies adopted by most central banks.
Cheap money is pouring into the global economy on an unprecedented scale. One of the consequences is a sharp decline in lending rates in traditional finance. Meanwhile, rates can go up to 20% per annum in decentralized lending, providing lenders with fantastic returns by TradFi standards.
Giving and receiving loans in cryptocurrencies has become extremely popular after emerging credit protocols like Aave or Compound. However, the unpredictability of exchange rates, characteristic of the entire crypto industry, is reflected in loan rates.
This is because they are almost as volatile as token exchange rates. There have been various derivative proposals to address this problem.
For example, the Saffron Finance and BarnBridge platforms are offering securitization of decentralized loans by combining variable rates of return across different lending protocols into separate tranches, each with a different risk/return profile.
Investors can choose a specific tranche depending on their own risk appetite. Otherwise, they can build their own portfolio of loans with individually calculated reliability and profitability.
Services like Yield and Notional generally give users the ability to borrow and lend cryptocurrencies at fixed rates but for a predetermined time. It is clear that loans are very short-term — a factor that reduces their effectiveness.
After all, most crypto loans are directed to the stock exchange. If there are no significant market movements during the loan period, it will be problematic to “recoup” it.
Interest rate options for crypto
In traditional finance, a special instrument exists to hedge the risks of changes in credit rates in the form of interest rate options. These allow the lender to set a floor option. Interest rate options enable companies to protect themselves from adverse interest rate fluctuations while benefiting from favourable fluctuations.
The emergence of similar derivatives on the cryptocurrency market was only a matter of time, and it has finally happened. The pioneer was Horizon Finance. It offered a fundamentally new interest rate derivative where participants can compete for preferential payment in return for capping their yield.
The bottom line is simple. An investor can submit their own interest rate bid (yield cap), which they consider to be fair at a given point in time. All of the different bids from investors are aggregated into an order book. Income on the underlying capital is distributed from lowest bid (%) to highest bid (%) until it either runs out or the excess spills over into the floating pool.
This derivative payoff is at the core of the Horizon protocol. It will be run over rounds of chosen time period lengths (2-week and 1-month initially) that are strung seamlessly together.
“We posit that in such a game, the ‘crowd’ will collectively act in a rational fashion in an attempt to maximize their individual profit according to individual risk preferences,” stated a representative of Horizon Finance.
There is no doubt that as the financial industry decentralizes, derivatives will become more widespread. Simple buy-and-hold investment strategies will become ineffective. At the same time, the ratio of money and derivatives will be approaching the values of the traditional financial market.
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