Key Factors of Decentralized Derivatives Trading | Notum
Apr 28, 20235 min read
The contemporary financial world has various assets with different functions and abilities. Derivatives are a significant part of this world. But before we dive deeper into decentralized derivatives, it is crucial to get common knowledge of regular derivatives.
Derivatives are financial instruments or contracts between two parties that are pointed into some future dateBasically, and it is a contract according to which each party takes responsibility or gets a right to transfer a particular asset or sum of money until a predetermined date in the future.
Usually, the main aim of derivatives is to hedge against price risk or get benefits because of the change in the underlying asset's price.
The owner of the derivative is not necessarily the same as its emitter.
There are different types of derivatives, including futures, options on stocks, indices, swaps, and mortgage-backed securities. Derivatives also vary by way of trading. Some of them can be traded privately or over the counter. Others can be traded on exchange services. Each way of trading has its advantages and disadvantages. For example, it is common to consider exchange-traded derivatives more standardized and protected from risks. There are two of the most popular categories in this type. They are futures and options.
Legislation for derivatives varies from country to country and may be different for different types.
Another asset also backs decentralized derivatives, which are traded on the blockchain protocol. Decentralized derivatives can be tied to any kind of asset. It is well-known that crypto prices are highly volatile. Derivatives help to get benefits out of this fluctuation and hedge the position against unpredictability. Unlike regular derivatives, crypto ones have an interesting advantage. They stay in the possession of the owner without the necessity to move them to a centralized exchange service. This feature leaves more flexibility to derivatives owners.
Decentralized derivatives operate on various existing blockchains, such as Ethereum or Binance. The important work-in-progress is cross-chain interoperability that some DEXs are trying to provide. This may bring more freedom to users and expand opportunities for use cases.
What else can be very beneficial for derivatives is smart contracts technology. They add more control to pre-defined contracts that must be executed without a third party. Derivatives owners can also benefit from decentralized governing protocols by participating in decision-making.
Decentralized Derivatives Trading: Pros and Cons
Any type of trading is a high-risk area. Decentralized derivatives trading adds more to this unpredictability by excluding the third party. Derivatives are even less stable than crypto, which makes any operations with it more complex. This means that both gains and losses can be surprisingly substential.
Traditional derivatives are meant to protect investors from various risks, such as inflation. However, in the decentralized world, the situation looks a bit different.
Many concerns in decentralized derivatives trading are connected to the fact that DEXs are relatively new, and a lot of their operation is unclear or adjusted. Some liquidity and security concerns arise regarding this type of exchange service. Undoubtedly, these platforms have vulnerabilities, and they become victims of hacker attacks occasionally. This is a great reminder that exchanges are not the best places to store possessions. Liquidity may be shaky for two reasons. First, participants are still getting used to how these platforms work. During this process, some mistakes, like forgotten passwords, may occur and become a significant obstacle on the way. Secondly, as mentioned above, DEXs are new to the crypto world, where many things depend on the number of users. Thus, they are a little behind with active participants. This may change with time.
Types of Decentralized Derivatives
As we said before, there are various types of traditional derivatives. This is also true for decentralized ones. Here are the main types:
Futures contracts are linked to a predetermined time or price in the future. This is a promise to buy or sell an asset at a certain price or date. The definition for this type of decentralized derivative is the same as for the traditional ones. The main difference between them is in the way of making the deal. In a decentralized environment, participants can make a deal directly with each other without intermediaries.
The other special feature of decentralized futures contracts is that they can have an expiration date or can be made perpetual. The last type is the most widespread one.
While a futures contract is an obligation, options contracts give rights. Holder always has a choice whether to buy or sell the asset at the predetermined price or time. It may be a good instrument to protect yourself from price volatility.
Synths are made to tokenize derivatives to enable them to use blockchain technologies. They are also called synthetic assets. They mimic every underlying asset's characteristic, including its price changes. Nonetheless, their main goal is to make blockchain accessible to anyone.
Examples of Decentralized Derivatives
Synthetix is a liquidity provisioning protocol that operates on Ethereum and uses a second-layer solution, Optimistic Ethereum. The platform uses a native token SNX as collateral for synthetic assets. The platform's model is called a pooled collateral, and it provides an opportunity to exchange synths using smart contracts and avoiding the third party.
UMA is a decentralized derivatives trading platform enabling several functions: creation, collateralization, and trading. This protocol is also built on Ethereum, allowing users to create tokenized derivatives with the help of self-executing smart contracts. With the instruments provided by UMA, the number of assets that can be traded on blockchain may increase significantly.
Hegic is a platform for options trading. It operates on Ethereum and uses a special smart contracts type called hedge contracts. Hegic provides an opportunity to trade Ethereum-based assets. There are two ways of participating on the platform. A user can become a buyer of a hedge contract or a writer. The platform has an interesting mechanism for accumulating liquidity from writers.
The crypto world is developing at a high speed. It produces its instruments and, at the same time, adopts the existing ones from traditional finance. Since trading is a number one activity in crypto, this is the spot for new ideas to emerge. Undoubtedly, having something to protect assets from inflation or sudden crash is nice. However, cryptocurrency and especially decentralized instruments, are still the most risky.
DeFi looks very attractive under the current circumstances. This is a good example of an attempt to develop an alternative financial system. And probably DEXs are not the only new thing to appear. It seems that there will be more.
However, whatever the future holds, it is vital to carefully acknowledge all the risks and evaluate personal opportunities.
Disclaimer: Notum does not provide any investment, tax, legal, or accounting advice. This article is written for informational purposes only. Cryptocurrency is subject to market risk. Please do your own research and trade with caution.