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What are DeFi Derivatives and how are they used
How do they work and what can you do with them?
Decentralized Financial Derivatives, or defi derivatives, are financial derivatives leveraging crypto blockchains. To understand defi derivatives (also referred to as synthetic derivatives and synthetic assets), we need to first understand what traditional financial derivatives are.
Financial derivatives are the most traded phenomenon on the face of the earth and the derivatives market is the single greatest financial market in the world, dwarfing all others. The derivatives market has an estimated high-end value of as much as $1 quadrillion ($1,000,000,000,000,000) dollars, whereas the market cap of all of the stock markets in the world combined add up to a paltry $90 trillion dollars. What we're trying to express here is that there are a lot of derivatives and a lot of value in them.
The idea behind derivatives is simple. Derivatives are contracts that state or establish an agreement between parties to buy, sell, or trade an asset on or before a specified date. The four common derivatives are options, forwards, futures, and swaps.
There are typically two main uses for derivatives:
- Hedging - where the parties are trying to mitigate or insure against volatile price swings
- Speculating - where traders take on higher risk bets, often leaning towards gambling
Both these use cases require the creation of additional contracts and marketplaces that leverage the value and price movement of an underlying asset.
For example, when hedging, parties want to prepare an opposing bet that will protect them from price movement that is potentially larger than expected.
A classic example of hedging is in commodities involving a wheat farmer and the wheat futures market. A farmer plants his seeds in the spring and sells his harvest in the fall, but between those months, the farmer is subject to potential price movement of wheat, which creates risk because the farmer might not be able to sell at a price that will bring him a profit. Therefore, he decides to sell futures of his wheat, which is a contract that guarantees a price that he will sell the wheat on a specified date in the future.
This contract is then tradable in the futures market. Traders who believe that the market for wheat at that time will be higher than the value of the wheat futures contract that this farmer sold will be interested in purchasing this contract so they can make a profit off the difference. If the market ends up showing that the price of wheat has dipped and will be less than the contract amount, then the farmer has protect themselves and will still make the contract amount.
By leveraging futures and hedging, the farmer has guaranteed the price he would sell his wheat in spring by giving up on the possibility of selling his wheat for more money during the fall.
As for speculation, all the above derivative tools can be used. One of the most common derivatives for speculation is options, typically available for stocks. Options are contracts that only gets fulfilled if the price hits the required price by a set date. For example, let's say a certain stock is currently worth $10 on the market. In exactly one month, you expect this stock to 2x up to $20, so you decide to buy options that will be fulfilled only if the stock price hits $20.
The reason this is attractive is because these options normally sell for much cheaper in comparison to the fulfillment price. For example, it might only cost $1 for each contract, meaning if you buy the contract and it hits the fulfillment price of $20, you make at least 20x your initial investment. The risky part is if the stock does not reach the fulfillment price, then you lose everything.
DeFi derivatives are financial derivatives leveraging crypto blockchains. What was traditionally only available in the traditional financial market like Wall Street will now also be available to everyone in a decentralized way.
Projects like Synthetix have paved the way, starting in 2018, by establishing ways to create synthetic assets in a decentralized way via collateralization, where a user deposits a certain amount of liquidity to guarantee the creation of a synthetic asset. Once these assets are created, decentralized marketplaces make them tradable.
The unique opportunity with DeFi derivatives is the lack of middlemen needed, replaced with the blockchain. In traditional finance, derivatives are issues and managed by banks as a middlemen between two parties. DeFi derivatives not only can replace the middlemen, but offers opportunities to create derivatives that do not require an opposing party to trade with, for example, perpetual futures and other derivatives via collateral.
Similar to traditional finance, DeFi derivatives have two main use cases.
A very obvious use case that is already available is perpetual futures. Perpetual futures are futures contracts without an expiration date, allowing holders of these futures to hold indefinitely. This can be useful for hedging against short term volatility while aiming for a longer term price target.
In addition, DeFi derivatives opens the doors to inverse assets, in other words, the shorting of assets. For example, there was previously no way to short a crypto asset other than buying the dip. With inverse assets, it will be possible to buy assets who's value is dependent on the inverse of the underlying asset, in essence, shorting. Shorting of different assets provides portfolios with significantly more options in regards to hedging.
Derivatives have many ways to allow for more speculation. DeFi derivatives, with the potential lack of oversight, will offer even more opportunities with multiple DeFi derivative projects each focusing on different derivative products. One of the good things about defi derivatives is that because it is on the blockchain, it is significantly more transparent with all the data out in the open instead of hidden away in dark pools, which is common practice in the traditional financial system, and also why it is so hard to designate an actual market value of all derivatives in the market.
Horizon Protocol is set up for the creation and trading of defi derivatives.
Horizon Protocol's mission is to become a borderless financial market for synthetic assets, a defi derivatives program designed to be used by everybody. Horizon Protocol focuses on easy access to financial exposure to assets around the world, designs that facilitate use and understanding of defi derivatives and synthetic assets, and education towards financial opportunity for the everyday man and woman.