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Since our last article on DeFi, the total worth of assets locked in various DeFi applications has increased to 40 billion USD. It gives a clear indication of the growing acceptance of the digital economy.
From bridging the gap between decentralized economy and traditional finance, DeFi is evolving beyond it to bring us some amazing use-cases. Most DeFi applications have expanded from just simple transactions to hedge the risks of holding any assets or merely simulating them.
Most of the interesting DeFi applications revolve around derivatives. As the name suggests, they derive their values from some underlying assets. Traditional derivatives are used to hedge one’s asset price against the other, but derivatives in DeFi allow building synthetic assets as well, with customizable assets within it.
To understand the basics of DeFi, please refer to our previous article here.
In this article, we will understand the concepts of derivatives in the traditional sense and how they have been maneuvered in the DeFi applications. It will follow a particular emphasis on synthetic assets which is a step further in revolutionizing the finance sector. They bring the possibility of mimicking the payoff of anything of value from the real world in the crypto realm. So let’s check out how speculation has been put to great use with the advent of DeFi.
Understanding Derivatives
A derivative is a contract between two or more parties whose value is based on an underlying financial asset or a set of assets. It is like secondary financial security with a value derived from the primary security they are linked to, according to the terms of the contract. Common underlying assets are bonds, commodities, currencies, interest rates, stocks, and cryptocurrencies.
In decentralized finance, the derivatives are digitized and held as tokens. These are created using smart contracts and the agreement terms are programmatically encoded. This let go need of any third party. It has opened up a new market for investors and created vast opportunities previously restricted to only those with specialized knowledge.
So what are actually these derivatives that claim to provide financial security against risks in the market? The financial market is always full of risks, with no correct predictions for the future. Purchase of an asset that seems profitable today may become worthless tomorrow. Or not buying an asset may risk losing profits in case it grows to be a fortune in the future. A derivative is security from this unpredictability and is used to hedge against price changes. Rather than a spot trade, it provides the option to buy or sell an asset at a future date for a price agreed in the present. Its price is derived from the price of the underlying asset it represents.
Futures and options are the types of derivatives products generally used. They allow parties to determine the terms of future transactions in the present.
Future is a contract between the parties about the price an asset can be bought and sold before an agreed-upon date.
Options are another form of derivative contract, which like a future allows parties of a transaction to determine the terms of the future trade in the present along with the flexibility to pull out of the contract in case hedging doesn’t go according to the plan. This ability to walk away from a contract comes at a price called a premium which is to be paid to the other party. Options could be either a call option or a put option. A call option is generally used by the buyer if he thinks that an asset’s price is going to go up. It allows the holder an option to buy or not buy the asset as per the terms decided in the options contract. It provides safety to the buyer if the price doesn’t go up. A put option, on the other hand, provides this flexibility to the seller of the asset.
Parties whose business or income is dependent on the stability of an asset price can use derivatives to make sure they are not losing funds.
Understand this from an example of a farmer who grows soybean. Its price fluctuates throughout the year pertaining to many reasons. In case the price of soybean is low at the time of harvest, the farmer is looking at a reduction in his profits. To accommodate this risk, the farmer can choose a future or option derivative for the amount that he predicts to harvest.
At the time of harvest, if the price of soybean is lower than initially anticipated, the farmer makes a profit from the derivative that offsets the loss from selling the actual soybean. If the price of soybean is higher, the farmer incurs losses from the derivative but profits from actually selling the soybean.
So no matter what happens the farmer will end up with a predictable income.
Another interesting example is of bitcoin miners leveraging derivatives. Since the price of Bitcoin is volatile and its mining process isn’t always profitable, miners use derivatives as a hedging option to cover their electricity and infrastructure costs and earn a profit for their work.
Derivatives in DeFi
In DeFi, derivatives allow crypto companies to hedge their exposure to different cryptocurrencies and run more predictable businesses. Combined with the concept of leverage, a trader can trade with and earn (or, lose) much more than the predictable income. If things go right, you’d make a profit as much as your leverage plus the price of the asset. If you bet wrong, the loss would depend upon the leverage and the price of the asset.
All the DeFi applications are heavily collateralized by locking up either a cryptocurrency (like ETH) or a stablecoin (like DAI). Now if you want to make a derivative depending upon the future price of BTC (not buying bitcoins here, just getting a price exposure), taking a 2X leverage on it. The collateral here would act as a form of safety if the price of the asset goes down. If BTC is trading at $45,000, and in a week its price increases to $46,000, you would get $2000 from the trade i.e. $1000*2. If the price of BTC goes down to $44,500, you owe $1000 i.e. $500*2. In this situation, the smart contract can liquidate a part of your collateral depending upon the liquidation ratio.
What Are Synthetic Assets?
These are the crypto tokens designed and engineered to simulate a real-world asset in the cryptocurrency ecosystem. It creates the same payoff as owning a financial instrument would have. The underlying assets can include stocks, bonds, indexes, digital assets, commodities, currencies, or interest rates. For eg., the stable coin USDT is a crypto token that is treated as the actual US dollar. It gives its holders exposure to the dollar without actually owning it.
Synthetic assets are basically the digital representation of derivatives. It combines one or more derivative products like options, futures, or swaps to simulate the underlying asset.
Examples of Synthetic Assets
Imagine you wish to purchase land. But you don’t have the necessary funds. Also, the complications involved in the process are tedious. With DeFi and crypto synthetic assets, users could purchase a fractional part of the land with fiat currencies (USD or INR) without actually owning the land. The synthetic asset tracks the value of land, and when the land’s value increases, the token’s value is also subjected to an increase.
You can create a synthetic asset that takes the price of multiple assets. Their price changes can be put on a derivatives smart contract allowing its holders to gain exposure. You can trade the price of anything from jet fuel, stocks, commodities, or cryptocurrencies with derivatives.
You could even go against the price if it suits your needs. Inverse derivatives contracts work the same way as ‘shorting’ an asset would. Put simply, shorting an asset means betting that its price will go down. Hence, you can enter into a derivatives contract betting against a single asset, an index, or anything else you’d like.
Why Are They Important
DeFi applications give open access to investors worldwide which is otherwise restricted in the traditional financial space. Anyone with a mobile phone and internet connection can be part of DeFi.
Synthetic assets help investors to access almost all the assets in the world. They can earn returns without a physical settlement, arbitrage trade, transfer risk, and hedge against price fluctuations.
DeFi space lacks liquidity in the market, synthetic assets help create liquidity in the market. Traditional financial instruments are in custody with a centralized counterparty whereas synthetic assets are backed by decentralized infrastructure using secured smart contracts and distributed ledgers.
Major Synthetic Asset Projects
You can check some of the popular derivative DeFi projects here.
- Market protocol– It allows the creation of ERC20 synthetic tokens on the Ethereum blockchain. These are minted after depositing collateral. These tokenized assets can be deposited into wallets and can be traded on exchanges. Traders can easily enter long or short positions in any contracts where they find liquidity.
- Synthetix– One of the popular DeFi projects and has more than $2.5B worth of cryptocurrencies locked as collateral. The protocol allows investors to mint and trade synthetic assets, giving exposure to non-crypto assets such as gold, USD, and stocks. SNX tokens (native Synthetix tokens), or Eth are kept as collateral to create synthetic assets. Represented by Synths which are ERC20, these synthetic assets track the value of real-world assets. Currently trading in the top 10 crypto tokens in the market, SNX tokens are in huge demand.
- Universal market access: UMA users can create financial products, using protocols such as ERC-20 to create tokenized derivatives that grant them exposure to real-world underlying assets.
As we move more into decentralizing finance, derivatives are going to be strong pillars on which DeFi stands. We sincerely hope that synthetic assets unravel some mystic use-cases and allow users to hedge all their losses and benefit from them.