What Are Decentralized Derivatives and How Do They Work?

Introduction

As decentralized finance (DeFi) continues gaining popularity, it attracts numerous financial vehicles. One of the remarkable developments in DeFi is decentralized derivatives, which are financial instruments that allow users to trade assets without intermediaries like brokers or banks. Being one of the fastest-growing sectors in DeFi, decentralized derivatives offer users new ways to enter the crypto market.

Like traditional derivatives, decentralized derivatives get their value from the assets they are based on. Because of these financial derivatives, traders and investors now have exclusive access to new investment opportunities for speculation, hedging, and risk management. They have exposure to a vast number of portfolios with which they can capitalize on returns.

Although decentralized derivatives play a pivotal role in the crypto market by allowing users to harness future price movements, they embody risks like low liquidity, complex user experience, and regulatory concerns. Because the concept of decentralized derivatives is still relatively new, there is a need for an in-depth understanding of their operations. In this article, we will answer key questions like the meaning of decentralized derivatives, how they work, their benefits and challenges, and examples of popular decentralized derivative platforms.

Derivatives Explained

Before delving into decentralized derivatives, we should briefly touch on derivatives. They are financial contracts that derive their value from underlying assets like crypto, stock, fiat, or other commodities. They can be viewed as a contract between two individuals based on the future value of an underlying asset.

Although there are different types of derivatives, including swaps, futures, and options, they all share similar underlying principles of allowing users to benefit from the future price actions of an asset without actually owning it. They help traders hedge against risks and potentially increase their returns through leveraging.

Some users also use derivatives to gain exposure to various asset classes and diversify their portfolios. It is important to note that due to their complex nature and leverage possibilities, derivatives also carry inherent risks that can exacerbate losses. Because of this, it is important to understand the risks and potential consequences of trading derivatives before getting involved.

Gate.io is a safe, stable, and reliable exchange platform that currently offers traditional derivative services like futures and options trading to users. With one of the highest liquidity volumes among all exchanges, Gate.io ensures the best trading experience for investors and traders.

What are Decentralized Derivatives?

Decentralized derivatives are financial instruments traded on decentralized exchanges (DEXes). They are becoming progressively popular in DeFi, a financial system that aims to create open and permissionless financial services on the blockchain. Like traditional derivatives, decentralized derivatives derive their value from underlying cryptocurrency assets.

Decentralized derivatives stand out because they often have low barriers to entry, as anyone can connect to them with their crypto wallet. Although unlike traditional derivatives, decentralized derivatives are powered by smart contracts that can automatically facilitate and execute contracts.

While cryptocurrency-based derivatives are most common in DeFi, it is also possible to create decentralized derivatives tied to other types of assets, such as stocks. Since crypto derivative protocols typically allow users to retain control of their assets and keys, users can easily move their assets between protocols without requiring a centralized or third-party custodian.

How Do Decentralized Derivatives Work?

The working principle of decentralized derivatives involves using blockchain to facilitate transactions without intermediaries. The blockchain is an immutable ledger that records all transactions and contract executions in a decentralized way, ensuring that a transaction cannot be altered or removed.

Decentralized derivative protocols can be built on different blockchains, such as Ethereum, BNB Chain, Solana, or Layer 2 platforms—Arbitrum, Optimism, etc. However, the overall performance and user experience of each protocol can differ because different blockchains have unique scalability, security, and transaction costs. Although some decentralized derivative protocols enable cross-chain compatibility, allowing the users to trade derivatives across various blockchains.

To properly function, protocols use blockchain oracles to ensure accurate and real-time price tracking of real-world assets. These oracles have different levels of data accuracy, update frequency, and decentralization, which will eventually affect the platform’s reliability.

Because different platforms offer decentralized derivatives, the mechanism of action may vary depending on the type of derivative and the platform’s mode of operation. However, here is a general overview of how they work:

1. A user connects their crypto wallet to a decentralized derivative platform and deposits some funds.
2. The user chooses an underlying asset and the type of derivative contract they want to trade. They may also need to specify parameters such as expiration date, strike price, or leverage ratio.
3. The platform then matches the user with another user who wants to take the opposite side of the trade. Depending on the type of derivative chosen, the platform may create a synthetic asset that tracks the underlying asset’s price.
4. Based on the contract, the platform creates a relevant smart contract and stores it on the blockchain.
5. The user can monitor the performance of the contract and close it at any time before or at the expiration date.
6. The smart contract automatically executes the contract and pays out the profits or losses to the user following the contract outcome.

Types of Decentralized Derivatives

There are different types of decentralized derivatives, all related to the corresponding traditional financial instruments. The most common types are options contracts, futures contracts, and synthetic assets. Let’s explore them in more detail:

Options Contracts

Source: Simpler Trading

An options contract gives a user the right and not the obligation to buy or sell an asset at a specified price on a specified date. It can be used to hedge against a digital asset’s price fluctuations or to trade its future price actions.

For example, if a trader owns SOL and is concerned about a potential price decline, they could buy a put option that allows them to sell SOL at a set price, regardless of its spot price. By this, they limit potential losses if the SOL price falls below the set price.

On the other hand, users can also use option contracts to enjoy future price movements of crypto assets. To do this, a user can buy a call option that gives them the right to buy the asset at a set price if its price exceeds the strike price.

Futures Contracts

Source: MasterTheCrypto

Futures contracts allow investors to benefit from the future price actions of underlying assets. A futures contract allows the user to buy or sell an underlying asset at a set price and date.

In traditional derivatives, futures contracts are traded on centralized exchanges like Gate.io. With decentralized derivatives, traders can access futures contracts in a trustless, permissionless environment and trade directly with one another on the blockchain without needing intermediaries.

Decentralized futures contracts can be either perpetual or have a fixed expiration date. Perpetuals are the most common types of derivative contracts and are programmed without an expiration date or settlement. Although they come with risks like high leverage and funding fees, perpetual futures contracts are designed to be flexible and accessible.

Synthetic Assets

Source: LinkedIn

Also called synths, synthetic assets are digital representations of assets and are designed to provide an accessible way to hold and trade them. They are primarily tokenized derivatives that use blockchain technology to replicate their underlying assets’ value. They aim to harness blockchain technology to allow anyone access to diverse assets without complexities.

Although they share similarities with stablecoins, synths are more diverse because they can represent a wide range of assets, including stocks, altcoins, futures, options, and precious metals. Furthermore, while synths attempt to represent the value of their underlying assets, they are not directly backed by them.

Overview of Popular Derivatives Platforms

Several decentralized derivative platforms have gained popularity in the DeFi space due to their innovative offerings and user-friendly interfaces. Here are some examples of the popular ones:

GMX

Source: GMX

GMX is a decentralized exchange where users can trade derivatives in a trustless and transparent environment. It uses smart contracts to foster the automation of transactions, reducing the need for intermediaries and increasing transaction speed. GMX also allows for leveraging and offers various derivative types, enabling users to diversify their investment strategies and maximize potential returns.

Created by an anonymous team, GMX first launched on Arbitrum on September 1, 2021, and later went live on Avalanche on January 5, 2022. It has two native tokens, namely $GMX and $GLP. $GMX is the platform’s utility and governance token, while $GLP is the liquidity provider token. Compared to dYdX, GMX is more decentralized and utilizes a GLP mechanism to function. The GLP liquidity pool provides liquidity for trading and divides users into traders and liquidity providers. In contrast to the order book methodology that incurs price discovery costs via arbitrage, GLP allows users to enter a trade without slippage or market impact due to its use of the oracle pricing mechanism.

dYdX

Source: dYdX

dYdX is another popular platform in the decentralized derivatives space. It has carved a niche by offering a seamless trading experience with high liquidity and low slippage. The platform provides a wide range of derivative products, including perpetual futures contracts, which are especially popular among traders. Its high trading volume and seamless usability explain its popularity and the trust users place in its security and reliability.

Furthermore, dYdX is a top perpetual trading exchange with an entirely new layer-1 blockchain based on the Cosmos SDK. Unlike decentralized exchanges using automated market makers (AMMs) to provide liquidity, dYdX uses the order book model. This model, commonly found in centralized exchanges, is believed to be more efficient and less capital-intensive as it requires fewer funds to achieve the same level of liquidity as AMMs. The dYdX protocol was, therefore, designed to have the transparency of a decentralized exchange and the efficiency of a centralized exchange.

Gains Network (GNS)

Source: Gains Network

Gains Network has also gained attention for its innovative approach to decentralized derivatives. It provides a unique blend of functionalities, including cross-chain compatibility, allowing users to trade derivatives across multiple blockchains. The platform’s use of native tokens in its governance model also adds to its appeal, allowing users to participate in decision-making processes and potentially reap the benefits of the platform’s growth.

Synthetix (SNX)

Source: Synthetix

Synthetix is a decentralized derivatives protocol that allows users to create and trade synthetic assets that track the underlying asset’s price, such as cryptocurrencies, fiat currencies, commodities, stocks, etc. Users can mint synthetic assets (Synths) by staking the protocol’s native token (SNX) as collateral. Users can then trade Synths on a decentralized exchange called Kwenta or use them for other purposes within the DeFi ecosystem.

UMA

Source: UMA

UMA is a decentralized derivatives protocol that allows users to create and trade custom synthetic assets representing the value of anything, such as cryptocurrencies, stocks, indexes, etc. Users can design their own synthetic assets (uTokens) by defining the parameters and price feed for the asset. They can then mint uTokens by locking up collateral in a smart contract. Users can also trade uTokens on a decentralized exchange platform called UMA Swap or use them for other purposes in the DeFi ecosystem.

Opyn

Source: Opyn

Opyn is a decentralized options trading platform that enables traders to create, buy, and sell Ethereum-based options. As applicable to other options protocols, Opyn allows users to buy or sell an asset at a specific price at the option expiration date. Through Opyn’s smart contracts, users interface to speculate on crypto assets and hedge risks.

Also, Opyn relies on AMM-based liquidity from Uniswap to enable DeFi options trading on ETH and ERC-20 tokens with data feeds from Compound and Chainlink. Known as oTokens, Opyn options are tradable on most decentralized exchanges and are ERC-20-compatible. The platform provides free limit orders to users by utilizing 0x’s unique off-chain relay and on-chain settlement architecture.

Aevo

Source: Aevo

Launched by Ribbon Finance, Aevo is a decentralized exchange focused on options and perpetual contracts. It utilizes a layer-2-based roll-up technology that ensures the delivery of excellent transaction efficiency and low costs. Using a combination of blockchain-based order settlement and centralized order book model, Aevo offers a unique platform that is useful to both expert traders and newbies. In addition to the common cryptocurrencies, Aevo allows users also to trade other tokens like Pepecoin (PEPE), Arbitrum’s ARB, Litecoin (LTC), Aptos (APT), and Lido DAO (LDO), Pepecoin that were only previously available through over-the-counter desks.

Decentralized Derivatives: Benefits and Risk

Decentralized derivatives offer a range of benefits that reshape DeFi, leading to the financial freedom of users. However, because of the novelty and complexities involved, they face some inherent risks. Let’s explore them in more detail:

Benefits

• Transparency: One of the most notable advantages of decentralized derivatives is their high level of transparency. As all transactions and contract executions are recorded on the blockchain, they are immutable and tamper-proof. This feature can significantly reduce the risk of fraud and manipulation, making decentralized derivatives safer than traditional derivatives.
• Peer-to-peer: Another major benefit of decentralized derivatives is the lack of third-party actors. Through smart contracts, these derivatives can automatically facilitate and execute the terms of the contracts, reducing the involvement of intermediaries. This makes the process efficient and allows users to retain control of their keys and assets.
• Accessibility: Because the contracts are executed on decentralized systems, anyone with an internet connection and a crypto wallet can participate in decentralized derivatives. This has removed the barrier to entry to these financial services.
• Innovation: Decentralized derivatives platforms allow for the inclusion of innovative features and products that may not be available on centralized platforms.

Risks

• Security: Despite the high level of transparency, decentralized derivatives platforms can pose significant risks. Furthermore, the possibility of high leverage and volatility of the underlying assets can magnify losses and lead to significant price fluctuations.
• Liquidity: They also suffer low liquidity and market depth due to the relative novelty of the platforms, leading to low trading volumes and loss of quality market makers.
• Regulation: As regulators worldwide are grappling with how to approach these new asset classes, decentralized derivatives platforms face heightened regulatory attention. Because of the borderless nature of these platforms, regulators are arguing that they increase the exposure to fraud, market manipulation, and instability.
• User experience: Decentralized derivatives platforms may be too complex for novice or non-technical users because of their inherent complexities.

Conclusion

Decentralized derivatives have enabled investors and traders to benefit from underlying assets’ price movements in a trustless environment. As blockchain technology continues to evolve, we can expect more innovations in decentralized finance to emerge. Although there are downsides to using decentralized derivatives platforms, they offer users transparency, accessibility, and financial freedom. Nevertheless, before trading any financial instruments, users should consider their trading experience, evaluate their risk management strategies, and only invest with the amount they can afford to lose.