Crypto Derivatives 101

5 min readJan 13, 2022

Derivatives are immensely significant in traditional finance. Estimates show that the global derivatives market in the traditional finance landscape is a hundred times the world money supply volume of US$10 trillion and ten times the world debt volume of US$100 trillion, hence dwarfing both.

This ratio is inversed when it comes to the derivatives market in decentralized finance. The estimates for the DeFi derivative market indicate a size of US$0.1 billion, which is tiny compared to the decentralized debt market of US$10 billion and the crypto market cap of US$200 billion.

However, as the trends show, the size will not stay small. DeFi is encroaching more and into the traditional finance space, indicating that market proportions in DeFi will eventually look much more like those in traditional finance.

Many of the traditional finance instruments apply in the DeFi space well. With the surging market for DeFi, we must become aware of how these instruments play out in the decentralized world. Here, we will learn about DeFi or crypto derivatives.

What are Derivatives?

As evident from the name, derivatives in the traditional finance world derive their values from another underlying asset. These assets could be anything, from commodities to precious metals, currency, bonds, stocks, stock indices, etc. The four most commonly traded derivatives are forwards, futures, options, and swaps.

A Forward Contract is a bipartite, customized one where settlement would happen on a specific date in the future at an agreed price. On the other hand, Futures are exchange-traded contracts that help trade financial instruments or physical commodities for future delivery at an agreed price.

If we look at Options, which could have equity, forex, or commodities as their underlying asset, the trader is offered with the right but not the obligation to purchase or sell a set amount of the assets before it expires. For instance, if you have bought an option to purchase shares of a company X before the end of the week for $100, paying a premium of $25, the trade will move in profit when the price exceeds $125, making you free to execute the trade.

Options derivatives can be of different types. Call options give you the right without the obligation to buy the asset, whereas put options give buyers the right without the obligation to sell the underlying asset at the specified strike price mentioned in the contract.

There are also more complex options, such as the Binary, where the payoff is either in a fixed monetary amount or nothing. A collar option asks you to hold shares of underlying security while buying protective Puts and writing Call options for the same underlying.

With these insights into the traditional finance world derivatives, let us look into what derivatives mean in the decentralized finance space. But, before that, we must understand why derivatives are vital in the finance world.

Derivatives help gain exposure to assets that would have been difficult to access otherwise. Trading oil futures is easier than trading actual barrels of oil. Derivatives also help gain leverage. For instance, a trader can only spend funds for the option premium to gain exposure to an asset by purchasing a call or put options — two traditional forms of derivative contracts. Such speculative trades are vital to the economy for two broad reasons.

First of all, it helps inject liquidity into the market and — secondly -allows people to hedge their risk by agreeing on a price beforehand. The second reason has a strengthening effect on the market. It helps the market appear less risky and brings down the barriers to entry.

DeFi or Crypto Derivatives

Derivatives in the crypto world — when first introduced in the market — allowed creating synthetic assets that would track the price of some other underlying assets. While it might sound like traditional derivatives, such as futures, there is a difference in how synthetic assets are set up and operate.

Unlike traditional derivatives, these synthetic crypto derivatives tokenize the relationship and do not create a contract. This way, an investor can leverage the concept of derivatives without having to leave the cryptocurrency and blockchain ecosystem.

For instance, if you want to own or trade the stocks of a company X, you can have the synthetic token that tracks its price. These tokens usually come with the symbol $sX and follow the price of the underlying asset using available data oracles.

Benefits

The question that would arise here is, what are the benefits of having such synthetic tokens? Having a stock as its underlying asset is quite common in traditional finance world derivatives. Why do we need to move into a decentralized finance world then? Well, the answer lies in the question itself.

The DeFi derivatives come with the inherent benefits of decentralization. Since it is in the DeFi world, anyone using open-source protocols can mint these blockchain-based assets. People can trade it anywhere using DEXes.

These assets, by the virtue of being blockchain assets, can easily move between standard crypto wallets. Finally, with these crypto derivatives, users can leverage any assets such as equities, commodities, etc., without having to leave the blockchain world.

Innovations

Some protocols bring more innovation into the creation of crypto derivative assets. For instance, there are protocols that instead of choosing to overcollateralize themselves go for liquidators who receive financial incentives to locate improperly collateralized positions and liquidate them.

Some protocols even allow for trading options in ways that are non-custodial and permissionless. There are also perpetual contracts that come with no expiry or settlement date and can be held and traded for an indefinite time.

The Right Platform for DeFi Derivatives: Precog Finance

When it comes to the right vehicle, Precog Finance presents an opportunity ripe with groundbreaking innovations. Its sophisticated solutions — powered by AI and ML, optimized by financial engineers and algorithm specialists, and governed by a DAO community — offer diverse trading opportunities with some of the most popular crypto-assets such as the ETH, USDC, or USDT.

Precog’s soon-to-be-launched decentralized crypto derivatives platform Cerebral will provide a superior user experience, as well. Sealing the deal, Cerebral will support gasless transactions.

If you are keen to try your hands on derivatives, Precog brings the best of two worlds. On one hand, it helps you with diverse choices, while on the other hand, it ensures that you get the best of experiences any derivative trading protocol could offer you.