DeFi

Derivatives on blockchain: will it be the year of DeFi?

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Among the various existing DeFi platforms, there are some that can be used to create derivative financial products on the blockchain. These are often ERC-20 tokens which are often linked in various ways to underlying assets. These are not only stablecoins, or tokens that replicate the price of another asset (such as gold), but real structured financial products built from other financial products.

For instance, the DeFi Pulse website lists four decentralized finance platforms dedicated to derivatives, all based on the Ethereum blockchain: Synthetix, Erasure, Augur and Veil.

Synthetix

Synthetix

Synthetix is the most widely used one, considering that it has more than $70 million in crypto assets locked up, whereas none of the others exceed $1 million in locked assets. Synthetix is actually the third largest DeFi platform in terms of volume of locked assets, behind Maker, which dominates undisputed with over 50% of the internal volume, and Compound, but ahead of Aave and Uniswap.

This makes it clear that the blockchain derivatives market is promising, and since DeFi assets can be assembled together in a similar way to Lego bricks, a further great development for this type of tokens is conceivable. However, it is no coincidence that Synthetix itself was born as a project aimed at creating a stablecoin, since a stablecoin is actually the simplest and most trivial form of derivative. Indeed, it is a token that replicates in a timely manner the value of an underlying, or another currency, so that it can be represented on the blockchain where it was issued.

However, this type of derivative is so trivial that it is not particularly interesting as a product, especially since more sophisticated and interesting ones can be built.

For example, Synthetix has about twenty derivative products, which replicate not only the value of fiat currencies, but also raw materials such as gold, or other crypto-assets. Its further development involves creating and trading other derivative tokens that represent shares, financial indices, or other derivative assets.

DeFiZap

DeFiZap

DefiZap does something more complex, as it assembles different assets within a so-called Zap, which is a multi-asset derivative product, structured with even complex programmable logics.

Even Erasure and Augur allow the creation of derivative products on very sophisticated blockchains.

Augur

Augur

Augur, for example, is a decentralized oracle for prediction markets that allows anyone to create a market based on the outcome of whatever event in the real world. This allows users to trade on the outcome of an event by buying and selling its derivative, the price of which reflects the probability of a given outcome.

Erasure

Erasure Protocol

Erasure is similar, a decentralized data market for predictions, allowing users to upload their forecasts and bet cryptocurrencies such as Numeraire (NMR) or DAI.

But this is only the beginning, since the greatest potential of these tools will be manifested when it will be possible to create derivatives on blockchains that can also be traded freely on decentralized exchanges. In fact, decentralized exchanges have some advantages that make them completely different from classic centralized exchanges where shares, securities, bonds, futures contracts or other traditional financial products are commonly traded.

First, they do not require KYC, i.e. they can be used anonymously.

They can be used Anonymously

In addition to this, they cannot be stopped, limited or hindered in the same way as decentralized cryptocurrencies. Nor can their use be restricted to certain countries or user groups or their trading volumes be controlled. Finally, they are non-custodial, i.e. they do not require users to actually entrust the storage of their assets to third parties, but they always remain in full exclusive possession of their assets.

All these things are not possible on current stock markets, or the like, and are only possible on decentralized exchanges. These, however, also have drawbacks, such as the fact of being able to use only blockchain-based digital assets (often only on Ethereum), and not yet have enough liquidity to be used as an alternative to the classic centralized exchanges. However, the more the needs related to the particular characteristics highlighted above grow, the more the demand should increase, and therefore the liquidity.

For this reason, derivatives on blockchain, and specifically the decentralized ones on Ethereum, are probably just at the beginning, and could still require some time before demonstrating their full potential. In particular, it is not so much the trivial derivatives, such as stablecoins, that can make the difference, but the more complex ones, such as futures contracts, which could introduce rare instruments in the decentralized market, allowing traders to hedge themselves against risk.

If anything, perhaps this is where the most important game is played with regard to the spread of derivative products on blockchain, and the consequent increase in the appeal of decentralized exchanges to professional investors. However, there are always obstacles lurking. In fact, these blockchain derivatives are fully verifiable as long as they remain on the blockchain. But when they collect data from the physical world, for example, or from traditional financial markets, there is a potential element of imbalance, or insecurity, that could undermine their proper functioning.

This is achieved by using oracles which, although they can be decentralized, extract data from non-decentralized sources, i.e. theoretically manipulable. Therefore, it will not be sufficient to create derivative products and put them on decentralized exchanges for them to be used, but it will also be necessary to make sure that they work properly, even when one is forced to link them to information coming from centralized sources.

To be fair, some DeFi derivatives, such as stablecoins, are showing that these risks may be lower than theoretically possible, but this observation cannot be extended generically to all crypto derivatives. In fact, the risks are higher when a very small number of sources have to be used, or when the quality of the individual sources used is not high enough.

It is safe to say that 2020 could be a pivotal year for testing these innovations, in order to fully understand all the advantages and disadvantages, as well as all the risks. Many more tests are still needed to be able to state that DeFi is ready to accept large trading volumes of these new derivatives, although it is certain that giant strides have already been made in a very short time, and over the next few months, it will be clear whether they are enough to get this market off the ground or not.

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