Mary Amakihi 
From Interest Rate Swaps to Futures: Types of DeFi Derivatives
DeFi derivatives are a relatively new approach to indirectly interacting with cryptocurrencies and other blockchain assets. This article will walk you through the types of DeFi derivatives and their unique features.
Derivatives are contracts between a buyer and a seller. These instruments can be classified as option or lock contracts. Options allow contract holders to sell or acquire the underlying asset before expiration.
In contrast, lock derivatives bind trade participants to the agreed-upon underlying price until expiration. Remember, investors are not required to own the underlying security or asset.
For example, ProShares Bitcoin Strategy (BITO) is an exchange-traded fund (ETF) that does not hold any Bitcoin on the Bitcoin network. Instead, the fund monitors the price of Bitcoin while charging a charge.
As a result, investors no longer have to worry about the custody difficulties associated with having BTC in a wallet.
Instead, BITO holds cash-settled futures contracts with expiration dates. Investors acquire these contracts in the same way that they buy ordinary shares, including placing limit orders.
Nonetheless, futures contracts must be repurchased because they expire monthly.
Although this raises monthly administration fees, investors who want to avoid the trouble of shifting BTC prefer this BTC-exposure trading option.
That is how derivatives work. Before explaining the types of DeFi derivatives, let us see what exactly DeFi derivatives are.
What Are DeFi Derivatives?
DeFi derivatives, like traditional derivatives, are used to hedge price risk and get exposure to a specific asset without actually owning it.
The primary distinction between DeFi derivatives and regular derivative contracts is that they are built on smart contracts housed on the blockchain.
Smart contracts automate transactions in a transparent system, eliminating the need for mediators and leaving the protocol as the only middleman.
Although DeFi derivatives’ values are often linked to cryptocurrency markets, they also reflect the values of commodities, fiat currencies, stocks, and other traditional assets.
How Does DeFi Derivatives Work?
The objectives driving DeFi derivatives are similar to those in traditional finance: hedging price risk and acquiring exposure to a particular asset or market without directly participating.
DeFi derivatives’ values are frequently linked to cryptocurrency markets, while in some situations, they mirror the value of cash, commodities, and other traditional assets.
Like many different aspects of decentralized finance, DeFi derivatives frequently rely on smart contract technology and other technology-enabled solutions.
Using automated market makers for derivatives trading might be complicated; however, numerous technological methods exist to address this issue.
For example, a virtual liquidity machine can use a smart contract to build a consistent product that provides long- and short-term liquidity.
Virtual liquidity machines reduce liquidity provider risk by removing the liquidity provider position and shifting the risk to the protocol.
Many DeFi derivatives protocols enable users to generate synthetic assets with values based on underlying real-world assets.
Synthetix, for example, allows traders to purchase and sell derivatives linked to cryptocurrencies, commodities, fiat currencies, equities, indices, and other assets.
Most exchanges that sell Defi derivatives allow traders to employ leverage, an essential aspect of derivatives.
Leverage enables traders to boost their risk-to-reward ratio by putting a small amount of capital upfront for potentially significant returns.
For example, if an investor believes that the price of a given cryptocurrency will rise, they can simply buy a certain amount of that cryptocurrency at the current market price.
Instead, the investor can make significant gains by leveraging a much lesser sum in derivatives. Of course, if they get it wrong, they could suffer substantial losses.
Recognizing that regulatory concerns may occur for some DeFi derivatives is critical.
The United States Securities and Exchange Commission has subpoenas to various cryptocurrency projects. It is involved in some high-profile lawsuits that could harm decentralized finance.
Without wasting any more time, let us delve straight into the types of DeFi derivatives.
Types of DeFi Derivatives
DeFi derivatives are accessible on cryptocurrency exchanges in various forms and are characterized according to their functionality and mechanics.
Here are the types of DeFi derivatives.
- Interest rate swaps
- Futures
- Perpetual futures derivatives
- Options derivatives
- Perpetual options derivatives
Interest Rate Swaps
This is the first among the types of DeFi derivatives that we will discuss here.
An interest rate swap is a forward contract that exchanges one stream of future interest payments for another based on a set principal amount.
Interest rate swaps often involve exchanging a fixed interest rate for a floating rate, or vice versa, to decrease or enhance exposure to interest rate swings or to get a somewhat cheaper interest rate than would have been achievable without the swap.
A swap can also include exchanging one form of variable rate for another, known as a basis swap.
Interest rate swaps involve exchanging one set of cash flows for another.
Because they trade over the counter (OTC), the contracts are between two or more parties based on their preferred parameters and can be tailored in various ways.
Swaps are commonly used when a corporation can borrow money at one interest rate but prefer another type.
Futures
Next, on the types of DeFi derivatives, we have futures.
Futures contracts are agreements to acquire or sell a specified underlying asset on a future date.
The underlying asset may be a commodity, a securities, or another financial instrument.
Futures trading requires the buyer or seller to purchase or sell the underlying asset at the fixed price, regardless of market price, on the expiration date.
Futures trading generally refers to futures with stock market securities as underlying assets.
These contracts are based on the future value of a specific company’s stock or a stock market index such as the S&P 500, Dow Jones Industrial Average, or Nasdaq.
Futures trading on markets like the Chicago Mercantile Exchange may involve underlying “assets” such as physical commodities, bonds, or meteorological events.
Perpetual Futures Derivative
Perpetual futures derivatives are the next among the types of DeFi derivatives that we will discuss.
Perpetual futures, also known as perpetual swaps or “perpetual,” are a type of derivative contract in which traders can bet on an asset’s future price without an expiration date. Perpetual futures, unlike ordinary futures contracts, have an endless holding period.
Perpetual futures are an increasingly popular financial tool, particularly for speculating on cryptocurrencies such as Bitcoin and Ethereum, but they can also be used to trade commodities and indexes.
They are popular because they offer greater leverage and may be more liquid than the spot crypto market.
Perpetual futures can be compared to perpetual options (XPOs), which do not have an expiry date.
Options DeFi Derivatives
An option is a derivative or a contract that grants the buyer the right but not the duty to buy or sell the underlying asset by a specific date (expiration date) at a predetermined price (strike price).
There are two kinds of options: calls and puts. American-style options may be exercised at any time before they expire. European-style options can be exercised only on their expiration date.
To enter into an option contract, the buyer must pay a premium.
Options are diverse financial products. These contracts involve a buyer and a seller, with the buyer paying a premium for the rights granted under the agreement.
Call options enable the holder to purchase the asset at a specific price within a specified timeframe. Put options allow the holder to sell the asset at a predetermined price within a particular time frame.
Each call option has a bullish buyer and a bearish seller, whereas put options have a bearish buyer and a bullish seller. Traders and investors purchase and sell options for a variety of reasons.
Options speculation enables a trader to maintain a leveraged position in an asset at a lesser cost than purchasing individual asset shares. Investors utilize options to hedge or minimize risk exposure in their holdings.
Perpetual Options Derivatives
A perpetual option is a non-standard or exotic financial option with no defined maturity or exercise restrictions.
While the life of a regular option might range from a few days to several years, a perpetual option (XPO) can be exercised at any time and has no expiration date.
Perpetual options are thus an American option, whereas European options can only be exercised on maturity.
XPO contracts are sometimes called “non-expiring options” or “expirationless options.”
An option contract grants the holder the right, but not the responsibility, to buy (for a call option) or sell (for a put option) a particular quantity of the underlying securities at a predetermined (strike) price on or before the option’s expiration date.
A perpetual option provides the same type of rights without expiration.
Perpetual options are technically categorized as exotic options because they are non-standard. Still, they can also be seen as plain vanilla options because the only difference is that there is no set expiration date.
For some investors, perpetual options offer an advantage over other instruments (especially when dividends and voting rights are not a top priority) because the strike price on a perpetual option allows the holder to select the buy or sell price point and their ability to buy/sell at that price does not expire.
Also, XPOs may be superior to ordinary options because they eliminate the expiration risk.
Risks and Advantages of DeFi Derivatives
Derivatives are financial goods, and like any other financial offering, they come with various benefits and opportunities, perils, and associated risks.
Counterparty risk is one of the most common risks of DeFi derivatives. Scenarios in which a side fails to fulfill the contract are prevalent and may result in unintended losses.
Also, regulatory uncertainty surrounding derivatives trading puts additional pressure on the niche’s future development and growth.
However, securitized contracts in the form of derivatives provide favorable conditions for the global audience’s widespread use of these financial tools.
Moreover, their accessibility, usage of decentralized technologies, and low costs make them even more desirable for exploration.
Conclusion
DeFi derivatives enable investors to restrict risk exposure while benefiting from price movement in underlying assets in a trustless environment.
As blockchain technology advances, we should expect new types of DeFi derivatives and new technological solutions to support derivatives trading on the blockchain.
Both DeFi and derivatives operate in complex settings. Putting them together is not for the weak of the heart.