The Fundamentals of Decentralized Derivatives
Derivatives are one of the most sophisticated market instruments in the financial ecosystem. According to the Bank of International Settlements (BIS), as of 2019, the entire derivatives market was estimated to be $640 trillion. As of 2020, the market cap of the derivatives market was estimated to be $1.2 quadrillion or $1200 trillion.
The onset of Decentralized Finance or DeFi has changed the fundamentals of the derivatives market. DeFi derivatives have become a powerful tool with the potential to disrupt the industry and bring a new class of investors and institutions.
In this detailed post, we look at the concept of decentralized derivatives and their fundamentals. Before that, let’s understand what financial derivatives are.
What are Derivatives?
A derivative is a financial contract between two parties that derives its price from an underlying asset. The most common underlying assets for derivatives include stocks, bonds, commodities, currencies, and indices. The contract specifies the conditions between two parties who transact with each other. These conditions are a pre-determined time period, underlying asset variable and its definition, the notional amount, and contractual obligations.
With this purview, a derivative is two parties entering agreement where one stands to make a profit if a specified asset (such as stock) appreciates in value over a specified time period while the other makes a profit if the price of the asset falls.
Derivatives offer several benefits to investors. Initially, derivatives were used to hedge risks of price movements in assets like commodities such as coffee or rice. Apart from mitigating risks of assets, they are also used by investors to make profits from making accurate speculations. Moreover, one of the most prominent benefits of derivatives is that they enable interaction with the asset without actually owning it.
The Derivatives Market
Derivatives contracts are usually carried out over two markets:
- Over the Counter (OTC) — In the OTC market, parties engage privately with each other. The underlying asset may not be listed on any exchange.
- Exchange-Traded — Derivative contracts with assets listed on public exchange platforms are known as exchange-traded derivatives. The terms of contracts are public.
In both these markets, derivatives contracts require a trusted intermediary or third party to monitor the transaction and govern the terms of the contract between two parties. Moreover, the restrictions on several factors, including geographical barriers and accessibility, have created unfair market dynamics in the derivatives industry.
Decentralized Finance or DeFi has all the legos and tools to offer derivatives financial instruments in a decentralized, trustless, permissionless, and peer-to-peer manner.
DeFi derivatives have opened up a whole new asset class and are gaining increasing relevance in the last few years. DeFi derivatives can offer all the services of a traditional derivatives market along with enabling the benefits from blockchain innovation.
The recent expansion of the blockchain ecosystem with smart contracts, tokenization of assets, and oracles facilitate the necessary tools to open the doors for innovation in decentralized derivatives. Apart from the advantages of conventional derivatives contracts, decentralized derivatives on blockchain facilitate benefits which include:
- Peer-to-Peer — Decentralized derivatives can be exchanged directly between two parties on a peer-to-peer network without the need for any intermediary organization governing operations.
- Tokenization — Blockchain allows issuance of synthetic assets — a tokenized derivative that follows the price of an underlying tangible asset. With tokenization, a physical asset can be divided into equal fractions and is represented with tokens on the decentralized ledger.
- Permissionless — DeFi allows a permissionless architecture for engaging with decentralized derivatives, thereby rebalancing the market dynamics by enabling fair opportunities for institutions and investors of all sizes.
- Liquidity — The fractional division of a tokenized derivative and the removal of geographical barriers facilitate increased liquidity in assets.
- Trustless — The fundamentals of engaging with decentralized derivatives are through automated smart contracts with decentralized price feeds and oracles. This enables a trustless architecture for parties to engage with derivative contracts.
DeFi has the potential to fundamentally change the derivatives market, offering a fair and equally accessible way of engaging with derivatives. At Octopus Protocol, we are building a DeFi protocol that offers unparalleled access and exposure to real-world assets through tokenized derivatives or synthetic assets.
About Octopus Protocol
Octopus Protocol, a robust DeFi protocol built on the Binance Smart Chain (BSC), allows issuance, trade, and management of decentralized derivative assets. Leveraging the technological innovation of blockchain, Octopus Protocol facilitates a platform that offers unparalleled access and exposure to real-world assets, thereby enabling a fair way to engage with synthetic assets and giving equal opportunities to access derivatives.
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