Derivatives are financial weapons of mass destruction.

Warren Buffett

Derivatives are one of the most sought-after financial instruments of mankind. With its total netted value at a mammoth $12.3 Trillion as of 2021 (Source - Investopedia.) They play a pivotal role in smoothening the rough edges(arbitrage opportunities) as well boost the liquidity of any market.

In the mid-2010s when crypto started grabbing eyeballs from all over the world. It was inevitable that we will get to see crypto derivatives as well. Bitmex launched the XBTUSD perpetual swap in 2016. which become an instant hit. Other centralized exchanges followed the suit and the users had access to a multitude of derivatives products of the most valued crypto tokens.

However when it came to the DeFi boom of 2020 primarily consisted of simple DEXs and lending/borrowing platforms. Derivates being a more complex product took longer to take off and still playing the catch-up game.

At the time of writing, derivatives contributed a TVL of about $2.2 billion to the DeFi space which is a mere 3.31% of the total TVL(source-Defillama ) . These numbers are just a drop in the ocean when compared to the role of derivatives in traditional finance.

Looking at the distribution of the total derivatives TVL. The bulk of the Total of it is locked up in a few protocols. It is no surprise that the top 5 derivative protocols include dydx , Synthetix , and Perpetual protocol which were the early pioneers and managed to build upon their credibility.

Remember this for the rest of your life. Whenever you see a legacy finance product being replicated On-chain. It will always come with added innovations.

And so are the derivatives.

In a short span of time, we have seen four main DeFi exclusive derivative products.

• Perpetual futures

The most popular derivative product that is being offered by the protocols is perpetual futures.

Though proposed in 1992 by the famed economist Robert Shiller, the concept could never materialize in TradFi.

As the name ‘perpetual’ suggests perpetual futures have no expiry date and the mark price of the contract is almost always equal to the spot price of the asset except in extremely volatile scenarios. These prices are maintained with the help of a funding rate.

The funding rate is the summation of the interest rate and the premium whose calculation method varies from protocol to protocol. it is the premium that ensures that the futures price coverage is the spot price. While the interest rate is part of the funding rate as most futures contracts are leveraged.

In case the futures contract price is lower than the spot price. Short holders would pay long holders which would drive the futures price up. The inverse would happen when the futures contract prices are higher than the spot price. On most of the platforms, the funding rate is revised and paid every 8 hours. All other facets of perpetual futures like margin account, and the maintenance margin is the same as the traditional futures contract.

• Squeeths

Squeeth is just a condensed way to say squared ETH. It is developed by Opyn and is the first use case of the concept of power perpetual, with its high convexity and gamma it gives an option like exposure to the traders.

Squeeths can be both long and short. The payoff of a long squeeth would be much more when compared to a 2X leveraged position and moreover, the downside of a squeeth would be limited due to no liquidation and high convexity, in layman’s terms having a high convexity simply implies that the in case the asset price goes up or down by an equal proportion. The proportion of your profit would far exceed the proportion of your losses.

However, there is no free lunch in finance, the price that you need to pay for long squeeths is the pocket-burning funding rate.

The average funding rate of squeeths to date is 0.25% per day. This is several times higher than what you might pay for a normal ETH perpetual futures contract.

Short Squeeth holders get to earn this attractive funding rate however the downside of short squeeths is that it is possible to get liquidated as collateral needs to be deposited to mint the Squeeths.

I highly recommend reading the paper on power perpetual to have a deeper understanding of squeeths.

• Synthetic assets

Synthetic assets are a form of derivatives that enable users to trade legacy assets like stocks, and commodities in a decentralized manner. This is particularly useful for people who live in places that lack access to quality assets as well as DeFi natives who would like to have exposure to legacy assets without having to join the centralized platforms.

So how is it even possible to replicate a legacy asset on the blockchain, you might ask? The answer lies in blockchain oracles and the minting mechanism. For example, A user on Synthetix deposits the SNX token as collateral and mints sJPY according to the set collateral ratio. The collateral ratio ensures that the system stays solvent.

This token tracks the price of Japanese yen via a reliable oracle such as chainlink. Once the token is minted the user can then add it to various liquidity pools and anyone who wants to have a long position in sJPY can then buy it.

While the minters would be technically shorting the tokens that they minted using their collateral. They will also get a yield by adding the minted tokens to the liquidity pool.

After the fall of mirror finance (Blame Do Kwon) , Synthetix is the only well-known protocol offering synthetic assets. However, we can expect many new players to enter this space soon.Kresko.fi is one of them to watch out for.

• Triple yield decentralized option vaults

Decentralized Option vaults or DOVs are a great way to have exposure to options passively. All a user needs to do is deposit his funds in the DOV contract and sit back. Essentially the DOV contract would act as a liquidity provider for options trading. Ex: A user deposits 10 SOL in the SOL covered call DOV by Psyfinance This vault is integrated with Serum which would distribute this liquidity on its DEXs. Any user trading these options would have to pay an option premium. This premium would flow to the SOL-covered call DOV and the vault LPs would get rewarded In addition to the option premium,

DOVs might also offer Staking rewards and Native token rewards Thus giving a user three sources of yield which don’t exist is the legacy option vaults

Moreover, the yield from DOVs is generally more organic than simple liquidity farming as the bulk of yield comes from the options premium unlike traditional yield farming where the yield is dependent on the price of the native token and in a lot of cases is eroded due to token inflation, leading to the problem of mercenary yield farming.

• L2s / alternative L1s are the blue-eyed children -

  Every novel derivative protocol started on Ethereum, after all, it is the breaking bad of DeFi . However, the high gas fees have a huge impact on derivative transactions. Most derivative users are traders and tend to have a high volume of transactions. The high gas fees on Ethereum can easily wipe off the entire profit for the traders.

  Thus almost every Ethereum native derivate protocol is now present on an L2 or less commonly a more scalable network like Avalanche. Their L2 transaction volume and TVL is increasing at a greater pace than their native platform on Ethereum. The biggest proponent of this trend has been dydx which is going to switch to Cosmos for their V4 launch.

  In other news, Synthetix´s TVL on Optimism has almost doubled in the last 6 months but it has halved on Ethereum during the same time. This trend should continue for all derivatives protocols until the scalability issues of Ethereum are solved.

• Composability is stronger than ever.

  Composability is one of the fundamental pillars of DeFi. Derivatives is a category where it truly shines. Derivatives have a lot of moving parts, and integration with various protocols to synergize those parts brings a lot more value to the protocol ecosystem. For example: When Synthetix created an integration with Curve and 1inch to create atomic swaps for synths. It increased the trading volume and fees by several times and made Synthetix one of the highest revenue-generating protocols. On average $300-600k per day in trading fees was being returned directly to SNX stakers. This boosted the SNX token as well which was underperforming for quite some time by encouraging more users to acquire it and stake it.

  While this is an example of intra-composability where a protocol integrates with other protocols. Protocols have also focused on inter composability where they encourage builders in their community to build another solution on top of the protocol layer. Example - TradeVaults is a DeFi marketplace turning trading strategies into investable vaults, utilizing perpetual protocol v2 as the backend, which will go live soon.

  As the protocols grow and introduce more complex derivative products they will have to turn themselves into DeFi legos. Composability would also be the breakout option for the protocols that have hit the plateau and want to rejuvenate their growth.

• Bear market? No problem.

  It’s no secret that the crypto winter is officially here. The total TVL in DeFi is down by 60% in the last 3 months. However, most top derivatives protocols have managed to thrive. As seen in the protocol Revenue per day graph below. Barring DYDX all other protocols have had revenues similar to the time period before the crash. For Synthetix and GMX managed to reach their all-time revenue per day highs during this market.

  The daily TVL graphs are more in line with the overall DeFi sentiment however they also indicate that despite the falling TVL most protocols managed to maintain similar revenue levels, again

*

Final Thoughts

While the DeFi 1.0 was dominated by DEXes, Lending/Borrowing, and yield aggregators. Derivatives might dominate DeFI 2.0, for any asset class in the TradFi the notional value of its derivates far exceed the market value of the asset. The current DeFi derivatives landscape looks ready to replicate the same.

However it would be lame to get ahead of ourselves, DeFi derivates are in their infancy There is a long way to go in improving the risk management of the protocols, user experience, and launching more sophisticated products.

There are also issues outside the protocol level with regulations being the biggest one that would play a critical role in shaping the future DeFi derivatives.

But for now, I highly recommend trying the unique DeFi derivatives offerings and satiate the degeness within you.

Disclaimer: This piece is only for educational purposes and is not to be taken as financial advice. Liquidity Evolved would not be responsible for any of your Ls, DYOR.

Derivatives are financial weapons of mass destruction.

Warren Buffett

Derivatives are one of the most sought-after financial instruments of mankind. With its total netted value at a mammoth $12.3 Trillion as of 2021 (Source - Investopedia.) They play a pivotal role in smoothening the rough edges(arbitrage opportunities) as well boost the liquidity of any market.

In the mid-2010s when crypto started grabbing eyeballs from all over the world. It was inevitable that we will get to see crypto derivatives as well. Bitmex launched the XBTUSD perpetual swap in 2016. which become an instant hit. Other centralized exchanges followed the suit and the users had access to a multitude of derivatives products of the most valued crypto tokens.

However when it came to the DeFi boom of 2020 primarily consisted of simple DEXs and lending/borrowing platforms. Derivates being a more complex product took longer to take off and still playing the catch-up game.

At the time of writing, derivatives contributed a TVL of about $2.2 billion to the DeFi space which is a mere 3.31% of the total TVL(source-Defillama ) . These numbers are just a drop in the ocean when compared to the role of derivatives in traditional finance.

Looking at the distribution of the total derivatives TVL. The bulk of the Total of it is locked up in a few protocols. It is no surprise that the top 5 derivative protocols include dydx , Synthetix , and Perpetual protocol which were the early pioneers and managed to build upon their credibility.

Remember this for the rest of your life. Whenever you see a legacy finance product being replicated On-chain. It will always come with added innovations.

And so are the derivatives.

In a short span of time, we have seen four main DeFi exclusive derivative products.

• Perpetual futures

The most popular derivative product that is being offered by the protocols is perpetual futures.

Though proposed in 1992 by the famed economist Robert Shiller, the concept could never materialize in TradFi.

As the name ‘perpetual’ suggests perpetual futures have no expiry date and the mark price of the contract is almost always equal to the spot price of the asset except in extremely volatile scenarios. These prices are maintained with the help of a funding rate.

The funding rate is the summation of the interest rate and the premium whose calculation method varies from protocol to protocol. it is the premium that ensures that the futures price coverage is the spot price. While the interest rate is part of the funding rate as most futures contracts are leveraged.

In case the futures contract price is lower than the spot price. Short holders would pay long holders which would drive the futures price up. The inverse would happen when the futures contract prices are higher than the spot price. On most of the platforms, the funding rate is revised and paid every 8 hours. All other facets of perpetual futures like margin account, and the maintenance margin is the same as the traditional futures contract.

• Squeeths

Squeeth is just a condensed way to say squared ETH. It is developed by Opyn and is the first use case of the concept of power perpetual, with its high convexity and gamma it gives an option like exposure to the traders.

Squeeths can be both long and short. The payoff of a long squeeth would be much more when compared to a 2X leveraged position and moreover, the downside of a squeeth would be limited due to no liquidation and high convexity, in layman’s terms having a high convexity simply implies that the in case the asset price goes up or down by an equal proportion. The proportion of your profit would far exceed the proportion of your losses.

However, there is no free lunch in finance, the price that you need to pay for long squeeths is the pocket-burning funding rate.

The average funding rate of squeeths to date is 0.25% per day. This is several times higher than what you might pay for a normal ETH perpetual futures contract.

Short Squeeth holders get to earn this attractive funding rate however the downside of short squeeths is that it is possible to get liquidated as collateral needs to be deposited to mint the Squeeths.

I highly recommend reading the paper on power perpetual to have a deeper understanding of squeeths.

• Synthetic assets

Synthetic assets are a form of derivatives that enable users to trade legacy assets like stocks, and commodities in a decentralized manner. This is particularly useful for people who live in places that lack access to quality assets as well as DeFi natives who would like to have exposure to legacy assets without having to join the centralized platforms.

So how is it even possible to replicate a legacy asset on the blockchain, you might ask? The answer lies in blockchain oracles and the minting mechanism. For example, A user on Synthetix deposits the SNX token as collateral and mints sJPY according to the set collateral ratio. The collateral ratio ensures that the system stays solvent.

This token tracks the price of Japanese yen via a reliable oracle such as chainlink. Once the token is minted the user can then add it to various liquidity pools and anyone who wants to have a long position in sJPY can then buy it.

While the minters would be technically shorting the tokens that they minted using their collateral. They will also get a yield by adding the minted tokens to the liquidity pool.

After the fall of mirror finance (Blame Do Kwon) , Synthetix is the only well-known protocol offering synthetic assets. However, we can expect many new players to enter this space soon.Kresko.fi is one of them to watch out for.

• Triple yield decentralized option vaults

Decentralized Option vaults or DOVs are a great way to have exposure to options passively. All a user needs to do is deposit his funds in the DOV contract and sit back. Essentially the DOV contract would act as a liquidity provider for options trading. Ex: A user deposits 10 SOL in the SOL covered call DOV by Psyfinance This vault is integrated with Serum which would distribute this liquidity on its DEXs. Any user trading these options would have to pay an option premium. This premium would flow to the SOL-covered call DOV and the vault LPs would get rewarded In addition to the option premium,

DOVs might also offer Staking rewards and Native token rewards Thus giving a user three sources of yield which don’t exist is the legacy option vaults

Moreover, the yield from DOVs is generally more organic than simple liquidity farming as the bulk of yield comes from the options premium unlike traditional yield farming where the yield is dependent on the price of the native token and in a lot of cases is eroded due to token inflation, leading to the problem of mercenary yield farming.

• L2s / alternative L1s are the blue-eyed children -

  Every novel derivative protocol started on Ethereum, after all, it is the breaking bad of DeFi . However, the high gas fees have a huge impact on derivative transactions. Most derivative users are traders and tend to have a high volume of transactions. The high gas fees on Ethereum can easily wipe off the entire profit for the traders.

  Thus almost every Ethereum native derivate protocol is now present on an L2 or less commonly a more scalable network like Avalanche. Their L2 transaction volume and TVL is increasing at a greater pace than their native platform on Ethereum. The biggest proponent of this trend has been dydx which is going to switch to Cosmos for their V4 launch.

  In other news, Synthetix´s TVL on Optimism has almost doubled in the last 6 months but it has halved on Ethereum during the same time. This trend should continue for all derivatives protocols until the scalability issues of Ethereum are solved.

• Composability is stronger than ever.

  Composability is one of the fundamental pillars of DeFi. Derivatives is a category where it truly shines. Derivatives have a lot of moving parts, and integration with various protocols to synergize those parts brings a lot more value to the protocol ecosystem. For example: When Synthetix created an integration with Curve and 1inch to create atomic swaps for synths. It increased the trading volume and fees by several times and made Synthetix one of the highest revenue-generating protocols. On average $300-600k per day in trading fees was being returned directly to SNX stakers. This boosted the SNX token as well which was underperforming for quite some time by encouraging more users to acquire it and stake it.

  While this is an example of intra-composability where a protocol integrates with other protocols. Protocols have also focused on inter composability where they encourage builders in their community to build another solution on top of the protocol layer. Example - TradeVaults is a DeFi marketplace turning trading strategies into investable vaults, utilizing perpetual protocol v2 as the backend, which will go live soon.

  As the protocols grow and introduce more complex derivative products they will have to turn themselves into DeFi legos. Composability would also be the breakout option for the protocols that have hit the plateau and want to rejuvenate their growth.

• Bear market? No problem.

  It’s no secret that the crypto winter is officially here. The total TVL in DeFi is down by 60% in the last 3 months. However, most top derivatives protocols have managed to thrive. As seen in the protocol Revenue per day graph below. Barring DYDX all other protocols have had revenues similar to the time period before the crash. For Synthetix and GMX managed to reach their all-time revenue per day highs during this market.

  The daily TVL graphs are more in line with the overall DeFi sentiment however they also indicate that despite the falling TVL most protocols managed to maintain similar revenue levels, again

*

Final Thoughts

While the DeFi 1.0 was dominated by DEXes, Lending/Borrowing, and yield aggregators. Derivatives might dominate DeFI 2.0, for any asset class in the TradFi the notional value of its derivates far exceed the market value of the asset. The current DeFi derivatives landscape looks ready to replicate the same.

However it would be lame to get ahead of ourselves, DeFi derivates are in their infancy There is a long way to go in improving the risk management of the protocols, user experience, and launching more sophisticated products.

There are also issues outside the protocol level with regulations being the biggest one that would play a critical role in shaping the future DeFi derivatives.

But for now, I highly recommend trying the unique DeFi derivatives offerings and satiate the degeness within you.

Disclaimer: This piece is only for educational purposes and is not to be taken as financial advice. Liquidity Evolved would not be responsible for any of your Ls, DYOR.