Derivatives help traders manage risk and speculate on asset prices. Traditionally based on stocks or commodities, they have now evolved into on-chain derivatives, operating entirely on decentralized networks. Unlike centralized platforms, these derivatives offer transparency, composability, and censorship resistance, allowing traders to engage in futures, options, and synthetic assets without intermediaries. In this article, SwapSpace CEO Andrew Wind explores the mechanics, benefits, innovations and risks of on-chain derivatives.

On-chain derivatives are financial contracts executed and settled on blockchain networks without relying on traditional financial institutions. Their value is linked to underlying assets, such as cryptocurrencies, stablecoins, or real-world assets, and is enforced through smart contracts.

On-chain vs. centralized derivatives

Traditional derivatives markets rely on intermediaries, such as brokers, to facilitate trading and settlement. In contrast, on-chain derivatives operate through decentralized protocols, removing the need for third-party trust. Settlement is automated via smart contracts, reducing counterparty risk and ensuring transparency.

Key features of on-chain derivatives

1. Decentralization – no single entity controls the market.

2. Transparency – transactions are recorded on public ledgers.

3. Composability – on-chain derivatives integrate seamlessly with other DeFi applications like lending platforms and yield farming.

4. 24/7 Availability – unlike traditional markets, they operate without restrictions.

By eliminating intermediaries, on-chain derivatives create a more efficient, trustless, and permissionless trading environment, opening new possibilities for financial innovation.

Interesting fact! The on-chain derivatives market has experienced significant growth, with derivatives trading accounting for approximately 71% of all digital asset trading volumes. Open interest in crypto derivatives surpassed $40 billion for the first time in 2025, indicating a deepening market. This surge is partly due to the ability of derivatives to offer leverage, allowing traders to amplify their positions without substantial capital.

On-chain derivatives come in various forms, each serving unique purposes in DeFi. The most common categories include futures and perpetual swaps, options, and synthetic assets, all of which enable traders to hedge risk, speculate on price movements, or gain exposure to different assets without direct ownership.

1. Futures and perpetual swaps

Futures contracts allow traders to agree on buying or selling an asset at a predetermined price on a future date. However, in DeFi, perpetual swaps are more popular. Unlike traditional futures, perpetual contracts have no expiration date, enabling traders to maintain positions indefinitely, provided they meet margin requirements.

A key feature of perpetual swaps is the funding rate mechanism, which ensures the contract price stays close to the underlying asset’s market price. If the contract price exceeds the spot price, long traders pay a fee to short traders, and vice versa.

Notable protocols:

• dYdX – Order book-based perpetual trading on Layer 2.

• GMX – Liquidity pool-based perpetual swaps with zero price impact trades.

• Perpetual Protocol – AMM-based perpetual swaps on Ethereum and Arbitrum.

2. Options and structured products

Options grant the right (but not the obligation) to buy or sell an asset at a set price before a certain date. DeFi options platforms leverage automated market makers or decentralized order books for permissionless trading.

Some protocols also offer structured products, combining options with yield strategies to create automated financial instruments that optimize returns.

Notable protocols:

• Lyra – AMM-based options trading on Optimism.

• Ribbon Finance – Structured vaults using options strategies.

• Premia – Decentralized options marketplace.

3. Synthetic assets and tokenized derivatives

Synthetic assets mirror the value of real-world assets such as stocks, commodities, or fiat currencies on the blockchain. These derivatives provide exposure to traditional markets without requiring direct ownership.

Notable protocols:

• Synthetix – Collateral-backed synthetic asset issuance.

• UMA – Customizable financial contracts for synthetic assets.

• Injective Protocol – Cross-chain derivatives and synthetic markets.

Each of these derivative types plays a vital role in expanding DeFi’s financial infrastructure, making markets more accessible and efficient.

Each of these derivative types plays a vital role in expanding DeFi’s financial infrastructure, making markets more accessible and efficient.

The rapid evolution of DeFi has driven major innovations in on-chain derivatives, making them more efficient, scalable, and accessible. Some of the most significant advancements include AMMs for derivatives, decentralized order books, oracle-driven pricing mechanisms, and composability with DeFi Legos.

1. AMMs for derivatives

   Traditional derivatives markets rely on order books, but DeFi protocols have introduced AMM-based derivatives trading to provide continuous liquidity. Unlike spot AMMs, which facilitate simple token swaps, derivatives-focused AMMs dynamically adjust liquidity based on demand and volatility. These mechanisms help reduce slippage and improve capital efficiency. For example, Perpetual Protocol uses a virtual AMM (vAMM) to enable leverage trading without requiring counterparties.

2. Decentralized order books and hybrid models

   While AMMs enhance accessibility, many traders prefer the precision of order books. Decentralized order book models are emerging, leveraging Layer 2 solutions and off-chain order matching to combine the benefits of CEX-like efficiency with DeFi’s transparency. For instance, dYdX uses a Layer 2 order book to offer high-speed, low-cost perpetual trading.

3. Oracle-driven pricing and risk mitigation

   On-chain derivatives rely on oracles to fetch real-time price data. Innovations in oracle design, such as decentralized price feeds and time-weighted average pricing (TWAP), help mitigate price manipulation and front-running risks. For example, Chainlink and Pyth provide high-frequency price updates for derivatives protocols.

4. Composability and DeFi legos

   On-chain derivatives integrate seamlessly with other DeFi applications, enabling structured vaults, yield strategies, and leverage stacking. This composability allows traders to build advanced financial strategies directly on-chain. Ribbon Finance uses option vaults to automate covered call and put-selling strategies, generating yield on crypto assets.

Interesting fact!* Joachim Emanuelsson, chief executive for EMEA energy and commodities at TP ICAP, envisions trading climate transition products, including weather derivatives and carbon offsets. He emphasizes the potential in trading new climate-related products, driven by growing market competence and data, highlighting the evolving nature of derivatives markets.* 

While on-chain derivatives offer significant advantages, they also come with some risks that traders and protocols must navigate.

• Liquidity constraints and slippage. Many on-chain derivatives protocols face liquidity fragmentation, leading to high slippage, wider spreads, and inefficient price execution. This makes it harder for traders to open and close large positions without losses. To address this, protocols incentivize liquidity providers through yield farming and staking.

• Smart contract vulnerabilities. DeFi protocols use smart contracts for automated trading, but bugs and exploits can cause losses. Hackers target vulnerabilities like reentrancy attacks and flash loans. Security audits and bug bounties help, but no system is entirely foolproof.

• Oracle manipulation and front-running. On-chain derivatives rely on oracles for real-time pricing, making them prone to manipulation and delays. Attackers can exploit low-liquidity assets or lagging updates, triggering unfair liquidations or flash loan exploits to drain funds.

• Regulatory uncertainty. Governments and regulators are closely watching DeFi derivatives because they mix elements of traditional finance and decentralized systems. Given the unclear regulatory landscape, on-chain derivatives face potential legal challenges, restrictions, or compliance requirements that may limit accessibility and adoption.

Important!* Rostin Behnam, chair of the U.S. Commodity Futures Trading Commission (CFTC), highlighted a regulatory gap concerning cryptocurrencies, emphasizing the need for comprehensive oversight of digital assets. He noted that many digital tokens classify as commodities, fitting within the CFTC's purview, and called for more scrutiny to ensure market integrity.* 

On-chain derivatives are still in their early stages, but rapid innovation is shaping their future. Key developments such as Layer 2 scaling, cross-chain interoperability, institutional adoption, and AI-driven automation will play a crucial role in expanding the market and improving efficiency.

1. Layer 2 scaling for cost efficiency

   High gas fees on Ethereum have historically limited the growth of on-chain derivatives. Layer 2 solutions like Arbitrum, Optimism, and zkSync are making trading more accessible by reducing transaction costs and improving execution speed. Moreover, as of October 2024, Ethereum Layer 2 solutions have seen moderate growth, with the total value locked (TVL) in bridged protocols reaching $19.8 billion, a 1.2% increase from September. More derivatives protocols are migrating to these solutions, enabling smoother trading experiences.

2. Cross-chain interoperability and omnichain derivatives

   Currently, derivatives markets are fragmented across different chains, limiting liquidity and user experience. The rise of cross-chain bridges and omnichain derivatives will allow seamless trading across multiple blockchains, improving market depth. Protocols like LayerZero are leading efforts to connect derivatives markets across ecosystems.

3. Institutional adoption and regulatory clarity

   As institutional players enter DeFi, we will likely see a rise in compliant, KYC-enabled derivatives platforms that cater to professional traders while maintaining decentralization. Clearer regulations could encourage traditional financial institutions to integrate DeFi derivatives into their strategies.

4. AI-driven trading and automation

   AI-powered strategies and automated trading bots will enhance efficiency in DeFi derivatives, optimizing market-making and risk management. Smart contract-driven structured products and AI-assisted risk assessment could make on-chain derivatives more sophisticated and accessible. By the end of 2025, it's expected that AI-driven agents will execute at least 20% of all on-chain DeFi trading volume, enhancing efficiency and enabling more sophisticated trading strategies. With these advancements, on-chain derivatives have the potential to rival traditional financial markets, offering a decentralized, transparent, and efficient alternative for global traders.

On-chain derivatives are transforming finance by enhancing transparency, efficiency, and accessibility. They eliminate intermediaries, reduce counterparty risk, and integrate seamlessly with DeFi. While challenges like liquidity constraints, security risks, and regulatory uncertainty persist, innovations in Layer 2 scaling, cross-chain interoperability, and AI-driven automation are addressing them. As DeFi evolves, on-chain derivatives will shape its future, providing a strong alternative to traditional markets and unlocking new opportunities for traders worldwide.