Derivatives

Traditional banking does not offer any attractive interest rates anymore. Some of them even go so far as to have a negative deposit rate. Because of this, It is getting more popular by the day for investors to move their money from their banking account to centralized exchanges to buy stocks or crypto. And then there are investors who take it even further: They invest in DeFi. It is common knowledge to spread your investments in, for example, various stocks, crypto and indices to minimize risks. In case of stocks and indices, this would still require the investor to invest via centralized exchanges. Except… they don’t have to. At least, not anymore.

Stocks in crypto

The DeFi market is gaining more and more platforms that allow investors to invest in regular stocks such as Tesla, Apple or Google. These products are called synthetic assets and are in fact derivatives. By investing in these products, investors can still trade “shares” of companies via DEXES, and therefore spread investments more widely.

Now, the term derevatives might not ring a bell, and that’s ok. Before we dive into some DeFi platforms that use derivatives, let’s first explain what they are.

Derivatives

Derivatives are financial products based on an underlying asset, such as shares or commodities. A derivative gives the buyer the right to buy or sell a specific commodity at a specific price. The most well-known derivatives are options, swaps and futures.

These derivatives can have different underlying values, such as a stock, stock index, commodity or currency. They are mainly used to hedge risk or to speculate.

Financial derivatives are traded on the stock exchange, but also between parties. This is called over the counter (OTC). Derivatives owe their popularity to the fact that the contracts are standardized. The products are therefore easy to trade and the liquidity is high.

Because derivatives are available on stock exchanges, it is possible to take a position in the underlying asset through this product, such as a share or a commodity such as oil.

Types of derivatives

Here is an overview of the most common derivatives you’ll find in centralized exchanges:

  • Futures: A future is a forward contract in which the buyer and seller set a price and time at which the underlying financial product is delivered. The traders enter into an obligation by means of a future. Futures are available for financial products such as stock indices and government bonds, as well as physical products such as gold, silver and oil.
  • Options: An option is a financial product that gives the buyer of the option the right to buy shares at a predetermined price. In addition, the date on which the right can be exercised has also been determined, the so-called expiry date. The price at which the option is traded is called the option premium.
  • CFDs: The abbreviation CFD stands for Contract For Difference. With this product, an investor can easily speculate with leverage on a price rise or fall. With a CFD, the buyer and seller agree to settle the difference in value of the underlying asset from the moment of agreement.
  • Swaps: An interest rate swap is a financial product in which two parties exchange interest payments. An interest rate risk can be hedged or an interest position can be taken by means of this derivative. The value of the swap depends on the interest rate.

Risks of derivatives

In view of the many negative experiences that individuals (and companies) have with financial derivatives, the risks of these products are always emphasized. It is recommended that you read carefully about how a derivative works before you start trading them.

The most important risks are:

  • Leverage: Due to the leverage effect, a small price movement in the underlying asset can already cause a large change in the value of the derivative. From a technical point of view, losses can often even be unlimited. On the other hand, it goes without saying that an enormous profit can be made through derivatives.
  • Counterparty risk: Counterparty risk is mainly run with an over-the-counter transaction. As a private investor you usually have little to do with this. Nevertheless, it is important to know exactly what the risk entails.

Now, with that out of the way, let’s look at some of the DeFi platforms that support synthetic assets.

Synthetix

Synthetix is ​​a decentralized protocol for deploying synthetic assets on the Ethereum network. The project also includes the Synthetix.Exchange. The deployment of synthetic assets is done through Ethereum tokens called Synths, which can replicate the value of cryptocurrencies such as Bitcoin or Ether. The value can also be replicated of more traditional stocks such as Apple shares (AAPL). The protocol uses its own Ethereum token, SNX, to ensure the proper functioning of its services. SNX is thus used as a guarantee for the stability and liquidity of the various Synths offered to the users.

The difference between Synths and “regular” tokens is that their value fluctuates in relation to the underlying asset they replicate. To take a simple example: sBTC will have a similar value to traditional BTC. This allows the investor to take advantage of the fluctuations of the underlying assets without having to own them directly.

The following Synths are available:

  • Cryptocurrencies such as BTC, ETH and BNB.
  • Fiat currensies such as USD, EURO and JPY
  • Stockindices such as gold- and silverindices.
  • Inverse Synths, such as inverse Bitcoin.

UMA

UMA, short for Universal Market Access, is an Ethereum-based protocol that allows users to create custom synthetic tokens that can track the price of just about anything. To be more specific, UMA allows you to trade any asset with ERC-20 tokens without any real exposure to the asset itself. This allows anyone to access assets that would otherwise be out of their reach. The UMA token is used for protocol management and price oracle.

Since an investor can use almost any asset as collateral with UMA, you can use, for example, cUSDC. cUSDC is received after depositing USDC into Compound. In this example, cUSDC accrues the interest from the initial USDC deposit. With this token, it is then possible to create a synthetic token. This synthetic token can represent, for example, the price of gold. This token not only tracks the price of gold, but also earns 10% interest per year through the USDC that is locked.

Final words

The DeFi derivatives market is growing. Thanks to platforms like UMA and Synthetix, it is now possible for investors to invest in synthetic assets, which would normally only be possible via CeFi. It is therefore expected that derivatives platforms are going to play a major role in future derivative investing.