Digital Asset Derivatives: Current State

Until now, derivatives were traded mostly in the form of options and futures on major crypto exchanges such as Binance, but other forms of derivatives are still upcoming to enter more traditional trading schemes. Currently, we can observe three main pools of activities regarding digital derivatives:

• Non-US markets (centralized)
• US markets (centralized)
• DeFi markets (decentralized)

US Markets

Trading with Bitcoin futures was first introduced in the US-market when Cboe Futures Exchange and the CME launched in December 2017. This was a crucial step in the adoption process of digital derivatives. Venture investors became also interested in them because:

• This asset does not require storage capabilities like in the case of physical assets.
• It is efficient for hedging.

Even though the market player changed later, derivatives were traded actively. The companies that were offering services in derivative trading were taking different forms and, thus, were regulated differently:

• Futures commission merchants needed to be registered with the Commodity Futures and Trading Commission (CFTC) and could offer trading with futures, options, and cleared swaps.

• Designated contract markets needed to be registered with the same CFTC and could offer listed futures and options, cleared swaps, and foreign futures.

• Swap execution facilities were also regulated by the CFTC and could offer swaps only.

• Derivatives clearing organizations were regulated by the CFTC and were in charge of futures contracts, options on futures contracts, and swaps.

• Broker-dealers were regulated by the Securities and Exchange Commission (SEC) and could offer activities with stocks, bonds, and options.

• Swap dealers were dealing with swaps only and had to obtain a license from the SEC and the CFTC.

• Security-based swap dealers were working with security-based swaps and were registered with the SEC.

The number of registered entities that can work in the USA is not very long, but it is growing. 

Non-US Markets

Even though the US market is big, the main exchanges, such as Binance, OKX, Kraken, and Huobi are located offshore. They take leadership positions in listed digital assets futures and options. 

Exchanges that operate in non-US markets have historically been more attractive to investors because they are less regulated. Along with futures and options, the following products are offered globally:

• Perpetual swaps: they are similar to futures, with the only difference being that they do not settle. The perpetual swap contract has no fixed maturity, and its price mirrors the price of the underlying asset (for example, Ether, Bitcoin, etc.). This financial instrument is especially attractive to investors because it provides a buyer with long exposure and a seller with short exposure to the same digital asset. There is no expiration, and it enables both the buyer and the seller to offset their risks. In this regard, perpetual swaps can be compared to equity-linked swaps in equity markets. 

• Non-deliverable forward contracts: their price is also based on the price of an underlying asset, and they are non-deliverable (for example, they can be settled in cash rather than in the underlying asset).

• Contract for differences: a financial contract between an investor and a financial institution in which investors take a position on the future price of an asset. CFDs allow investors to trade on the price movement of an asset without owning the asset.

DeFi Markets

Source: https://coindoo.com/what-are-crypto-derivatives/ 

Decentralized Finance, or DeFi, offers financial services, including derivatives using a blockchain-based infrastructure with smart contracts and decentralized derivative protocols (DDPs) as the foundation for this infrastructure.

While DeFi eliminates the need for an intermediary (a centralized exchange such as Binance, Kraken, etc.) and, thus, the risks connected with involving an intermediary, it is far from perfect. The DDP technology is still immature. It exposes users to certain risks, such as vulnerabilities in smart contracts that can be exploited by malicious users. Regulatory uncertainty is another reason why DeFi is considered to be the riskiest form of all types of derivatives exchanges.

Even though DeFi comes with a lot of new opportunities, users need to understand that there are some things to check and consider before starting to use one or another DeFi platform. 

Collateralization

The system is new and, thus, the risks are higher than in traditional financial systems that have been around for ages. This is why collateral is required whenever you want to use DeFi to obtain funds. Overcollateralization is characteristic of most DeFi services. 

The amount of collateral and the terms for its liquidation differ on different platforms. This is why users should calculate their decision very carefully and take all details into consideration.

For some users, the condition of overcollateralization may be a factor that makes them reconsider their participation in DeFi, but overcollateralization is needed to protect users’ funds. Over time, when the system matures and earns a more robust reputation, collateral requirements may be reconsidered. 

Liquidation

Another factor to consider is the liquidation terms. When a collateral price drops, some platforms send a notification and allow a user to add funds to prevent collateral liquidation, while others do not do this, but instead proceed with the liquidation procedure immediately. 

DeFi operations are based on smart contracts. This is why users have to deal with whatever conditions are predetermined by a smart contract. Centralized exchanges handle these matters differently. They may delay a liquidation if a user has a positive prior repayment history, or based on other conditions. DeFi does not offer such flexibility at the moment.

Credit Backstop

In the traditional financial system, there are central counterparty clearinghouses (CCPs) that perform the role of a credit backstop in the case of a counterparty’s default. In DeFi, there are no such organizations. The only credit backstop is collateral, so DeFi does not have any shock absorbers during periods of distress. This is another factor to consider if you opt for DeFi.

DeFi Protocol Governance

DeFi governance systems are new and, thus, many things are still undeveloped. Governance in DeFi relies on open and transparent communication and decision-making by the community, developers, and investors. In some DeFi, all three parties have voting rights while in others, a specific party can vote on the changes in a protocol. So, what if this party votes for changes that are beneficial for the voting party only, and do not consider the opinion of other parties? Here is where a governance risk lies. Over time, when the governance system evolves and matures, this risk will be eliminated.

Smart Contracts

Smart contracts can have vulnerabilities that are exploited by hackers. That is why it is important to make sure that smart contracts used by a DeFi platform are audited both internally and by a renowned smart contracts auditor. 

Closing Thoughts

Currently, we deal with centralized platforms that operate either in the USA or offshore, and DeFi that is not limited to a specific region. While the former are clear and offer options that we are used to, DeFi offers new unique opportunities. Over time, DeFi will develop, the market will mature, and we may switch to decentralized services completely.