Here's Why The On-Chain Derivatives Market Continues To Propel DeFi

The growing capitalization of Bitcoin is continuing to drive the entire crypto market up the charts, and the DeFi segment is trailing close behind. New records are being attained as on February 13, the segment reached a milestone of $41 billion – the amount of user funds locked in DeFi almost doubled since January.

Such figures are understandable, considering that the market offers investors a broad variety of innovative financial products and instruments to choose from, including Wrapped Bitcoin, non-collateral loans, staking, and much more. (Source: DeFi Pulse)

Among the most prominent assets currently attracting the attention of investors are derivatives – direct descendants of the traditional financial market. On the traditional market, the share of derivatives was valued at over $640 trillion in notional contract value in late 2019. Now some estimations refer to $1 quadrillion on the high end. 

Derivatives have also migrated onto the cryptocurrency market, considering the growing demand for new investment instruments among crypto users.

The main allure of liquid options contracts for investors is the inherent abundance of complex and highly-profitable investment strategies. Such developments are rapidly leading to the adoption of permissionless, non-custodial options contracts in the near future as a critical stepping stone in the formation of the DeFi sector. 

DeFi derivatives

A particularly interesting type of derivatives that have emerged over the past year are options based on digital assets such as BTC and ETH. These instruments have the necessary backing as Ethereum alone currently has over $1.03 billion equivalent in total locked assets in various applications on the network, which is roughly 3.5% of all of the 6.9 million $ETH hosted in different applications.

Option – a financial contract concluded between two parties – the holder and the seller. The former gets the right, but not the obligation, to buy or sell a certain amount of the underlying asset at the strike price on a specific date.

Bitcoin options are already traded on regulated and primarily whale-focused exchanges CME, LedgerX, and Bakkt. Deribit leads the unregulated market, followed by FTX and OKEx.

If at the beginning of 2020 investors were aware of BTC and ETH options only, now the variety of options is growing. In November of 2020, Zubin Koticha offered the Convexity Protocol for making options operational on Ethereum in the form of NFTs of the ERC-20 standard based on a set of parameters. Such options give their holders ownership rights to specific assets, essentially digitizing real-world assets.

What’s offered by exchanges?

Considering the growing demand for new investment products on the market, first trading platforms have already offered options and other derivatives for trading.

In February the DMEX decentralized exchange launched the world's first crypto derivatives trading offering zero-gas fees. The platform moved to xDAI sidechain and now offers trading orders starting from as little as $100 and does not require any KYC procedures, thus allowing users to retain full anonymity.

The use of the xDAI contracts for processing trading transactions allows DMEX to significantly cut trading-related expenses, making derivatives more accessible to traders.

Ethereum smart contracts are directly connected to the xDAI blockchain through a decentralized bridge that relays messages between the two chains. DMEX claims that users require an Ethereum wallet only to start trading derivatives and retain full control over their funds. 

The prospects of DeFi derivatives

The application side of DeFi derivatives is quite high, if the events surrounding their segment are to be taken into account.

Recently, Wells Fargo announced their latest investment in its Startup Accelerator program, which hosts OpenRisk Technologies – a company that relies on blockchain for managing the liquidity and collateral of traders working with derivatives. Participant companies can get up to a million dollars in funding.

Other notable examples include the ISDA, which launched a hackathon together with Barclays, resulting in Baton Systems adopting ISDA’s Common Domain Model.

The DTCC is also intent on launching a new version of its Trade Information Warehouse based on distributed ledger technology with the current version processing over $9.9 trillion in cleared and bilateral derivatives. Further in the East, the Korean Shinhan Bank recently implemented blockchain and smart contracts for its Interest Rate Swaps contracts.

There is no denying the fact that derivatives are on the way to the market and are an essential element for ensuring its sustained development and leveling with its traditional counterpart. Given the potential of the volume of on-chain derivatives and the volumes involved, it is possible that decentralized exchanges with their own mechanisms may be the main carriers of derivatives.