Crypto and DeFi Derivatives: More than Just Trading
What does the future hold?
Think of derivatives as a time machine. Well, not really, but it’s close enough!
Nobody can predict the future. Because of that, there’s always risk out there. The risk that something we buy today will be worthless tomorrow. The risk that if we don’t buy something today, it will be worth a fortune tomorrow. Oh, the peril!
To live with uncertainty like this is difficult. But what can we do about it?
Short of building a time machine, there’s not much we can do to predict the price of something. But an alternative to a time machine is a financial instrument called derivatives. Derivatives are financial products that can be used to buy or sell an asset at a future date for a price agreed in the present. Pretty neat, eh?
The word ‘derivative’ is precisely that, a derivative. It is derived from the price of the underlying asset it represents. It isn’t the asset itself, it’s just the asset’s price derivation. Every asset has a price, every asset can have a derivative, though not every asset has one [a derivative, not a price!]. Currency, commodity, indexes, cryptocurrencies, oil, crops, even marijuana have derivatives! The derivative will track the price of the asset and allows investors to lock-in its price in the future.
Owing to this feature of buying or selling an asset at a future price, derivatives are used to hedge against price changes. But how do they work? Well, let’s get into them.
(If you’re already familiar with derivatives and its types, you can skip to Defi derivatives)
Type of derivatives
Broadly speaking there are two types of derivative products used – Futures and Options. You’ll hear them abbreviated as F&Os. Both futures and options are similar. They derive their price from an underlying asset and allow holders to hedge against price change. However, they differ based on the degree of hedging allowed. Let’s get to how they are structured.
As the name suggests, futures allows parties in a transaction to determine terms of future transactions in the present. What do we mean by terms? Well, we specifically mean the two things most important to a transaction. The price of the asset and the date of the transaction. In futures, both the price and the date of the transaction are predetermined.
Since futures allow parties to agree on the date and the price, it’s a form of ‘contract’ between the parties. In fact, all derivatives are contracts. To put it in legal terms, contractual obligations between parties to satisfy the terms of the contract. Again, ‘terms’ here mean price and date, don’t let the jargon confuse you.
Futures are contracts denoting the price an asset can be bought or sold at between parties before a specified date. Once the date passes, the contract expires, hence the date is referred to as the ‘expiration date’. Because the future price and the expiry are known to transacting parties, they can use this to hedge. So, how would a futures contract work? I’m glad you asked.
Let’s understand this concept with an example. Adam wants to buy one ounce (oz) of gold from Ron, which is trading at $1,000. Since both Adam and Ron believe that gold’s price will change in the coming months, rather than transact on the spot (otherwise known as a spot-trade), they enter into a futures contract. The agreed-upon price for the ounce of gold is $1,500, and the expiration date is three months later. So, if Adam and Ron entered into the contract on January 1, on April 1, Ron will sell one ounce of gold to Adam for $1,500. This transaction will not be affected by what the market price of gold will be on April 1.
Before we jump ahead, let’s understand why Adam and Ron would enter into this contract at this price. In Adam’s case, he thinks that gold would rise over $1,500, if he can buy it at $1,500, he would profit. That’s why he agrees on the price of $1,500. On the other hand, Ron is of the opinion that gold won’t rise to $1,500 by April 1, it will only reach, say, $1,200. If Ron is right, and gold’s market value on April 1 is $1,200, he makes a profit of $300 by selling the ounce of gold to Adam for $1,500. Through the futures contract, each participant can hedge future changes of an asset based on their preferences.
Fast forward to April 1, and gold has jumped to $1,800 an ounce. Adam takes delivery (or simply receives) the 1 ounce of gold from Ron, for the agreed price of $1,500. He can then immediately sell it on the spot market and make a $300 profit. We can add, Ron is happy selling his ounce of gold for $1,500 because he bought it when at $800. Hence, Ron’s is also making a profit of $700 i.e. $1,500 – $800.
One of the reasons Ron agreed to this contract is because he wanted to lock-in any future profit. He wanted to make sure he would make at least a $700 profit on selling his ounce of gold. Think about it this way, say the markets turned sour, and gold dropped from $1,000 an ounce to $800. In this situation, Ron is not making a profit or a loss, but since he entered into the futures contract with Adam, he can sell his ounce of gold for $1,500 despite gold trading at $800. While both parties cannot profit at the same time, what they can do is hedge, this is the crux of futures.
But wait, what if the price change is so high or low either party wants to pull out! Can they do that? That’s the basis for the second type of derivatives contract, options.
Options are another form of derivatives contract which are largely similar to futures, except for one additional feature. Like futures, options contracts allow parties to a transaction to determine the terms of the future transaction in the present. But the catch here is one of the parties has an “option” to pull out of the contract. For this section we’ll be using the word “options” to refer to “options contracts,” and not specifically to the “option” of pulling out of the contract. Boy, that’s a lot of options!
Why would they pull out? Well, if your hedging doesn’t go according to plan, you end up paying a high price for an asset or selling an asset for a low price. Here, you’d prefer to walk away from the contract, no questions asked, wouldn’t you? An options contract allows you that option. But this comes at a price.
To have the ability to walk away from a contract, you’d have to pay a premium to the other party. This premium is fixed. It’s decided when the contract is agreed and paid irrespective of the change in the price. Put simply, the premium is the safety you pay to walk away from the contract if things go south.
Now, options are slightly tricky because there are two sides to it. There’s a buying side and a selling side, options are divided into call options and put options. Premiums are paid for both contracts.
Let’s start with call options. Call options allow the holder the option to buy the asset as per the terms decided in the options contract. Why would someone want to hold a call option? This is best used when you think an asset’s price is going to go up. However, you want a form of safety if it doesn’t.
Looking back at the previous example, how would it play out if they used options? And specifically, call options at that.
Adam wants to buy one ounce (oz) of gold from Ron, which is trading at $1,000. On January 1, Adam is of the opinion that the price of gold is set to rise, but he remains unsure. So, instead of a futures contract, with no ‘walk away option’ Adam enters into a call option with Ron, or simply buys a call option from Ron. He now has the option but not the obligation to buy an ounce of gold at $1,500 in three months i.e. on April 1. Adam pays Ron a premium of $50 to give him the option to walk away should the gold market go south. By using a call option rather than a futures contract, Adam can rest assured if the price of gold drops. On the other hand, Ron has already pocketed $50 without giving up his gold.
Fast forward to April 1, and gold has jumped to $1,800 an ounce. Adam was right that the price of gold would rise. He takes delivery (or simply receives) the 1 ounce of gold from Ron, for the agreed price of $1,500. Since he already paid a premium of $50, his profit, if he immediately sells the gold on the market, would be $250 i.e. $300 received as a difference between the selling price and the price at which he bought the gold, and the $50 premium paid on January 1.
Now, what if Adam was wrong, and the gold markets go south? Could his call options help? Let’s find out. Fast forward to April 1, and gold has dropped to $900 an ounce. According to the terms of the contract, he has to pay $1,500 for the ounce of gold. Adam is staring at a $600 loss. What can he do? Here, he can use his option to offset his loss. Since his contract gives him the option but not the obligation to buy the ounce of gold, he can simply choose not to exercise his option to buy. In this case, the ounce of gold remains with Ron. Adam is only worse off by $50 (the premium paid to Ron), instead of $600 (the difference between the market price of gold at $900, and the agreed price as per the contract at $1,500).
Put simply, if the asset’s price rises, Adam, the holder of the call option will profit based on how high the price rises over the agreed price. However, if the asset’s price falls, the most Adam, the holder of the call option, will lose is the premium he paid for the option.
This is how a call option would help in hedging a change in price of the asset. How would it work out from the other end of the transaction, from the selling end?
Put options allow the holder the option to sell the asset as per the terms decided in the options contract. Why would someone want to hold a put option? This is best used when you’re of the opinion that an asset’s price is going to go down, but you want a form of safety if it doesn’t.
Looking back at the previous Adam and Ron example, how would it play out if instead of futures, they used options? And specifically put options at that.
Adam wants to buy one ounce (oz) of gold from Ron, which is trading at $1,000. On January 1, Ron is of the opinion that the price of gold is set to fall, but he remains unsure. So, instead of a futures contract, with no ‘walk away option’ Ron enters a put option with Adam, or simply buys a put option from Adam. He now has the option but not the obligation to sell an ounce of gold at say $1,200, in three months i.e. on April 1. Ron pays Adam a premium of $50 to give him the option to walk away should the gold market go up. By using a put option rather than a futures contract, Ron can rest assured if the price of gold rises. On the other hand, Adam has already pocketed $50 without buying any gold.
Fast forward to April 1, and gold has dropped to $900 an ounce. Ron was right that the price of gold would fall. He delivers (or simply sends) the 1 ounce of gold to Adam, for the agreed price of $1,200. Since he already paid a premium of $50, his profit, if he immediately buys gold on the market, would be $250 i.e. $300 received as a difference between the price he received from Adam ($1,200) and the market price of gold ($900), and the $50 premium paid on January 1.
Now, what if Ron was wrong, and the price of gold rises? Could his put options help. Let’s find out! Fast forward to April 1, and gold has jumped to $1,500 an ounce. According to the terms of the contract, he has to sell the ounce of gold for $1,200. At the face of it, Ron is staring at a $300 loss. What can he do? Here, he can use his option to offset his loss. Since his contract gives him the option but not the obligation to sell the ounce of gold, he can simply choose not to exercise his option to sell. In this case, the ounce of gold remains with Ron. He is only worse off by $50 (the premium paid to Adam), instead of $300 (the difference between the market price of gold at $1,500, and the agreed price of $1,200).
Put simply, if the asset’s price decreases, Ron, the holder of the put option will profit based on how low the price drops under the agreed price. However, if the asset’s price falls, the most Ron, the holder of the put option, will lose is the premium he paid for the option.
As you might have observed, both forms of options serve the same purpose, hedging. Let’s look at where hedging works best!
Now, I should add, options are a lot more comprehensive than I’ve made them out to be. A lot of details have been oversimplified. But for the purpose of the basic concept of hedging, this limited understanding is apt.
Who needs to hedge?
With all this hoo-ha about futures and options, who actually uses it? Like the examples presented above, futures and options allow their holders to hedge against price changes in the future. Anyone who doesn’t want a large change in an asset’s price in the future will take up such contracts. Hence, the next question naturally is, who requires futures?
Anyone who’s business depends on an asset’s price being relatively unchanged would benefit from these contracts. If your business or income is dependent on the stability of an asset’s price you could use derivatives to make sure of this. Companies reliant on fuel would lock-in the price of oil using derivatives contracts. This would allow these companies to hedge against large fluctuations in the price of oil, which could increase their cost in the future.
Take the airline industry for instance. Oil is a fundamental resource for regular airline operations, but its price is very volatile. Companies in this space often use derivatives to hedge future price changes. An airline company can take out call options to purchase a certain number of barrels of oil at a future date for an agreed price. They pay a premium and secure their operating expenses for the future. This will allow the companies to control for the volatile price of oil and maintain their expenses regardless of the market price of oil.
Like these businesses hedging against the change in price of oil, companies in the cryptocurrency ecosystem do the same, against the change in price of Bitcoin. Bitcoin is produced through a process called mining, where complex mathematical equations are solved in order to create a block on the Bitcoin blockchain. Without getting too much into the weeds, and putting it simply, as a block is added to the blockchain, the miner is paid a certain number of Bitcoin. This certain number changes every four years. Currently, that number of 6.25 BTC per block.
Can you guess how derivatives could be used here? If you guessed using derivatives to lock-in the future price of Bitcoin, then you’d be correct. Since a fixed number of Bitcoins are paid out, with the dollar price fluctuating, miners can lock-in the future price of the crypto using futures. It should be noted that mining is long, tedious, and requires a series amount of computing power, leading to high electricity costs. So, miners do need to hedge against them.
Miners can take out futures contracts selling a certain amount of Bitcoin they mine for a fixed price. This price can be based on what the price of Bitcoin will change to, their electricity cost in the interim, and a profit for their work. Once the price is decided and the other party agrees, the contract can be drawn up. At the end of the period, irrespective of the market price of Bitcoin, the miner receives his payment, enough to pay the electricity bills and pocket a profit. If the price falls in the interim, he has already locked-in his future price, so he is unaffected. If the price rises, he would be making a loss, but at least his expenses are covered.
Since the price of Bitcoin is so volatile, and its mining process difficult, miners require such contracts to cover their costs. This not only makes sense in the Bitcoin system, but it works out as a hedging option.
All these financial instruments on top of Bitcoin allow parties to take custody, hedge and profit go on to emphasize the maturity of the cryptocurrency as an asset class. Using this as the foundation, let’s look at how derivatives can fit into the decentralized finance space.
Derivatives: All for the price?
Before we dive into how derivatives can work in the decentralized finance world, lets go over a few terms we’ll be using.
- Smart contracts are computerized programs that automatically execute when certain terms of the contracts are met.
- Ethereum is a decentralized open-source blockchain network built on smart contracts. The native token to this network is called Ether (ETH) which is the second-largest cryptocurrency in the market, behind Bitcoin.
- Tokens that are designed for use on the Ethereum blockchain are called ERC-20 tokens.
- Collateralization simply means backing a loan, with an asset that can be sold to repay the loan amount
- Stablecoins are cryptocurrencies that are backed by real-world assets so that their prices remain stable despite market changes.
- DAI is a stablecoin backed by cryptocurrencies such that it is equal to $1
- Oracles are programs that provide data [eg. price data, weather data, polling data, etc.]
With that house-keeping done, let’s get into decentralized finance and derivatives.
Derivatives in the Defi world are important because what is being built here is not a trading and speculation market, it’s a use-case market. The principle of hedging goes far beyond Defi or cryptocurrencies, it’s applicable to the traditional financial world as well.
Hedging should also be customizable per individual. This isn’t the case in the traditional world, nor is it the case for crypto-derivatives. However, in the decentralized finance world, such an ‘all-purpose hedging’ system is being built right now.
We’ve seen that a derivative is just a representation of an asset in a contract form, right? Derivatives in the Defi space can be changed so that the change in price of the asset could have a larger effect on the contract’s price.
Broadly, in trading, there is a concept called ‘leverage’ which allows the trader to trade with more than the amount of money they own. Think of leverage as a form of borrowing, with upside and downside. If you’re right, the profit you’d make goes up as much as your leverage, and the price of the asset. Similarly, if you bet wrong, the loss you make depends on the leverage and the price of the asset. You might’ve come across the terms “10x leverage” or “100x leverage” in the trading market. Well, that’s what that means!
With that explained, let’s see how a few decentralized derivatives work. Say you’re hopeful about the price of ETH, and you want to gain exposure to it. Well, in the Defi work, a derivatives contract could be drawn up which would not only allow you to make a bet on the future price of ETH. You can also take leverage on it. Similar to the application of leverage, without any borrowings, you could have a 2x risk-to-return ratio against the price of ETH. In this situation, if the price of ETH would go up by $1, your contract would go up by $2. Such a contract could be just that, a 2x ETH contract, or it could be made into its own token. Wait, so you’re telling me that you can go 2x on the price of ETH at no cost?
There is a cost, but unlike the concept of ‘leverage’, there are no borrowings. The cost is in the form of collateralization. To have a 2x exposure to the price of ETH, you have to lock-up either a cryptocurrency (like ETH) or a stablecoin (like DAI). This collateral would act as a form of safety if the price of ETH goes down. In such a price drop event, the cryptocurrency you collateralized would be liquidated (or sold on the open market). Through this, you’ll have a x2 exposure to ETH while pledging (as collateral) a cryptocurrency or a stablecoin. Oh! All this is neatly packed into a smart contract, so, there’s no person on the other end selling your collateral.
Let’s understand this with an example. Adam is hopeful about the price of ETH. He would like to get a larger exposure to it without buying anymore. He could enter into a smart contract which could allow him to hedge the risk of holding more Ethereum without actually doing so.
A smart contract with a 2x risk to reward ratio is created. This means that if ETH is trading at $400, and in a week its price increases to $410, Adam would get $20 from the trade i.e. $10*2. Adam’s cost in taking this position is the ETH he pledges as collateral. For this contract, let’s say he pledges 2 ETH. So, if the price of ETH goes down to $350, he owes $100 i.e. $50*2. In this situation, the smart contract can liquidate a part of his collateral. This is based on the liquidation ratio of the contract. Put simply a liquidation ratio is the proportion of the collateral to the change in the price of the hedge.
Since this is very price related, these contracts are the basis for trading related crypto-derivatives. However, these contracts miss the bigger picture of derivatives contracts. In the Defi world, derivatives are being built to allow their holders to have all sorts of exposure. Exposure that isn’t just price-related.
Derivatives: A step further
Beyond just price-related trading, the concept of derivatives allow holders to participate in a range of activities. But let’s say the holder doesn’t want to completely break away from the price aspect (because they expect the price to go up). Well, since cryptocurrencies can be traded in fractions i.e. not as a single BTC or ETH, part of the crypto can be used for price-hedging, and part of the crypto for something else.
As a simple example, let’s say Adam holds one ETH and he wants to go use it for two activities. First, like the above example, he wants to hedge its price. Second, he wants to participate in a yield pool. Put simply, a yield pool is a collective pool where holders deposit their cryptocurrencies for purposes like lending, collateralizing, etc. increasing the liquidity of the pool. This gives the depositor a return (in the form of fees) on the amount deposited. Adam can put part of his ETH in the yield pool gaining transaction fees as returns and part of it in the 2x ETH returns as collateral.
This would allow Adam to have exposure to the price of ETH, by virtue of the price hedge. However, this will only kick-in if there is a price change in either direction. If the price of ETH remains unchanged, he is still receiving the transaction fees from the yield pool. Not only will Adam have the opportunity to participate in the price of ETH, but also make some fees on the side through the liquidity pool.
What this system does is it allows the holder to participate in a risk-return position while still maintaining a regular inflow of income. Both these sides can be hedged against the other using custom derivatives. But again this is all within the crypto world, what if I wanted to take this to the traditional finance world? And have a bit of both? Well, this is where the concept of derivatives gets really fun and exciting!
Derivatives and synthetic assets
Synthetics or synthetic assets are very similar to derivatives. Put simply, they are assets that mimic the price movements of other assets, with a few changes depending on the holder. Derivatives can be used to create custom synthetic assets by using forward-looking features of locking the price in, and the ability to either buy or sell an asset. Like derivatives are a contract that represents an asset bought or sold at a future date for a future price, synthetics are the very underlying asset representative of other assets.
In the example below, we’ve shown a synthetic asset that takes the price of three assets – ETH, gold, and BTC. Similarly, other synthetic assets can be built deriving its price from the price increase or decrease of a different group of assets. These price changes can be put on a derivatives smart contract allowing its holders to gain exposure.
This doesn’t have to be either limited to crypto or directly proportionally. Projects in the Defi world have created smart contracts that track the change of anything and give it a hedging mechanism. The synthetic asset could have assets that aren’t simply represented in price, they could be represented in any form of data-retrieving oracles. These oracles are placed in a synthetic asset, wrapped into a smart contract, and traded like derivatives. Holders could hedge anything with anything. You could hedge the change in the S&P 500 with the price of Bitcoin, or the price of Tesla stock with Elon Musk’s Twitter followers. Pretty cool, isn’t it?
You could even go against the price if it suits your needs. Inverse derivatives contracts work the same way as ‘shorting’ an asset would. Put simply, shorting an asset means betting that its price will go down. Hence, you can enter into a derivatives contract betting against a single asset, an index or anything else you’d like.
Could you use this in your own life? Beyond just profiting from the ups-and-downs of crypto? Let’s find out using an example. Adam lives in Texas, which is an oil-dependent state. Despite not participating in the oil market directly, the change in the price of the commodity can have an impact on his day-to-day life. In order to take advantage of his position, he could enter into an inverse WTI (West Texas Intermediate, a type of crude oil) contract. This contract could be represented as a token, say iWTI, wrapped in a smart contract, and put on a blockchain. Adam could use this as a hedge.
Adam can buy such a contract offsetting the risk of oil’s price in his day-to-day life. Say, WTI is trading at $40. A drop in its price would hurt the producers who now make less on its sales. Since Adam’s home state of Texas is dependent on the price of WTI, a drop would mean other sources of revenue would have to be increased to make up for the loss in oil revenue. In this situation, Adam’s iWTI would give a return as the price of WTI falls, allowing him to offset his livelihood risk. Here, while Adam’s day to day expenses are increasing, he is hedging this risk with his WTI contract, giving him returns as the price of oil falls.
For your unique situation, you can replace the asset tied to you. If for some reason the quality and cost of your livelihood is tied to oil, or gold, or silver, or Bitcoin, or wheat, or any other asset, you could benefit from its downside to offset your risk in the real world. Several products like these are being built by the financial architects of the decentralized finance world. Some of the notable examples are Synthetix and UMA.
But what about the derivatives contracts you mentioned earlier? Like put and call options? Surely we can do the same with them! Yes, you can, but those contracts aren’t meant to hedge against risk. They are mainly meant to make a buck on an asset’s downside. Plus, those contracts are complex. They run on tight-knit exchanges, have several fees tied to them, and all sorts of leverages which make profit-taking more enticing than risk management.
Using a crypto-wallet in the DeFi world allows you to more effectively manage your risk. What’s more is, this management is not done through brokerages, banks, or even private exchanges, it’s done with your private wallet alone. This means that you can manage your risk, and create hedging opportunities for your business and financial life. The best part about this is you do this on your own without an intermediary.
Derivatives: The true use-case
Derivatives weren’t merely meant to be used to chase prices and profits. The real use of derivatives was the ability to hedge. Decentralized finance and blockchain technology is rebuilding that very use-case of derivatives, and it isn’t limited to the price. Sure, you can use derivatives to hedge one asset’s price against the other, but it can be used for more than that. You can build your own synthetic asset, with customizable assets within it, you could go for the price or against it. Or, you could protect your livelihood from economic shifts, which in ordinary situations aren’t in your grasp. You could even benefit from these changes.
Never has ‘speculation’ been put to better use. Never has ‘hedging’ been more important that it is today.
What derivatives on the DeFi world are creating is not just a way to hedge our finances or hedge our business. It’s allowing us to hedge our lives.
If you want to know more about Crypto and DeFi derivatives, you can watch our video here.