Derivatives gaining traction
Credit derivatives aren’t the only ones gaining traction in DeFi.
More traditional call and put options can now be traded across a variety of numerous platforms.
Visual interfaces look different to those used in traditional markets, mainly because decentralised crypto platforms don’t operate under the same order book principle. Instead they allow someone to create an option of their choosing and the pricing works out automatically:
The fundamental principles of option buying are the same, with traditional payoffs in place. Some platforms are trying to replicate the more traditional orderbook interface and principles, but there is still more room to go. Below is the orderbook from one of the most widely used platforms in DeFi.
Given the (more) complex nature of these contracts, transaction processing costs are quite high:
As per our previous article, it’s fascinating to see people transact on the blockchain despite high gas costs.
Systemic risk protection
Apart from buying options to speculate on BTC and ETH prices (or hedge them), we are able to protect ourselves from more fundamental crypto risks, such as stablecoins breaking their pegs to USD:
For those choosing to keep their savings in crypto stablecoins (~$60bn), it’s a vital instrument giving them peace of mind.
Selling options
Options are different from other instruments due to the non-linear nature of their payoffs. When someone buys stocks, they have a 1:1 exposure to both upside and downside. Options work differently - buyers have limited downside and unlimited upside and for sellers it’s the exact opposite. Those selling an option might be exposed to (sometimes) unlimited downside.
In the traditional world, brokers apply a margining system, monitoring their clients’ positions on an ongoing basis and demanding account top up if the trade goes against the seller. Sophisticated option traders also benefit from a ‘netting’ system where they may have numerous trades open in different directions, mutually offsetting each other and resulting in high capital efficiency (i.e. ability to utilise the same amount of capital across more trades).
In DeFi the netting system hasn’t been figured out yet and full collateralisation is required at all time. This results in the capital being ‘staked’ to provide cover for market movements, in a manner similar to insurance provision.
As with most financial products in DeFi, they are far from perfect, but it’s encouraging to see a vibrant ecosystem of solutions, addressing real market needs.