What are Decentralized Derivatives?

The crypto derivatives market has absolutely skyrocketed in the past couple of years with platforms issuing more and more assets every day. Bitcoin derivatives have been in the market from 2011 and traditional derivatives for over a century, but only now the market is opening up to regular investors, instead of being dominated by Wall Street and big-money investors.

In iBNB we’re also planning to introduce derivative instruments to our investors to create an all-encompassing ecosystem.

Since derivative trading in the financial market is a path less traveled, many people, especially average investors, don’t have a clear concept of how derivatives work.

In this article, I’ll go over the basics of derivatives and how they apply to cryptocurrencies as well.

What is Financial Derivative?

A financial derivative is a contract to the perceived value of an underlying entity. The underlying entity can be anything from index funds, mortgages, interest rates, to commodities like oil and gold.

Think of it this way, you are moving out of the city in 3 months and want to sell your gaming setup before leaving. Your friend offers to buy it from you after 3 months for $1500. You agree as you don’t know if you can get a better customer then and might have to sell it in a hurry for a cheap price.

You drew up a contract to ensure that your friend will buy the setup after 3 months, and the deal is done.

Congratulations, you just created a derivative. Even though the contract has no intrinsic value, since it’s attached to a valuable product, the contract also gains some value.

Your friend can sell the contract to someone else for $100 and then that person will be liable to buy the setup from you upon the expiration of the contract.

Now the question is why would someone buy a derivative? The derivatives market is all about betting against each other. You’re selling because you fear you might have to sell it for less when the time comes, the contract gives you an assured price.

On the other hand, the person buying it thinks that the derivative, in this case, your gaming setup, will increase in value by that time getting them a nice profit.

But there’s a lot more to it.

Types of Derivatives

Primarily, there are 4 types of derivatives,

  1. Forward
  2. Futures
  3. Call Options
  4. Put Options

Forward Contracts

A forward contract is a customized contract between two parties. It doesn’t trade on exchanges. Also, a forward contract only gets exercised at expiry.

The contract you created is an example of a forward contract.

Futures

A futures contract is similar to a forward contract with a few key differences.

A futures contract is a standardized contract of an asset that can be bought and sold on exchanges. Also, unlike forwards, futures can be bought and sold every day instead of waiting for the expiry date.

An example will be Tesla stock futures that you can buy and sell on Robinhood.

Options

Unlike the forward and futures contract, where the contract ultimately gets exercised at the end of the agreed-upon period, options derivatives present a third option. At the end of the contract expiry date, if the conditions aren’t favorable to one party, they have the option to exit the contract. Thus the name — options contract.

The buyer has the right but not the obligation to buy the option under a call option. That means, under a call option, if the conditions aren’t favorable to the buyer, they can decide to call (exit) the contract. However, the seller is obliged to sell the contract under any circumstances if the buyer wants to buy.

For example, if the price of the underlying asset decreases, it won’t be profitable for the buyer to go ahead with the contract so they exit. They can also set a stop loss to avoid any undesirable loss, in some cases.

On the other hand, a put option gives the seller the right but not the obligation to sell a contract, and the same applies to the buyer in this case.

However, to exercise these options a premium needs to be paid as an initial investment. The party, having the right to exit the contract, will need to pay the premium upfront, to create such a contract. Upon exercising a call or a put, the premium will be deducted from the contract. The amount of premium depends on the market.

Use Cases of Derivatives

Financial derivatives are used for a few particular purposes.

Cost Hedging

Companies plan their budgets in advance, which makes them vulnerable to market price fluctuations. This is where derivatives come into play.

For example, an airline company needs tons of barrels of oil every year to function properly. But, the price of crude oil fluctuates a great deal around the year. Buying long-term futures of crude oil at a fixed rate with a favorable expiry date makes it a lot easier for the company to ensure supply at a favorable price. Also, they can choose to sell the contract for a profit.

This solves two problems. The airlines don’t need the oil right now, so they don’t have to buy barrels of oil and store it. This will be a logistical nightmare and not very efficient.

On the other hand, they will also have the cash to spend elsewhere instead of buying something they don’t need right then.

Speculation

Speculation is another big market for derivatives and it includes most of the risks. Using the example I started with, let’s say the price of the gaming setup increased and you sold it for $2000. You made a $500 profit purely from speculation.

You can do the same thing on a much broader scale on securities exchanges. Even a small price movement can rake in huge profits from these trades. However, the accompanying risks are equally high.

How Crypto Derivatives Work

Take all of what you learned so far and apply it to the crypto market. It works the same way in both markets, only at a much larger scale, since volatility and liquidity are higher and operated independently.

For example, a Bitcoin future is a contract that bets that after a certain period, BTC’s price will rise(go long)/fall(go short) by this amount. If the price increases more than the said amount, the buyer profits and vice versa.

Bitcoin Perpetual Contracts

Bitcoin perpetual contracts are derivatives with no expiry date. It means you can basically bet that the price of BTC will increase and sit on the contract for days or months. Once it reaches your favorable condition, you can sell it. You’ll be essentially betting against other traders who’re counting on the downfall of BTC in the long term.

Opening a perpetual contract depends on certain criteria such as the amount of BTC in the account and the funding rate depending on the exchange used.

nBNB Derivatives

Now that you have the basics of derivatives cleared, here’s how nBNB is going to implement it in the ecosystem.

As more projects join the network, investors will have a lot of options to invest, bet, and speculate on the performance and movement of these projects and subsequent assets attached to them.

For example, you can create a futures contract or call/put longs and shorts on these projects, and depending on your analysis, you will be able to rake in profits.

This will facilitate investors trading within the iBNB ecosystem with additional financial instruments to broaden the range of opportunities provided.

At iBNB, the focus is on crypto-finance.

As the ecosystem matures, the financial instruments will grow more sophisticated and nuanced creating more derivatives and other investment methods.

This article is the first edition with regard to decentralized derivatives within the iBNB ecosystem. As the scope of DeFi derivates within the context of decentralised markets is providing iBNB with a big range of possibilities, investors will be benefiting from unique opportunities.

2022 looks to be an interesting year.

Written by:

Romeo Fardeen

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