Ethereum's upcoming derivative primitives

The race to build the legacy financial system is on, this time with 100% more blockchain.

Thanks to all the projects who reached out from this tweet! If you’re working on a DeFi protocol feel free to email me and I’ll be sure to check it out :)


Ethereum has more and more financial primitives coming out. This piece is to educate what some traditional derivative primitives are and then the landscape of them in DeFi.

When talking about derivatives we often refer to one of the following:

  • Forward and futures contracts

  • Option contracts

  • Swap contracts

Below I'll outline what these are and how they're being mapped back in Ethereum.

I’ll be saving synthetics for another day since there’s a lot happening and one article doesn’t do justice!

Forward and future contracts

A futures contract is a way for:

  • A buyer to acquire an asset on a particular date in the future

  • A seller to sell it at whatever price of the asset is at that date in the future

You can also have futures for one type of asset, but settled in another. For example, you might have ETH futures that settle in USD instead of ETH.

A forwards contract is similar to a futures contract except that the forward contracts are customised based on certain characteristics such as:

  • The number of units

  • An acceptable grade/parameters

  • The place where assets are to be delivered on settlement

  • The time interval to deliver the goods at expiry

In the realm of crypto, the settlement part of this equation is highly efficient since it's just computers pointing and transferring to wallets. There are no physical settlement risks.

On December 10, 2017, CBOE Futures Exchange launched the first ever Bitcoin futures market. There's currently no on-chain futures market available in DeFi. Some novel forward/futures that exist or would be neat if they existed:

  • Electricity futures for crypto mining as they help miners hedge risk

  • Lockdrop futures for trading an asset before it's available and settlement happens when the asset is available. You could probably do the same for illiquid ICOs if there was a market large enough

As per my current understand, the main DeFi players operating in the futures field are as follows:

  • https://www.futureswap.com/ - AMM-based futures with up to 20x leverage on-chain. It looks like they’re in alpha stage at the moment and that Ric Burton is shilling them 24x7. To me this seems like the next generation of degen like on-chain speculation.

  • https://mcdex.io/ - futures exchange with no KYC. This looks like a fairly polished product that is live and in production, doesn’t get much CT hype though. Maybe the builders are too busy shipping.

Option contracts

Through the past month or two we've seen a massive surge in options in DeFi! Options are similar to forwards and futures, except that the buyer has the RIGHT but no an OBLIGATION to purchase the asset at a date in the future.

Depending on who has the optionality at the time of expiry, we call it a put or call.

  • Calls are the right to acquire an asset at a certain price in the future

  • Puts are the right to sell an asset at a certain price in the future

Example 1: I buy a call option for $155 with the strike price being $150. That means that if the price of ETH goes to $200, I can acquire ETH for $150 and profit $45 (not $50 because I paid a $5 premium for the call).

Example 2: I buy a put option for $155 with the strike price being $150. That means that if the price of ETH goes to $100, I can sell ETH for $150 and profit $45 (not $50 because I paid a $5 premium for the put)

Because the counter-party of the option is giving the right, but not obligation, to the seller - they charge a premium. Futures/forwards don't impose this premium since both parties have an obligation at the time of expiry.

The first use cases of options are insurance, although it's now shifting to price speculation as well. Three contenders make up this space at the moment:

  • Opyn - https://opyn.co/#/

    • In essence, Opyn is an options protocol that started off with selling puts to provide insurance against users losing stable coins deposited to DeFi protocols. The idea is simple, a put seller will sell the right to claim $1 for $1.05. This means that you're effectively paying 5% for insurance. Since then Opyn has moved into selling generalised options for price speculation.

  • Nexus Mutual - https://nexusmutual.io/

    • Nexus Mutual's core value proposition is insurance, however it acts like an options protocol, except you don't have the right to exercise your options. What does that mean? Well NXM is the native token of Nexus Mutual and is a claim over the capital in the pool. All the capital in excess of the amount to make payouts according to their prediction model is owned by NXM holders. In this sense you're purchasing an option but NXM token holders have the right to determine whether to pay you out or not. Of course it's in Nexus Mutual's best interest that they pay out when hacks happen, although the subjectivity of hacks is up to NXM holders at the end of the day. I'd be expecting Nexus Mutual insurance to become cheaper in the future.

  • Hegic - https://www.hegic.co/

    • Hegic is also another options protocol, however what makes it unique is the fact that it's run by an anonymous founder by the handle 0mollywint3ermutz. The site is pretty primitive, contracts are in beta, however I wanted to mention it since this will be a project to keep your eyes on due to the lack of legal boundaries this can go. Options for securities and other risky assets, I'm sure Hegic will happily do something as risky as that.

Other honourable mentions:

Swaps

The simplest way to think of a swap is the exchange of cash flows at prespecified terms in advanced. In the traditional world, a company might create a bond that pays LIBOR + 1.5% profit. In order to make their interest payments more predictable, they might enter into an agreement with another party that pays a constant, fixed amount of interest (say 5%). If LIBOR increases above 3.5% then they'll be safe guarded since their interest payments are fixed at 5%. If LIBOR decreases below 3.5% then they'll be losing money since 5% will be greater than the actual payment required. The simplest way to think about it is that you're speculating on the interest payments rather than the value of an asset.

In the case of DeFi, the most wished-for liquid swap market is a fixed vs variable swap market for DeFi lending rates.

As of this time the space around DeFi swaps is pretty limited. The two projects I could find in this space were:

  • https://umaproject.org/ - is more than just synthetics but can also do swaps. Not live yet but apparently will be later on this year.

  • https://swaprate.finance/ - pretty early stage. Tried using it but the interface was unfortunately too hard to use.

Liquidity is most likely the biggest bottle neck and buyers and sellers on both sides can't make strong bets on what they think will happen in on-chain lending markets.


Closing Up

I've been really excited to see the pace of innovation happening across the board with all of these DeFi protocols. It's quite easy to dismiss many of them given the stage they're at although as we see the world adopting stable coins for the improvements they bring in transporting and using US dollars things are going to get heated very quickly. We've already crossed $10b+ in stable coin market cap, I don't expect this to slow down anytime soon.

I wanted to go into synthetic assets, which are usually a mix of many derivatives however this piece was getting a bit too long. Flick me a message if you'd be interested in seeing this piece come out eventually.