What is a Decentralized Derivative?
Decentralized derivatives are investment contracts that are exchanged on decentralized trading platforms. These decentralized forums are based on blockchain technology and build upon an underlying asset such as commodities, virtual currencies, stocks, and other derivatives.
At the same time, these derivatives do not require third-party intermediaries such as clearing houses or centralized exchanges. Decentralized derivatives enable peer-to-peer trading and contract settlement.
Features of Decentralized Derivatives
Here are some important features of decentralized derivatives:
A decentralized derivative contract is based on a specified core asset. This asset can be a stock index, a virtual currency, a derivative, or even a commodity.
Derivatives contracts on decentralized platforms take value from the core asset. They are present in a varied variety of classifications such as futures, options, swaps, and others. In this manner, investors are able to predict the price movement of the core currency without directly acquiring it.
Decentralized derivatives operate without the presence of warrantors or intermediaries. Therefore, these platforms use smart contracts that are automated protocols added directly to the code. Ethereum is the most used blockchain for decentralized derivatives on account of its smart contract compatibility.
Smart contracts automate the process of trading, clearing, and settlements when required conditions are met. In this manner, the process is unbiased and activated around the clock.
P2P trading takes place on decentralized derivatives because there are no intermediaries such as brokers or exchanges involved. In this manner, investors have more transparency and lesser counter-party risks.
Users who are using smart contracts provide liquidity for decentralized protocols. As a combination these assets create liquidity pools to increase the tradability.
Automated Market Makers (AMMs)
AMMs are algorithms that measure the asset price based on the LP reserves. They eliminate the need for order books and ensure continued trading.
Decentralized derivatives have to deal with a number of risks such as lack of accessibility, absence of intermediaries, and regulatory uncertainty. Some other risks involve price manipulation and smart contract hacks.
Decentralized Oracle Network
Decentralized oracle networks are smart contracts that have access to external data resources. In this manner, these trading platforms may be able to predict price change in real time.
Working Mechanism of Decentralized Derivatives
Here are some steps in the progression of a typical decentralized derivative:
The first step is generation of a smart contract that is created on a DeFi platform. The contract creator has to set required parameters such as type of underlying asset, contract duration, expiration date, and premium etc.
Premium amount for a decentralized derivative determines the additional price over Net Asset Value or NAV and discount it vice versa. The smart contract must contain precise information regarding the premium and discount values for a given derivatives contract.
The next step is contract execution that can lead to either creation of premium in case of added prices or discount in case of price reduction.
Risks Associated with Decentralized Derivatives
- Decentralized derivatives are based on smart contracts and can be subjected to technical errors.
- Smart contracts are open to hacks and exploit that can lead to loss of cryptocurrencies.
- In case of an incomplete transaction, investors cannot appeal to a centralized authority such as governments or banks that can increase their risks.
- Decentralized derivatives struggle with scalability. Their execution time is slow and leads to network congestion and gas fee inflation on host blockchains.
- Price discovery is difficult for decentralized derivatives contracts that make them less adoptable.
- Accessibility and inclusion is the main reason that many traders do not invest in them keeping in view their lack of experience and market knowledge.
- There is a lack of standardized protocols in DeFi derivatives that deter institutional investors from them.
- There is a lack of regulatory certainty and compliance in this product.
Decentralized derivatives bring financial inclusion for investors that can lead to greater interest from commercial companies. At the same time, it may also lead to demand for better regulatory infrastructure that can streamline this crypto trading product.