Financial derivatives and what they are used for.
As you probably know, MetalSwap is the first dApp to introduce the derivative instrument of Hedging Swap to the DeFi world. Today, we bring you an in-depth look at financial derivatives, including their main categories and uses, with the goal of helping you better understand this complex world.
This article will cover the following topics:
- An introduction to financial derivatives.
- The most popular derivative instruments.
- The main uses of these instruments.
- A comparison of derivatives trading volumes in traditional and crypto markets.
Financial derivatives do not possess their own inherent value. Rather, their value is derived from the performance of other financial assets. This is why the concept of the underlying is integral to understanding these financial instruments. The underlying refers to the asset to which the derivative is attached and from which its value is derived. The underlying can be almost any asset whose value fluctuates over time and is of interest to the parties involved. These assets can be classified into two types:
- Financial assets, such as shares, interest rates, bonds, market indices and currency exchanges.
- Real assets, such as commodities and cryptocurrencies.
What are the main types of derivatives?
Before identifying the most common derivatives, it's important to note that there are two types: those traded on regulated markets and those traded over-the-counter (OTC) outside regulated markets.
Derivatives traded within exchange-regulated markets have standardised characteristics regarding the type of underlying asset, the duration of the contract, and other key features, making them relatively safer than OTC derivatives. On the other hand, OTC derivatives are customised contracts created and managed directly by the two counterparties, where the terms and characteristics of the contract are determined by the entities involved.
The main derivative contracts include:
- Futures: Futures are financial contracts in which two parties (a buyer and a seller) agree to exchange an underlying asset at a specified price on a specified date in the future. Futures give the buyer an obligation to buy the underlying and the seller an obligation to sell before the contract expires.
- Forward: This contract is a financial derivative instrument that allows counterparties to set the terms today for an exchange of commodities or financial assets that will take place in the future. The particularity of the forward contract is that it is entered into OTC markets.
- Options: These are derivative financial instruments that provide the right, but not the obligation, to buy or sell an underlying asset at a specified price, known as the strike price, on or before a specified expiration date. Options grant different and opposite rights to the parties involved.
- Hedging Swap: An Hedging Swap is a contract in which two parties, A and B, agree to exchange sums of money, typically the difference between them, according to the terms of the contract. A swap becomes a hedging swap when it is used to protect against the volatility of a specific asset over time by securing a predetermined price and paying a premium for this service. Currently, MetalSwap is the only dApp that offers hedging swaps on commodities in DeFi. With our dApp, you can protect yourself against the volatility of Bitcoin, Ether, Gold, and soon, other commodities. To learn more about our dApp, we recommend reading this article which explains the functionality of the hedging swap that MetalSwap is bringing to the DeFi world.
MetalSwap dApp - Hedging Swap
What are the main uses of derivatives?
There are three main uses of derivative instruments:
- Hedging: Derivatives can be used to manage risk by protecting parties from unwanted fluctuations in the price of the underlying asset. MetalSwap was created for this purpose.
- Speculation: Derivatives are highly volatile assets with a significant degree of leverage. In other words, while it is possible to gain significant profits in a short period, it is also possible to suffer substantial losses. Experienced speculators often use derivatives to profit from the performance of the underlying asset, but the risk of loss is also high.
- Arbitrage: Finally, arbitrageurs seek to profit from errors in the valuation of derivatives. If the price of a derivative contract does not accurately reflect the result of the formula within it, an arbitrageur can seize the opportunity to make money without bearing any risk. Specifically, if the price of the derivative is lower than its ideal corrected rate, which is based on the formula-dependent valuation, the arbitrageur can buy the derivative and wait for it to be correctly valued, earning a risk-free profit. The issuer of the derivative is obligated to comply with the rules inscribed in the contract and will be forced to value the derivative correctly, providing an arbitrage opportunity. However, such opportunities are very rare and generally very short-lived.
Derivative volumes in the traditional and crypto financial markets
According to the WFE Derivatives Report 2021, which was published in April 2022 and based on a sample of 50 exchanges "there was a 33% increase in the volumes traded compared with 2020, with a record number of 63.24 billion derivatives contracts traded in a year (33.88 billion options and 29.35 billion futures)”. For example, in just the first half of 2022, the OTC derivatives market recorded more than $600 trillion in trading volumes. This market is the largest in the world, and new dApps on derivatives aim to capture a significant share of it.
The decentralised world still has lower volumes compared to traditional markets. According to the data provided by Defillma, the TVL of the entire DeFi ecosystem is $65 billion, and the share of dApps dealing with derivatives is relatively small at $1.4 billion. The most commonly used derivative instruments in DeFi currently are Perpetuals, but we are witnessing an increase in the usage of Swap and Option instruments. Today, the decentralised derivatives market is dominated by two dApps - GMX and DyDx - which collectively have a weekly volume range of between $15 billion and $25 billion.
Financial derivatives are complex instruments with enormous potential. They generate trillions of dollars in volumes every year, although still practically all within centralized markets. MetalSwap and other dApps are bringing these instruments into the world of DeFi, along with all the associated benefits that we will explore in an upcoming article. Stay tuned! ;)
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✎ What is MetalSwap?
With MetalSwap we enable hedging swap transactions through the use of Smart Contracts, AMM style.