Derivatives have played a key role in almost every financial market in history. In the case of crypto-assets, you can make a case that derivatives have taken a second priority to the development of tier 1 blockchain protocols, exchanges and, of course, token sales. To some extent, the first iteration of Bitcoin futures at the CME and Cboe exchanges hasn’t have the major impact in the market that was initially predicted. However, with all the noise surrounding the potential approval of a Bitcoin Exchanged Traded Fund(ETF) and the emergence of trends such as security tokens, crypto derivatives are called to become a foundational building block of the next generation of crypto-assets.
Crypto-derivatives are different from any other type of financial derivative in a key point: THEY ARE PROGRAMMABLE PROTOCOLS which opens the door to all sort of interesting possibilities. Today, I would like to review a group of new protocols that are innovating on the notion of programmable derivatives enabling the implementation of all sorts of sophisticated financial instruments.
As Old as Writing
Most people associate derivatives with sophisticated financial instruments from the 1980s. The truth is that derivatives have been with us since humans learned to make promise. The invention of writing certainly catalyze the creation of records that formalize commercial agreement that were based on the future delivery of goods. There are records dating back to 1700 BC in which farmers will borrow items needed for the harvest with the promise of a future payout.
The first derivative that resemble modern products can be traced back to feudal Japan in the 1700s. Around 1730, the Dojima Rice Exchange is established with the full support of the government. At the exchange, there are two types of rice markets; the shomai and choaimai. The shomai market is where traders buy and sell different grades of rice based on the spot price. Rice vouchers are issued for each transaction and would be settled within four days. At the choaimai the first future market was operating. In the spring, summer, and fall different grades of rice were contracted with standardized agreements. No cash or vouchers were exchanged; all relevant information was recorded in a book at a clearinghouse. The contract period was limited to four months at a time
These day, the Chicago Mercantile Exchange(CME) is synonymous with derivatives. The establishment of the financial powerhouse in 1919 represented the legitimization of derivatives in financial markets. Derivatives will remain obscure instruments until the 1970s in which computers make possible to execute complex mathematical models in a sub-second timeframe and, from there, derivatives have been at the center of every relevant financial instrument in the market and have been the cause of more than one disaster.
Types of Derivatives
Conceptually, a derivative is any financial product that derives its price from an underlying asset. From that perspective, there is no limit to the financial derivatives market. While we are here obsessing about a crypto-asset market that it remains somewhere below $300 billion, financial derivatives amount to somewhere above a QUADRILLION dollars market which, in an important part, remains virtually unregulated.
The types of mathematical models that can represent derivatives is effectively infinite but there is a small group of classes of derivatives that encapsulate most models in the market:
The Quant’s Dream: Programmable Derivatives
What make crypto-derivatives different from any other financial derivative is the simple fact that they are programmable smart contracts that can be dynamically used in higher order contracts. While a bank will spend years building the legal contract that represents Swap model, a hacker can use a crypto derivative protocol and build a financial derivative in minutes. More importantly, the nature of crypto-derivatives enables the implementation of more sophisticated financial models as there are many things that can be expressed in code and smart contracts that can’t be done using simple statistics.
The Security Token Catalyzer
The emergence of security tokens should, without a doubt, become one of the factors that streamlines the adoption of crypto-derivatives. By definition, many security tokens are representations of underlying alternative assets such as real estate leases or money loans which makes it natural to create models based on the future performance of those assets. More importantly, a large percentage of the derivative product in today’s financial markets can be adapted to the security token space. I’ve written about the impact of derivatives in security tokens here….
Crypto-Derivative Protocols
In general, the attempts to implement derivative models for crypto-assets haven’t been widely successful. However, in the last few months, a new generation of protocols have emerged that seem to bring the right combination of financial and crypto rigor to establish a solid foundation for the crypto-derivative space. Here are a few of my favorites.
{Set} Protocol
{Set} Protocol is an Ethereum-based protocol for collateralized ERC20 tokens. Practically speaking, a {Set} token is an ERC20 token with two additional functions: issue and redeem which serve to convert between the {Set} token and its constituent tokens. The architecture of the {Set} Protocol is illustrated in the following diagram:
While the {Set} Protocol team has their eyes set on enabling higher order derivatives such as index funds, they recently launched TokenSets to illustrate the possibilities of the protocol.
dYdX
dYdX is one of the most complete derivative protocols in the market. At its core, dYdY introduces the notion of a Margin Trading Protocol which mimics the analogous behavior in financial markets. In traditional margin trades, a trader borrows an asset and immediately trades it for another asset. The asset must be repaid to the lender, usually along with interest, at a later date. Margin trading includes both short sells and leveraged longs.
The dYdX Margin Trading protocol uses one main Ethereum Smart Contract to facilitate decentralized margin trading of ERC20 tokens. Lenders can offer loans for margin trades by signing a message containing information about the loan such as the amount, tokens involved, and interest rate. These loan offers can be transmitted and listed on off-blockchain platforms.
Recently, the dYdX team released a series of second-layer contracts that use the base Marging Trading protocol to implement more sophisticated financial constructs such as Price Oracle or Lenders.
Dharma
Dharma protocol is a highly generic construction that allows debt agreements of virtually any type to be issued, crowdfunded, and traded as tokens. The Dharma protocol is based on two main concepts:
· Agents: Represent the end-consumers of the protocol — i.e. entities looking to borrow or lend crypto-assets. The main two types of Agents are Debtors and Creditors.
· Keepers: Represent utility players who provide value-added services to the network and compete in their respective marketplaces for compensatory fees. The main two types of Keepers are Underwriters and Relayers.
Firmo.Network
The Firmo protocol is an interesting addition to the crypto-derivatives ecosystems. Technically, the platform implements a higher level domain specific language called FirmoLang that enables the implementation of financial instruments using tokens on any blockchain. Obviously, that’s another way of saying that FirmoLang enables the implementation of crypt-derivatives across different blockchains 😉 The platform already offers compilers for the Ethereum Virtual Machine and other platforms should soon be supported.
These are just some of the main examples of derivative protocols that are becoming relevant in the crypto space. As trends like security tokens or crypto ETFs become more popular we should see crypto-derivatives become a more relevant component of the next generation of crypto-assets.