Derivatives, the Second Half of DeFi

Incuba Alpha Labs
6 min readOct 24, 2020

DeFi is a Big Thing, but we’ve only just glimpsed a corner of the Holy Grail.

To understand the meaning of DeFi — decentralized finance, in a narrow sense, is “using decentralized networks to transform traditional financial products into a disintermediated, trustless, and transparent protocol”. We think the more ambitious vision of DeFi is to realize a “universal market access”, which allows anyone in the world with access to the internet to own or trade any financial assets openly.

From the recent explosion in DeFi market, we can see some significant features. From DEX, stable coin, leveraged lending, synthetic assets to emerging insurance products. With the strong momentum of liquidity mining, DeFi is transforming traditional financial products into protocol forms a hundred times faster than we used to see. We are also seeing more complex principles and structured financial tools have begun to penetrate the DeFi market. But the current DeFi is still incomplete as a “decentralized financial market” because of the lack of some basic products and services.

Similar to the development of traditional financial products, the current DeFi market boom is a typical expansion based on “debt-on-debt”, including the well-known over-collateralization rate and the nested multi-layer asset which is mostly seen in liquidity mining. In such a market, we can only rely on over-collateralization to circumvent the evaluation of the subject’s credit. However, collateralized-debt is essentially the least info-sensitive product in the financial market.

In the DeFi boom of the past several months, the basic underlying assets that support liquidity mining can be roughly divided into three categories: transaction fees, lending spread income, and collateralized governance tokens. We have already witnessed that when revenues of fundamental assets (or “productivity”) are not persistent enough to support credit prosperity, a risk backlash similar to traditional “financial crisis” will appear. Therefore, if the DeFi industry is to strive for real developments, rich and solid fundamental assets are still the most important cornerstone.

Whether in traditional financial markets or in DeFi, demands for “SAFU” assets and liquidity are lasting and stable. In the traditional financial market, we find at one side a large group of monetary assets collateralized by short-term debt, long-term debt based on sovereign credit, quasi-currency created based on the repurchase or asset securitization, or MBS, ABS, and other assets. But on the other hand, there are large-scale financial derivatives products with rich tools that has been formed on this basis, set to play a role of risk management, asset pricing, and market liquidity enhancement, forming a systemic financial market as a whole.

Whether we expect that the DeFi market eats the CeFi (centralized finance)market, or a convergence of these two parallel universes, DeFi users’ demand for “SAFU” assets, liquidity and risk pricing are equally urgent. We do not expect DeFi to produce absolute riskless assets, but expect to produce substitutes like asset-based securities as near-riskless assets by derivative protocols, and so forth.

In the current DeFi market, we can see that there are assets pegged to fiat like USDC and debt collateral debt position “DAI” as near-risk-free assets. But we still yearn for a more comprehensive yield and volatility structure. However, the market is still lack of essential financial tools and pricing mechanisms. In the process of mapping traditional financial market products, it is inevitable to break through the challenge of constructing a comprehensive decentralized financial derivatives.

DeFi lacking derivative products and markets is always immature.

We have been paying strong attention to synthetic assets that mimic positions for financial assets, some synthetic assets themselves are performing well as tokenization of financial derivatives. At the same time, we are looking forward to native decentralized derivative protocols to support Defi with tools for structuring “SAFU” assets, trade and hedge risk/volatilities, and complete the Defi universe with richer risk management and liquidity enhancement tools.

The concept of financial derivatives is actually quite broad, ranging from swap, forwards to futures and options. The underlying assets cover interest rate, equity, foreign exchange, commodities, and other asset products. They are widely used to balance position risk, liquidity, hedging, leverage, and other needs of portfolio and liquidity management. According to statistics from the Bank for International Settlements BIS, the scale of the global financial derivatives market is beyond imagination; its size can be more than 10 times of the global GDP and continues to maintain a rapid growth level.

Source: Greenwich Associate and FIA 2020 Derivatives Study

We are firmly positive on the decentralized derivatives sector, not only because from a short-term business perspective, decentralized derivatives protocols can share a cut of the profits from centralized derivatives giants such as BitMEX, OKEX, and Deribit; more importantly, from the perspective of creating long-term values, the decentralized derivatives market has huge potential and sits at the core of the entire DeFi ecosystem. It will be the most difficult part to overcome and complete within the DeFi industry, but it is also the most lucrative jigsaw puzzle piece.

The vigorous development of the decentralized derivatives protocols will break the islanding of DeFi protocols; Combining the Defi LEGOs can give birth to more promising trend opportunities.

Several trends we believe that will happen soon:

  1. The combination of derivative protocols will create financial products with a rich risk-return profile

The decentralized derivatives protocols can enrich the structure of the underlying financial products available in the DeFi world. More standardized investments and wealth management products based on these protocols will emerge to meet the investment needs of users. At the same time, more customized products or strategies that adapt to specific risk and profit structure requirements can be developed through the combination of derivative protocols.

For example:

  • MCDEX plans to launch structured products based on decentralized perpetual swaps, allowing users to gain exposure for leveraged trading profits.
  • the FinNexus option protocol plans to launch an option trading strategy to help liquidity providers hedge against impermanent loss in the AMM market making;
  • the emergence of IRS (Interest Rate Swap) protocol (such as Horizon.Finance) can be combined with options/future protocols to replicate the classic OBPI (Option Based Portfolio Insurance), providing fixed-income enhanced products for the DeFi market.

These mappings of the traditional financial market will offer a richer asset class for the DeFi world, smoothing out the current volatile yield curve in the DeFi world.

2. The specialization and complexity of decentralized financial derivatives will redefine the business model of asset management

Traditional financial markets generally face problems such as the fiduciary challenges and moral hazard of investment managers. With the non-custodial nature of DeFi and decentralized financial derivatives, the business model of traditional financial institutions with asset managers and third-party custodians will be revolutionized.

In the short term, DeFi vaults, which is now acting a role as “investment managers” will be facing the challenges of being homogeneous and decreasing the expected rate of return, will soon start to compete with each other on the capabilities in product design.

Vaults limited to plain-vanilla liquidity mining “farm and dump” strategies will lose market competitiveness soon. We can see vaults like DFI. Money, SashimiSwap, and other communities have already been discussing richer investment strategies and planning to launch strategies based on financial derivatives to provide users with richer risks return matrix.

In the long run, the enrichment of financial products in the DeFi market and the improvement of market depth will further increase the demands for specialized investment advice and services. Decentralized active asset management protocols and investment advisory protocols such as dHedge and Set Protocol will show great development potential.

Merely mapping the financial products from traditional financial markets in a decentralized way is not the true meaning of DeFi and decentralized protocols. The development of decentralized derivatives protocols will be unprecedented and will redefine the nature of asset management, a business model that has been unchallenged for more than hundreds of years, and thus realizing our ambitious vision of “allowing anyone in the world with access the internet to openly own or trade any financial assets”.

Incuba-alpha is a fund empowering talents building an open digital society. We are searching for entrepreneurial teams who want to create transformative decentralized financial derivatives protocols and will actively deploy resources and invest in this field. If you want to participate in the decentralized derivatives sector, we will be happy to get in touch with you.

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Incuba Alpha Labs

Incuba-alpha is a fund empowering talents building an open digital society.