Analysis Of On-Chain Derivatives and It’s Use Cases

Blockchain has presented several approaches on how it can change existing structures more efficiently, flexible & cheap than traditional ones. This is particularly more visible in the financial services, which over the past few years have seen widespread interest in blockchain enabled deFi platform. The use of this new technology is increasing in all types of financial products and blockchain technology is opening up paths for more new ways in which it can be aligned with a traditionally understood investors interests. As a result, blockchain has contributed to the transformation of the global derivatives market that is valued at over a quadrillion dollars.

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An overview of financial and crypto derivatives.

A derivative is any other financial product in which the price will reflect the attributes of the underlying asset. However, there is usually no delivery of the underlying assets in a derivatives contract. However, the price of a sold derivative depends on some other indicator specific for the same reference asset. Firstly, the changes in market prices of the contract occur due to fluctuations and dynamics of their underlying assets. Anything tangible or not tangible with a feature that is quantifiable within an agreed upon frame of reference forms the base for a derivative. Hence, some of these include future contracts, options, and even swaps and collateralized debt obligations (cdos) which can be linked to just about anything conceivable.

Within the last decade, most cryptocurrency users have largely traded solely the spot market by instantly buying or selling an asset at its set price. However, as investor interest in the space has grown, numerous new cryptocurrency based derivatives have appeared, offering investors greater opportunities for various investments.
The first crypto derivate was a futures contract based on BTC price offered to the market in 2011. Years after, exchanges started offering diverse ranges of derivates which investor could utilize to cushion their investments with expected market movements and make profits owing to volatility. The crypto derivatives trading market experienced unprecedented growth culminating in an all-time peak by the year 2023.

On-Chain Derivatives: What you need to know

Trading in derivatives has always played a large role in traditional markets as traders are able to make bets on price movements without having an actual stake in the underlying asset. On-chain derivatives take this model further into the crypto arena by incorporating transparency, high speed, and decentralized trading in derivates markets.

Smart-contracts also known as, on-chain derivatives give an opportunity to create and trade the instruments like futures, options, swaps, etc. using the blockchain technology. Each of these contracts operates on its own and trust has been established, therefore no third party is required. On the other hand, on-chain derivatives are based on a variety of assets such as cryptocurrency, tokens, and even physical assets which have been coded into the blockchain.

On-Chain Derivatives Benefits

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[a] Transparency and Efficiency Enhancement

Transparency is among the most important benefits that on-chain derivatives provide. Traditionally, derivatives markets have been opaque, which makes it difficult for market participants to access information on the underlying transactions and pricing rules thereof. Conversely, real-time tracking and auditing of all transactions are possible with on-chain derivatives, which leads to a transparent market that is less prone to manipulation and fraud.

In addition, smart contracts automate all stages of derivatives contract lifecycle. On-chain derivate is an agreement, which eliminates involvement of intermediates while cutting down costs associated with conventional processes. Such efficiency does not just benefit the participants in the markets but further improves market liquidity as those on chain derivatives can be traded by a broad base of investors worldwide irrespective of their capital size and physical location.

[b] Risk Management and Regulatory Compliance

The use of on-chain derivates, which include creation of futures contracts and other complex financial instruments, enables advanced risk management. Smart contracts can be programmed in a way that they allow market participants to specify their risks. They can choose to customize them and thus be exposed to various price fluctuations, interests, and other risks associated with the markets.

In addition, regulators are empowered to have real time view of the derivative transactions due to the nature that blockchain is decentralized thus making it easy for regulators when they want to inspect transactions so as to ensure compliance. Due to the immutable nature of the blockchain, every transaction is etched in stone and cannot be altered, thus allowing regulators to track the markets more confidently.

On-chain Derivatives Use Cases

Speculation: On-chain derivatives in trading serve as a tool for traders to bet on asset price changes. Through employing derivatives to take long or short positions, traders may be able to earn in any market environment.

Yield Farming: Decentralized finance platforms are able to include some derivatives on chain in order to maximize the yield farming strategies. Thanks to derivatives, investors can protect their underlying assets while receiving a bonus token or more tokens as well as yield their assets passively on an open market.

Risk Management: Decentralized finance (DeFi) protocols require on-chain derivatives as risk management tools. There are several kinds of such protocols which use derivatives to hedge risky positions, diversify holdings, and improve performance of existing financial instruments.

Hedging: Crypto holders can use on-chain derivatives to minimize their losses resulting from price fluctuations. Such as futures contracts, which help an investor to agree on a certain price for buying or selling an asset at a particular time and avoid prices volatility.

On-chain derivatives come along numerous pros but it’s important to beware of associated challenges also:

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Smart Contract Risks: Financial losses may be experienced due to vulnerabilities present in smart contracts that are used for on-chain derivatives. Therefore, in this attempt, it is important to audit codes extensively and carry out thorough security assessments in an attempt to reduce associated complications.

Regulatory Environment: With growing acceptance of on-chain derivatives, cryptocurrency regulators remain vigilant. While a regulatory landscape is not yet developed, all involved parties need to constantly monitor for new legislative and compliance trends that apply within one specific field of law or another.

Liquidity: Derivative markets are dependent factors of liquidity such as the market. On-chain derivatives needs enough liquidity for better price discovery, smoother trade, and ease of funding. The task of developing liquidity pool and drawing participants into the markets is yet an ongoing challenge.

Education and Awareness: Although on-chain derivatives are still a new concept, one needs knowledge and technical proficiency to understand it. In this regard, education and awareness programs should be undertaken to ensure effective navigation of these instruments and decision making by users.

In conclusion

On-chain derivatives will significantly influence the development of the crypto market as it matures. These derivatives leverage the benefits of blockchain technology and allow users to make decentralized and effective trades among individuals and institutions. The rise of on-chain derivatives offers promising opportunities, as new innovative strategies are likely to emerge as their use becomes widespread among investors and traders.