How to play with derivation in DeFi? Let's understand it from scratch.

Warning: The content is lengthy, but full of valuable insights.

If you want to profit in the crypto market without directly holding a particular cryptocurrency, derivatives are an excellent choice. The value of this financial instrument, derivatives, depends on an underlying asset (such as Bitcoin or Ethereum), allowing traders to make money through price fluctuations—even if they do not own the asset at all.

In the DeFi (Decentralized Finance) ecosystem, derivatives are growing at an astonishing rate. Unlike traditional derivatives, DeFi derivatives operate on the blockchain, automatically executing trade conditions through smart contracts without the need for intermediaries.

The Core Logic of Derivatives

Derivatives are essentially contracts between two parties, with value derived from the future price movements of an underlying asset. Simply put, derivatives give you the opportunity to profit from price fluctuations in the asset—whether the price goes up or down.

Derivatives are divided into several types: futures contracts, options, and swaps. Their commonality lies in a core principle - investors can profit from the future price movements of an asset without actually owning that asset.

Derivatives have two important functions: risk hedging and leverage trading. For example, a trader with limited funds can use leverage to control larger amounts of futures contracts. Additionally, derivatives can also be used for portfolio hedging—offsetting potential losses through inverse derivative positions.

But be aware: Derivatives are complex instruments, leverage can amplify gains but also amplify losses. It is essential to understand the risks before trading.

Key Differences Between DeFi Derivatives and Traditional Derivatives

The value of DeFi derivatives still depends on the underlying assets (usually cryptocurrencies), but they operate on blockchain protocols. The most common in DeFi are cryptocurrency derivatives, although users can also create derivatives associated with other assets such as stocks.

Through derivative contracts, anyone can profit from asset price fluctuations or hedge positions in a transparent, trustless environment. DeFi derivative protocols are usually easy to use—anyone with a crypto wallet can participate.

The biggest advantage is self-custody. Traders can control their own assets and private keys without having to hand them over to centralized platforms or third-party custodians. This means you can freely move assets between different DeFi protocols without having to wait for long withdrawal times.

How DEX Derivative Platforms Operate

Decentralized derivatives exchanges (Derivative DEX) operate on the blockchain, eliminating intermediaries. The blockchain itself is an immutable ledger— all transactions and contract executions are permanently recorded and cannot be tampered with.

DeFi derivatives protocols are built on various blockchains: Ethereum, BNB Chain, Solana, or layer two solutions. They differ in security, scalability, and transaction costs, which can affect the platform's usability and overall performance.

Some DEXs focus on cross-chain compatibility, allowing users to trade derivatives on multiple blockchains simultaneously.

Smart contracts are the core technology of DEX. These self-executing programs directly encode the conditions, automatically executing transactions, settlements, and other functions (such as staking and governance) without human intervention.

DEX also relies on blockchain oracles to accurately track prices and maintain a connection with real assets. The degree of decentralization, data accuracy, and update frequency of different oracles vary, which affects the overall reliability of the platform.

The Power Structure of Derivatives

The DeFi derivatives protocol adopts a decentralized governance model—users can participate in decision-making to a certain extent. However, some protocols adopt a highly decentralized structure, while others rely on centralized decision-making.

Native tokens play a key role in DeFi derivatives. On certain platforms, token holders can participate in governance through DAOs (Decentralized Autonomous Organizations) and vote on protocol improvements and other changes. Sometimes tokens can also serve as collateral for trading instead of stablecoins.

DEX may also incentivize market makers with native tokens. For example, some exchanges charge fees and distribute them to liquidity providers as a reward for adding liquidity to the platform.

Four Major Types of DeFi Derivatives

perpetual futures

Futures contracts allow traders to profit from future price movements of the underlying asset. A future is an agreement to buy or sell an asset at a predetermined price on a specified future date.

In traditional finance, futures are typically traded on centralized exchanges. DeFi provides traders with a decentralized, trustless environment to trade futures directly on the blockchain, without intermediaries.

DeFi futures can be perpetual or have a fixed expiration date. Perpetual futures simulate traditional futures trading but do not have an expiration or settlement date - this is the most common type of derivative in DeFi. Perpetual futures offer greater flexibility and accessibility than regular futures but come with risks of high leverage and financing costs.

options contract

Options give the holder the right (but not the obligation) to buy or sell the underlying asset at a specific price on a specific date. The same goes for crypto options.

Options can be used to hedge against price volatility risks or to trade on the future price movements of assets. For example, if you hold ETH but are concerned about a future decline, you can purchase a put option, which allows you to sell ETH at a predetermined price regardless of the spot price. This can limit potential losses.

Conversely, options can also be used to profit from the rise in cryptocurrency prices. In this case, you would purchase a call option, which allows you to buy the asset at a predetermined price, profiting when the asset's value exceeds the strike price.

synthetic assets

Synthetic assets (or “synths”) are digital versions of real assets, making them convenient for storage and trading. They are essentially blockchain derivatives that use blockchain to replicate the value of underlying assets, including features such as inflation.

Although synthetic assets are similar to stablecoins, they are more diverse - they can represent stocks, precious metals, altcoins, options, and even futures.

Synthetic assets attempt to accurately reflect the value of underlying assets, but are not directly backed by them. Their purpose is to leverage the transparency and openness of blockchain to provide barrier-free access to anyone globally, creating a trustless investment space that makes traditional assets more accessible.

Swap Contract

A swap is an agreement between two parties to exchange cash flows, usually based on different assets or price indices. In DeFi, swaps can be used to exchange the value of different tokens or to hedge against interest rate risk.

The Real Dilemmas Facing DeFi Derivatives

Before investing, it is crucial to understand the trading risks. DeFi derivative trading is often riskier than direct crypto trading because derivatives are complex and volatile instruments. Traders should be prepared to bear greater gains and losses.

Liquidity issues may also arise. DEX is still an emerging platform, and low trading volume can lead to significant slippage. Compared to traditional crypto exchanges, the experience of using DEX is not as smooth.

Beginners may encounter difficulties when using non-custodial wallets—connecting wallets, remembering passwords, and saving mnemonic phrases all require learning. Moreover, most centralized platforms support real-time trading, which is not subject to block time constraints; however, due to network congestion and rising fees, using an order book on a DEX is not always straightforward.

Security risks cannot be ignored either. DEX is not completely immune to hackers and has its own vulnerabilities. Since smart contracts manage DeFi protocols, a single error in the code can lead to the collapse of derivative contracts. DeFi platforms have suffered significant losses due to contract vulnerabilities.

To mitigate risks, always conduct your own research (DYOR), review the platform team, types of derivatives, and the security level of smart contracts.

The Future of Derivatives in DeFi

DeFi derivatives are growing rapidly, providing investors with the opportunity to profit from asset price fluctuations in a trustless environment. As blockchain develops, more types of DeFi derivatives will emerge.

But before trading any financial instruments, objectively assess your knowledge level, risk tolerance, and the maximum loss you are prepared to bear. Responsible trading starts with understanding yourself.