Decentralized derivatives are financial instruments that are traded on decentralized exchanges (DEXes). They are becoming progressively popular in DeFi, a financial system that aims to create open and permissionless financial services on the blockchain. Like traditional derivatives, decentralized derivatives derive their value from underlying cryptocurrency assets.

Decentralized derivatives stand out because they often have low barriers to entry as anyone can connect to them with their crypto wallet. Although, unlike traditional derivatives, decentralized derivatives are powered by smart contracts that can automatically facilitate and execute contracts.

While cryptocurrency-based derivatives are most common in DeFi, it is also possible to create decentralized derivatives tied to other types of assets, such as stocks. Since crypto derivative protocols typically allow users to retain control of their assets and keys, users can easily move their assets between different protocols without requiring a centralized or third-party custodian.

How Do Decentralized Derivatives Work?

The working principle of decentralized derivatives involves the use of blockchain to facilitate transactions without intermediaries. The blockchain serves as an immutable ledger that records all transactions and contract executions in a decentralized way, ensuring that a transaction cannot be altered or removed.

Decentralized derivative protocols can be built on different blockchains, such as Ethereum, BNB Chain, Solana, or Layer 2 platforms—Arbitrum, Optimism, etc. However, the overall performance and user experience of each protocol can differ because different blockchains have their own unique levels of scalability, security, and transaction costs. Although some decentralized derivative protocols enable cross-chain compatibility, enabling users to trade derivatives across various blockchains.

To properly function, protocols use blockchain oracles to ensure accurate and real-time price tracking of real-world assets. These oracles have different levels of data accuracy, update frequency, and decentralization, which will eventually affect the platform’s reliability.

Because different platforms offer decentralized derivatives, the mechanism of action may vary depending on the type of derivative and the platform’s mode of operation. However, here is a general overview of how they work:

A user connects their crypto wallet to a decentralized derivative platform and deposits some funds.
The user chooses an underlying asset and the type of derivative contract they want to trade. They may also need to specify parameters such as expiration date, strike price, or leverage ratio.
The platform then matches the user with another user who wants to take the opposite side of the trade. Depending on the type of derivative chosen, the platform may also create a synthetic asset that tracks the price of the underlying asset.
Based on the contract, the platform creates a relevant smart contract and stores it on the blockchain.
The user can monitor the performance of the contract and close it at any time before or at the expiration date.
The smart contract automatically executes the contract and pays out the profits or losses to the user following the contract outcome.