Derivative Markets - An IntroductionThe derivatives market will be disrupted and decentralised, providing immense potential for insurance markets and risk applications
The global derivatives market is an untouched area of concern that the decentralised landscape could support. Currently, the notional value of derivatives in traditional finance is four times the world’s debt and sixteen times the world’s estimated money supply. How is this so? We’ll take a closer look throughout this education series, starting here at derivatives and the size of this market, and working through topics such as perpetual swaps, options, and what the future of the derivative market really could be.
In 2019 the global derivatives market represented $640T in notional value. The size and scope of this market is staggering. While these figures may seem impossible, it's due to a concept called leverage that this large volume can exist. More importantly, the potential for monumental impact in the near future warrants the need for reliable risk management systems.
With leverage, the notional value is the amount the derivatives contract controls, or, the total underlying amount of a derivatives trade. Because of this, the notional value of derivative contracts is much higher than the market value.
First things first, let’s examine the basics. Derivatives are contracts based on the value of an underlying asset such as currency or interest rates. Derivatives can be thought of as essential synthetic oil in the economic engine, a crucial element that commands significant sway over the rates we pay for goods and services. And yet, the market is rarely seen or heard of by those outside trading floors. Forwards and futures, options, and swaps are the three types of derivatives. Swaps, which are soon coming to the Tracer DAO ecosystem, allow for the exchange of cash flows between two parties and usually involve the exchange of a fixed cash flow for a floating cash flow.
Unsurprisingly, derivatives exert a notable impact on modern finance by providing some advantages to the financial markets. They provide a way to lock in prices, hedge against unfavourable movements in rates, and mitigate risks, often at a limited cost. In addition, derivatives can often be purchased on margin — that is, with borrowed funds — which makes them even less expensive. They also enable organizations to gain access to otherwise unavailable assets or markets — for example, by employing interest rate swaps, a company may obtain a more favourable interest rate relative to the interest rates available from direct borrowing.
When we look at current estimations of the global derivatives market, the notional value is sitting around ~640T$USD. Whilst it is difficult to quantify the exact figure, it is clear that the value of these trading instruments (or at least the total value these instruments control), are an order of magnitude larger than its underlying market. Previously, this may cause one to err on the side of caution. After all, it was the credit default swap that caused the global financial crisis. However, with new technologies there is the potential for safer, transparent, risk mitigation systems to prevent these events reoccurring.
While Debt, Market Cap and Notional Value are different metrics of value, these images depict quantitative measurements of financial markets in FIAT denomination.
Currently, the everyday retail trader (regardless of experience) has little to no access to this market. The privilege of this access has only been bestowed upon corporate institutions and hedge funds. The growing decentralised derivatives market highlights the retail investor appetite for this untapped market, utilizing the added benefits of decentralised technology, using a transparent, open source environment.
Derivative Contracts on the Blockchain
This decentralised derivatives market is an untapped goldmine, waiting to be discovered. With enormous potential for risk mitigation strategies and protection against price fluctuation. And, with DeFi continuing to challenge the dominance of traditional finance, it's only a matter of time before we see a decentralised derivative protocol such as Tracer DAO emerge as the next generation of financial infrastructure.
To assist this expansion, blockchain networks like Ethereum are allowing for new financial infrastructure, such as derivative protocols, to be built. With the help of smart contracts, this infrastructure provides extremely efficient and secure peer-to-peer transactions and agreements that are redefining the global financial landscape. As the power of smart contracts and blockchain continues to be realised by mainstream institutions, consumers will continue to shift their preferences from traditional fintech and to blockchain-powered technologies.
As reliable data becomes significantly more accessible on-chain, courtesy of projects like Chainlink, the potential for new and exotic derivatives markets is opening up. Tracer aims to utilise these oracle data feeds to allow retail traders to take both long and short positions on any asset with a publicly available price feed. Tracer is bringing previously uncontemplated and inaccessible markets to anyone with an internet connection; allowing more people to gain access to risk mitigation strategies for unpredictable everyday events.
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