Challenges Facing The Decentralized Derivatives Market And How To Solve Them

Derivatives spark conversations around any financial table as an essential element of any capital market, and with the recent approval of Bitcoin ETFs, crypto enthusiasts are increasingly finding a footing in the space. Derivatives can help traders hedge against potential risks and increase their returns through leverage.

There are several types of derivatives available in the financial markets today, including swaps, futures and options. Despite the differences in each of them, they all share a common principle – allowing investors to benefit from future asset price fluctuations without owning the asset, but rather a contract.

Derivatives have been used by financial traders for centuries and millennia, helping them gain exposure to different assets, diversify their portfolios and as a risk management tool to offset potential losses on an existing investment. As such, the financial derivatives market stands as the largest financial market today as per Business Research Insights reporting. The market stood at $22 trillion in 2020 and is expected to touch the $55 trillion mark by 2031, representing a CAGR of 8.6%.

As the crypto market recovers from a long winter period, the opportunity to develop a new generation of derivatives products within the space has never been bigger, especially in the decentralized finance (DeFi) market. The space needs to develop radical solutions to the current challenges facing the DeFi derivatives market to compete with their CEX counterparts and the traditional derivatives markets.

A slow growth across DeFi

Over the past five years, the decentralized finance market has witnessed astonishing growth – with $103.30 billion locked in the space, data on DeFi Llama shows. Despite the tremendous growth across the space, DeFi derivatives remain relatively immature, with only $20 billion locked on derivatives platforms.

In stark contrast, centralized crypto exchanges’ derivatives trading volume rose by nearly 40% across the last three quarters of 2023 to close the month of December at $2.58 trillion, a record figure for the year. There is no denying that derivatives are one of the most important missing pieces in the DeFi space, and more developments and solutions need to be put forward to grow these financial products.

With products such as dYdX, Synthetix, and Ithaca showing potential in the space, decentralized derivative markets could achieve meaningful adoption. Before we dive into how upcoming DeFi platforms are boosting innovation in derivatives, let’s take a look at the challenges preventing mass adoption of these financial instruments.

Challenges hindering the adoption of decentralized derivatives

Most of the challenges preventing the mass adoption of DeFi derivatives can be pointed to the explosive growth of the space and the intrinsic nature of DeFi platforms. Critically, the space faces five major challenges that need to be addressed to catalyze the adoption and trading of DeFi derivatives.

While this is not an exhaustive list, these challenges, if these challenges are solved, it would be a great starting point for enticing traders into DeFi derivatives markets.

1. No collateral optimization

In the decentralized world of DeFi, collateral plays a crucial role in enabling various financial activities, including derivative trading. On CEXs users usually have access to leverage, which helps them trade more volumes than they currently hold. However, on most DeFi derivative platforms, users need to lock up more liquidity than the actual value of the trade – over-collateralization. This reduces the efficiency of capital utility on decentralized derivatives markets and the ability for traders to leverage their assets effectively.

Additionally, traders have a limited range of assets to set up as collateral, usually large-cap tokens such as Bitcoin and Ethereum. Finally, managing collateral on DeFi derivatives platforms can be a complex feature for traders due to the intricacies of smart contracts, leading to suboptimal usage of crypto assets.

2. Lack of seamless derivative strategies

Secondly, decentralized derivatives are siloed within a single blockchain, leading to capital utility inefficiencies and poor economic incentives. Notwithstanding, most DeFi platforms also lack seamless derivative strategies, limiting users to buying calls and selling puts as the only available option.

This limits the traders from adequately hedging their positions, hence the switch to CEXs or TradFi. Luckily, platforms such as Ithaca aim to change this with their option trading infrastructure that reimagines derivatives markets and can be deployed in DeFi, CeFi, and TradFi. This helps jumpstart liquidity across DeFi platforms and with their algorithmic market maker embedded into its matching engine, market makers can easily create new derivative strategies.

3. Complexity of decentralized derivatives

Compared to their CEX and TradFi counterparts, decentralized derivatives are more complex to use, which may dissuade less experienced users from engaging. The need for non-custodial wallets, understanding gas fees and how DeFi systems work could also play a role in hampering the adoption of decentralized derivatives.

4. Regulatory concerns

One of the leading challenges across the wider DeFi ecosystem is regulatory uncertainty. Currently, there’s little to no regulation within the space, which has hindered the massive adoption of the technology or institutional investment in decentralized derivatives. The unregulated environment poses a challenge in compliance and investor protection, hence lower capital investment and liquidity which negatively impact the adoption of decentralized derivatives.

The DeFi space operates in a relatively unregulated environment, posing challenges in compliance and investor protection. Regulatory uncertainties could impact the growth and adoption of decentralized derivatives.

Final comments: Unlocking the next level of DeFi derivatives

Innovation and demand is rapidly rising for decentralized financial solutions and instruments across the Web 3 landscape. This calls for the creation of platforms that offer solutions to the challenges facing decentralized derivatives. As mentioned before, Ithaca stands out as one of these platforms, offering traders access to an interoperable, multichain and user-friendly options protocol for their needs.

Effectiveness and accessibility of DeFi derivatives will become more prevalent, as better smart contract capabilities are built, security safeguards are maintained, and blockchains are able to ‘talk to each other’. Institutional involvement is likely to increase as regulatory clarity increases, thereby legitimizing the area.