The Evolution of DeFi and the Emergence of DeFi Derivatives

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By Reza Akhlaghi, Senior Content Marketing Manager, CoinDesk Indices

Much of the news coverage of the crypto industry, to no one’s surprise, has revolved around one overarching theme: business practices and subsequent business failures that have evoked an image of a house of cards. Some of these failures were of epic proportions, such as those of FTX and Three Arrows Capital. In fact, dampening of and outright loss in investor confidence were hallmarks of the blockchain economy in 2022. But another look at the above failures reveals that none were caused by the underlying blockchain infrastructure.

In the same year, 2022, progress in underlying blockchain technology and infrastructure continued apace. Ethereum underwent a successful upgrade and transitioned from a proof-of-work (POW) blockchain to one of proof-of-stake (POS), which came to be known as the “merge.” The tokenomics of Ethereum continued to evolve as smart contract platforms saw growing use cases and viable business adoption in NFT and DeFi, positively impacting the Ethereum ecosystem.

In this post, we look at institutional adoption of DeFi, the role and emergence of derivatives in it, and digital assets in the CoinDesk Market Index that are DeFi derivatives.

Decentralized Finance (DeFi) refers to digital assets that support financial products and services that are not facilitated or controlled by any central entity. These financial products and services are accessible without any barrier to entry or identification requirements. All DeFi tokens must be created on smart contract platforms and offer open-sourced liquidity with the ability for token holders to reserve governance rights. Growth and investment in DeFi have been one of the key developments in digital asset market and crypto ecosystem with increasing interest from institutional investors.

To be or not to be in crypto—that is the question for institutional investors today. Over the past two years, the emergence of Web3 and its related technologies, such as non-fungible tokens (NFTs) and the growth in the development of smart contract protocols that power the DeFi infrastructure, have drawn attention and interest from institutional investors to crypto as an emerging asset class with promising investment opportunities. Despite current economic challenges, as of early March of this year, the current total value locked (TVL) in DeFi protocols, which is a method that measures the value of all assets locked in them, stood at $49.82 billion, according to DeFiLlama. Another barometer of growth in DeFi is trading activity on decentralized exchanges, or DEXs. Trading activity on DEXs has grown significantly over the last two years as DEXs have established themselves in the industry as gateways to DeFi.

In the banking sector, a growing and diverse number of players are opening and launching crypto and digital asset desks and divisions. In 2022, banking institutions of all stripes went on a hiring spree, seeking high-calibre talent with expertise and experience in the crypto space.

In November of last year, JP Morgan, a bellwether of investment banking, in a joint project with the Monetary Authority of Singapore, executed its first cross-border transaction using DeFi on a public blockchain. As another stamp of approval for DeFi, in October last year, BNY Mellon, the world’s largest custodian bank, announced the formation of an enterprise digital assets unit to develop solutions for digital asset technology that bridges digital and traditional asset custody. And within retail banking, according to CB Insights, from August 2021 to May 2022 alone, over 20 banks made at least one investment in blockchain and crypto-related entities. Another development that was widely seen as a major vote of confidence in DeFi, this time coming from regulatory circles, was the approval of Anchorage Digital, a crypto custodian, to become the first federally chartered cryptocurrency bank. Many of these institutions now offer a whole slew of DeFi products, including crypto index funds that give investors a varying degree of exposure to crypto.

In essence, what the market has witnessed over the past two years is a gradual about-face by institutional investors on digital assets; that is, a shift from looking at crypto with skepticism to embracing it as an investment opportunity. As institutional investment in this asset class takes hold, different institutions will develop their own requirements for risk management along with their custody requirements. Seen from a socio-economic perspective, DeFi could be on its way to making access to financial services more egalitarian by migrating the trust layer from intermediaries to sophisticated software codes on the blockchain.

DeFi derivatives, similar to their counterparts in TradFi, are securitized contracts that give their owners exposure to an asset’s value and the ability to hedge price risk without owning the asset. But in the DeFi world, derivatives are smart contracts hosted on the blockchain. Derivative products include futures, options, swaps, forward contracts, prediction markets, and collateralized loans.

Some DeFi derivatives products offer investors the opportunity to develop synthetic assets whose values are tied to underlying real-world assets. DeFi derivatives are practically smart contracts that eliminate the role of a broker. In other words, in DeFi, the terms of derivatives are fulfilled on-chain by smart contracts.

With their ability to tokenize securities, DeFi derivatives are poised to transform not just the derivatives market, but also the overall securities market. According to BlackRock, the next generation of securities markets will be tokenization of assets through distributed ledgers.

The CoinDesk Market Index (CMI) is a broad-based index consisting of over 150 constituents¹ that is designed to function as a benchmark for the performance of the digital asset market. The CMI measures the market capitalization-weighted performance of the digital asset market, subject to minimum trading and exchange eligibility requirements.

At present, there are four DeFi derivatives assets in CMI. The four digital assets are as follows:

BarnBridge (BOND)

Ren (REN)

Synthetix (SNX)

UMA (UMA)

For more information about the CMI, and our broad market benchmarks and investible sectors, including CoinDesk DeFi Index (DCF) and CoinDesk DeFi Select Index (DFX), contact us at sales@coindesk-indices.com .

¹As of February 3, 2023

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