Potential of DeFi, TradFi and blockchain derivatives
In TradFi, there are no problems ā the issue is actually in the regulations, in bureaucracy, but not in the tools themselves.
Author: Sonya Sun
January 26
In TradFi, there are no problems ā the issue is actually in the regulations, in bureaucracy, but not in the tools themselves.
About the Background
I was deeply involved in mathematics and eventually transitioned into financial markets, specifically focusing on debt obligations, debt instruments, and interest rates. More accurately, I worked with a range of financial instruments that were tied to interest rates. This area involved a substantial amount of mathematics due to the constantly recalculated curves. Furthermore, various interest rates had different impacts on pricing ā this is a fascinating aspect of finance that is heavily linked to mathematics.
I worked in a hedge fund. At a certain point, I managed several funds within one organization. Then Ethereum emerged. In my opinion, Ethereum is not just another cryptocurrency. It represents a whole, impressive ecosystem.
My friends and I began experimenting in this ecosystem, treating it as a hobby. We believed that it could someday resemble a financial system. This 'someday' arrived quicker than we anticipated, and now it is part of the financial system known as DeFi, which we are actively involved in.
Back in the early 2000s, working at a hedge fund was trendy. Firstly, because it was appealing to women. Hedge fund managers flew in their private jets and were very wealthy. Secondly, these managers were very intelligent, which also was attractive. They earned their wealth not just by being in the right place at the right time but by outsmarting the market.
They earned their money with their brains. Everyone wants an interesting job: to work intellectually, face something new every day, solve fresh challenges, and live an extraordinary life.
Transitioning from TradFi to DeFi
The main insight I gained during my time in web3 is that the future has arrived. The traditional, cumbersome, complex financial system, where banks once held more sway than anyone else, has encountered the emergence of web3. It appeared like the Internet did in the 90s.
Lawyers, notaries, attorneys ā all part of a huge system that, until then, existed mainly to sustain itself. Obviously, web3 didn't emerge in its ideal or final form, just as the Internet exists today. And this is just the beginning. Many from our generation thought, "It would be cool if I had created Google back then." We see the same potential now with blockchain technology, and it's exciting.
I tried to create a DeFi protocol within the company, and it would have been the ideal scenario. But such corporations are highly bureaucratic, and it's tough to introduce anything new and innovative, even though we had a working group on innovations, which, to be honest, was quite uninspiring.
At one point, I met with a very important person within the organization. We went for coffee, and during the meeting, I talked to him about web3 and the future. I insisted that we couldn't miss such an opportunity.
He listened to me and finally said that I could do it within the fund, although it would cause me a lot of stress. If I succeeded, I would get a bottle of champagne and a watch as a bonus. But he also suggested that I leave and start my own startup, with the potential to grow into a billion-dollar company. He then asked what my motivation was to do this within the fund. That made me think.
My friends and I started working with crypto, treating it as a hobby. We never thought that DeFi would take off so quickly. Initially, we were very interested in trading derivatives and thought, why not create them on the blockchain? Just out of interest.
After all, blockchain contains everything necessary. You can create any derivative, and it will work. Without a legal contract, without corporate backing, but simply through programmed code.
Initially, it was a hobby, but then I left my job. I decided to develop my protocol. My friends and I first created one, then a second, a third, and a fifth ā and realized they were very similar to each other. It made sense to create a universal protocol that could work with any instrument.
Essentially, 90% of what people do with financial instruments is similar. Buy, sell, mint, burn ā it doesn't depend on the instrument, whether it's a future or an option. The logic is the same. And we developed our logic with a superimposed instrument that allows working with it within the system.
About Opium Integrations and the Power of the Crypto Community
The Opium Protocol garnered significant attention, investors, and integrations in 2020 and 2021. It was one of the few protocols to do so. Furthermore, we've always collaborated with other DeFi projects. You could say we've grown alongside them: lending protocols, aggregators, DEXs, you name it.
Collaboration, integration, composability - these are crucial aspects of DeFi. It's one of the benefits that web3 offers. In essence, you're not building something isolated; you're creating something that interacts with other protocols at a native level.
At present, we have strong connections with many projects. If you look at the number of chats we have, the amount of tea we've consumed, and the meetups we've attended, it's quite extensive. This is what drives me - the atmosphere. There are many brilliant minds: they're all friendly, responsive, and help each other - it has formed a fantastic community. This sense of community is what I missed in my previous roles.
I studied at the Faculty of Mechanics and Mathematics in Moscow. It's a unique gathering of tough and talented mathematicians. I've never encountered such a community after university, despite working in various Western companies and living in Amsterdam for the past 15 years. I've worked in funds, in different departments, but I've never experienced such a community.
Currently, our most extensive integration is with 1inch. That's because they handle the part we don't. They've grown into a massive aggregator of DEXs, a vast order book for all of DeFi. And we need that. For instance, we require their Pathfinder so our products can remain liquid and arbitrage across any pools, market makers, and anything else. So, they handle the transport layer for us. With other protocols, we integrate, but probably to a slightly lesser extent.
We began our activity during the bear market, just like everyone else, I suppose. It was a good period because it freed up our hands, good people entered the market, and the amount of scams and marketing decreased. We are currently regrouping, collaborating on a few projects. We've hired new employees, and this year, we will focus more on articles, marketing, and our channel.
Active development during the bull run is challenging due to the high amount of scams. Scam projects thrive by investing heavily in advertising and trying to extract as much as possible without creating something long-term and complex. It was quite challenging in such a noisy information environment. But now, everything is going well - we are building again.
At Opium, we have more of an engineering culture because derivatives are a relatively complex product. If we were developing a very simple NFT project, our strategy would be different. We lean more towards B2B, and we excel at it.
Selling to retail users can be risky from a regulatory standpoint. Such instruments should be sold to people who understand the risks.
It's like selling knives. A knife is a useful tool, but you can cut yourself with it. B2B turns out to be very relevant for us. Market makers, exchanges, and other professionals with millions of dollars come to us because they understand why they need Opium.
Thanks to web3, a certain barrier disappears. Previously, you had to study, work, and maybe, if you were lucky, end up in a hedge fund alongside big money. Now it's much easier. You can understand everything on your own and launch a mini hedge fund in web3 right from home. Although the risks haven't gone away: those who don't fully understand can lose money out of ignorance.
For some time, the risk of losing money will still be an issue. On CEX, for example, we saw regulatory problems: when FTX sent funds where they shouldn't have. Because there was no regulation. Because FTX didn't have to be accountable to anyone.
When I say that anyone can create their own derivative, I mean the community. Those who are interested in what we do. For example, someone wants to create a derivative for the price of something exotic, say, legalized marijuana. So, a new market opens up, factories start operating in Europe, and legalization begins. Accordingly, someone can create a hedging tool for themselves. To do this, you need to understand web3 at least a little and have some programming skills.
Opium has evolved into a tool for the community. This is the essence of web3. Andreessen Horowitz has described this idea well.
Web1 is like a newspaper. You read something that someone else wrote. Web2 is content generated by those who consume it, but the ownership of that content belongs to a corporation. Think Instagram, YouTube, Facebook. Web3 adds ownership to the mix. Corporations share profits with users, but some give very little. Facebook seems to give nothing at all, just like Instagram. YouTube gives about 40% of its profits to content creators.
Opensea, on the other hand, gives 97% of its profits to the community. Users not only create and consume but also fully own. And this ownership is made possible by blockchain.
About Derivatives and Risks in Economic Activities
When engaging in any economic activity, there are always risks involved, and these risks come in various forms. For instance, if you're trading commodities like wheat or oil, the price can either go up or down, presenting you with market risk. You might also be trading these commodities in different currencies, which introduces currency risk. Additionally, if you've taken out a loan at a certain interest rate, changes in interest rates can affect your ability to repay the loan, making interest rate risk a factor.
Understanding markets boils down to two basic things. Firstly, it's about how one perceives the market. For instance, someone might believe that ETH won't see significant growth in the near future, and for them, investing in it would entail a substantial risk. On the other hand, I, for example, consider Ethereum a solid and valuable asset. I'm willing to invest in it because I'm confident it will appreciate.
But for a 60-year-old librarian, ETH might seem daunting, a risky proposition they're not prepared to engage with, making the risk substantial for them. And that's perfectly fine.
People of different ages, professions, and mindsets perceive risks differently, which is why they are willing to trade them. Some people sell risks to others and receive compensation in return.
Secondly, companies behave in both precise and unpredictable ways. For some, a rise in prices is seen as a risk, while for others, it's an opportunity to profit. This abstract concept gave rise to the derivatives market.
A derivative is essentially a contract that describes a specific risk, one that can be bought or sold. In a way, it's similar to car insurance. However, in the modern derivatives market, the key distinction lies in standardization.
So, we don't have a billion different contracts. We have one contract representing one ton of oil, and the price of oil is determined by a specific exchange rate. If someone has two tons of oil, they buy two contracts. If someone has a hundred tons, they buy a hundred contracts. If someone has oil that's consistently 20% cheaper, they buy 0.8 contracts for each ton. Those who understand their risks determine how many standardized instruments they need.
The simplest derivative is a futures contract. It's an agreement on a future price. Let's say I'm a wheat farmer and I'm growing wheat. I don't want the price of my wheat to drop next year because I won't have enough money to maintain my farm. However, if the price significantly rises, I'll have a lot of money. I don't want to take that risk of having a year of huge profits followed by a year of bankruptcy because I need to maintain my farm consistently.
Although this scenario is much better than having a year of bankruptcy followed by a year of abundance. After bankruptcy, there's no guarantee I'd even survive to the next year. And such an outcome is entirely possible.
So, people came up with the idea of risk exchange. For a baker who buys wheat every year, a high price is a catastrophe. They can approach a farmer and agree on a fixed wheat price for the next year, one that's either the current market price or slightly higher. It's a price that works for both parties and protects them from financial catastrophe. That's the simplest form of a futures contract.
When people say that derivatives caused the financial crisis in 2008, it's not entirely true. They did play a role because they existed without limits, without risk assessments, and without a clear understanding of what was being sold and used. However, in general, derivatives help smooth out many fluctuations and prevent crises.
The situation was different then. Derivatives were being sold on top of other derivatives, which were bundled into yet more derivatives. These were sold to investors who didn't even understand what they were buying. That's what caused the crisis. But derivatives themselves aren't to blame. It's like blaming a car for transporting a bomb.
The hype around derivatives can affect the underlying asset. If we agree on the price of wheat for the next year, that's the price we'll sell at, regardless of market fluctuations. If we want to create futures, we issue standardized contracts for one ton of wheat. You sell one contract, I buy it. Let's say the agreed-upon price suddenly becomes very high, perhaps due to an imbalance between sellers and buyers. It happens. This can impact the current market.
Imagine there's a hedge fund, and I'm in it, observing prices. I see that prices for the next year are very high, but current prices are low. I buy wheat at the low prices, store it, and know for sure that I'll sell it at a much higher price through a futures contract next year. This way, I influence both the futures and the current market. The current asset becomes more expensive because I start buying it, while futures become slightly cheaper because someone starts selling.
The futures market is fascinating to watch. If there's some catastrophe that wipes out all wheat fields, the futures market reacts instantly. The spot market doesn't because it represents the current market, and right now, there's plenty of wheat. But everyone knows that it won't be the case in the future, and wheat prices will undoubtedly soar.
The derivatives market is vast, larger than any other market in the world. It's not just two or five times larger but 20 times larger than the world's GDP. This market still has room for improvement. Currently, it's not as efficient because banks make excessive profits through fees. However, in crypto, this market has seen innovation, which is why Opium is involved in derivatives.
About the Mechanics of the Opium Protocol in Steps
We might look like your classic TradFi derivatives, and there are several advantages to that. Professionals don't need guidance on how to work with us because it all adheres to market standards. Moreover, you can interact with TradFi directly since it's essentially the same instrument.
Our protocol serves as the foundation, a settlement protocol that allows you to define the parameters of a financial instrument, such as options, straddles, or spreads, based on the price of the underlying asset. You can create an instrument by specifying its parameters and logic, then use it in DeFi. You have the option to use various valuation models independently, like Black-Scholes or MatLab, or leverage automated market makers operating on the principles of Uniswap or other AMMs.
Let's break down the process into steps. The first step involves creating the financial instrument of interest, which can be either an existing one or a new one. For instance, it could be a specific option on a particular product. We can issue it in any quantity, using collateral. When you issue the instrument, you don't pay its full cost; you provide collateral and receive the instrument. Upon returning the instrument, your collateral is refunded.
The Opium protocol isn't concerned with the instrument's value; it only focuses on the amount of collateral backing it. If the collateral is sufficient, the protocol mints the instrument, such as long or short. These positions always have a fixed collateral, and you can sell them at any price.
For convenience, we have an order book integrated with the 1inch protocol, allowing you to see all your orders. You can place your option in the order book and specify, for example, that you want to sell it at 10 basis points. Various strategies, Uniswap market makers, and other major market makers are connected to the order book. If they like your price, they execute the trade. If not, you'll have to wait.
We also employ a Dutch auction mechanism that enables you to list an option with a high initial price that gradually decreases until it becomes attractive for purchase. This is particularly useful for smart contracts, which may find it challenging to determine a fair option price.
The Opium protocol is the foundational layer for settlement, providing the infrastructure for trading instruments among various participants, including professional market makers, smart contracts, and AMM pools like Uniswap. The primary advantage is that all market participants have access, allowing them to submit orders and acquire options.
About Oracles and Ways to Provide Prices to Blockchains
We collaborate with Chainlink, and they excel in integrating prices into the Ethereum blockchain. Opium utilizes any available blockchain prices. For instance, if there's a gold price on the blockchain, we can create a contract based on it.
Chainlink significantly simplifies this process, and their solutions have been very convenient and efficient. We regularly communicate with them, and they listen carefully to feedback and implement innovations.
It's not obligatory to exclusively rely on Chainlink for price feeds. There's also Uniswap with the ETH to USD trading pair and a substantial trading volume, allowing us to see the actual market price. It's also an excellent oracle for Opium contracts since it's challenging to manipulate. To distort the price, one would need to manipulate all the trades.
We use the weighted average price for the last hour or 10 minutes. To manipulate an option and earn, for example, $100k or $1m, it would require billions of dollars in Ether, which is practically impossible. Personally, I really like such oracles.
The third type of oracles we've worked with are Proof-of-Stake (PoS) oracles, like the project with UMA and Elon Musk. The concept is simple and was described many years ago. Suppose we need to know what tie the President of France wore to lunchāinformation not available on the blockchain. Validators stake, say, $1000 and provide information about the tie's color.
Those who vote against consensus lose their funds, but the consensus is still recognized. Thus, if we have many validators and they are sufficiently decentralized, we get a reliable PoS oracle system capable of bringing any data into the blockchain. This is an interesting direction actively developed by UMA. Such oracles can reach consensus on any questions, which is also a unique system.
About Market Manipulations and Market Makers
One of the most notorious market manipulations of the past year was related to Avraham Eisenberg and Mango Markets on Solana, and then he attempted the same on Aave by manipulating the collateral value of CRV. In DeFi, even when using collateral and over-collateralization, manipulating the token's value can lead to arbitrage opportunities, sometimes even breaking the law, as in Eisenberg's case, who, as far as I know, is now facing legal consequences.
To prevent such situations, high-quality oracles and adequate collateral are required. Our Opium platform is designed to be permissionless and open to all. We don't evaluate whether a token, such as XYZ, is good or not. If a token is created, it will be available on the platform. However, the question is, who will buy it if the token is low quality?
The same applies to oracles: you can set up an oracle that reports data independently. Opium allows you to create any product, but if it's of low quality, no one will buy it. Typically, what trades on our platform is supported by good oracles with adequate collateral.
As for market makers like Wintermute, they use derivatives to hedge their risks. They purchase derivatives from our pools that they need for organic hedging. Most likely, they aren't speculating on them, although it's also possible. Mostly, they buy derivatives to hedge their risks.
I had the idea of getting into market making. Market making for options is a cool subject because not many people understand it, and not many people engage in it at all. There's an opportunity to engage in market making for options and hedge it with futures; you can do some riskier strategies. I think there's potential to make a lot of money there and make the market more efficient. I believe we might do something in that direction this year.
The Advantage of Knowledge in Market Adaptation
Among lending protocols, you can choose Aave and Compound. These are practically two protocols that are somewhat comprehensible. Compound is well-written and audited, while Aave is a bit more complex. But both have quality mechanics and high TVL.
Still, you won't make a fortune on these protocols alone. It seems to me that I would strive to delve deeper into DeFi and explore other protocols with the application of various strategies. This is much more important than earning some extra 2% in a protocol that nobody understands and where they lose all their money.
Overall, the best strategy is to look into the distant horizon for 5 years, hold ETH, and acquire knowledge. Because with knowledge, you can adapt and navigate faster when something happens in the market. Knowledge provides an advantage, and that advantage is precisely in making money.
Yes, there are currently no insurance options for losses in DeFi. But this issue will be resolved in the future. For example, insurance for stakingāwe've already tried to create such a tool. And then, theoretically, you can build a startup that conducts research on protocols and buys these insurances when necessary, while providing users with a convenient and understandable front-end and protocol reviews. It becomes a product oriented towards retail users. I believe that ultimately, that's how it will be.
Bootcamp: DeFi Analyst
From a Reddit Degen to a Dune guru.
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