So what was the first large scale bank run in DeFi all about? Why is it so hard to create a working algorithmic stablecoin? And what can we learn from the IronFinance fiasco? You’ll find answers to these questions in this article. 

Algorithmic Stablecoins 

IronFinance initially launched on Binance Smart Chain in March 2021 and aimed at creating an ecosystem for a partially collateralized algorithmic stablecoin. 

As we know, building algorithmic stablecoins is hard. Most projects either completely fail or end up in a no man’s land by struggling to maintain their peg to the US Dollar. Because of this, building an algorithmic stablecoin has become one of the holy grails in DeFi. 

Achieving it would clearly revolutionize the DeFi space as we know it today. 

The current ecosystem relies heavily on stablecoins that come with major trade-offs. They maintain their peg to the US Dollar at the cost of either centralization or capital inefficiency. 

For example, the custody of USDC or USDT is fully centralized. On the flip side, stablecoins like DAI or RAI require a lot of collateral which makes them capital inefficient.  

IronFinance tried to address these problems by creating a partially collateralized stablecoin – IRON. 

IronFinance 

Despite a few hiccups along the road, such as short periods of time when IRON unpegged from USD or when ValueDeFi exploits affected some of the IronFinance users, the protocol kept marching forward. 

In retrospect, recovering from these issues most likely built a false level of confidence in the protocol design as its users thought they were dealing with a “battle-tested” project.

In May 2021 IronFinance expanded to Polygon and started gaining more and more traction. 

Total value locked in the protocol quickly went from millions to billions of dollars, surpassing 2 billion before the final collapse. The value of TITAN – protocol’s native token on Polygon – went from $10 to $64 just in the last week leading to the bank run. 

This parabolic growth was mostly driven by extremely high yield farming rewards and subsequent high demand for both the TITAN and the IRON tokens. Yield farmers were able to benefit from around 500% APR on stablecoin pairs: IRON/USDC and around 1700% APR on more volatile pairs like TITAN/MATIC.  

To add even more fuel to this parabolic growth, IronFinance was mentioned by a famous investor – Mark Cuban – in his blog post. This further legitimised the project and brought even more attention to it. 

On the 16th of June 2021, the protocol experienced a massive bank run that crashed the TITAN price to 0 and resulted in thousands of people experiencing major financial losses.

Before we start unfolding all of the events that led to the collapse of IronFinance, let’s try to understand how the protocol was built.

It’s worth noting that reviewing the design of projects, including the ones that failed, is important as it allows us to better understand what works and what doesn’t work in DeFi. It also makes it easier to assess new protocols that very often reuse a lot of elements of the already existing systems. 

Protocol Design 

The IronFinance protocol was designed around 3 types of tokens: 

• Its own partially collateralized stablecoin – IRON that should maintain a soft peg to the US Dollar,
• Its own token: TITAN on Polygon and STEEL on BSC, 
• an established stablecoin used as collateral: USDC on Polygon and BUSD on BSC   

The combination of USDC and TITAN on Polygon or BUSD and STEEL on BSC was supposed to allow the protocol to decrease the amount of stablecoin collateral over time and in turn, making IRON partially collateralized leading to a greater capital efficiency. 

The protocol, although using different tokens on Polygon and BSC, worked in an analogous way on both platforms so in order to simplify this article going further I’m going to skip the BSC tokens BUSD and STEEL in the explanation. 

In order to achieve price stability of the IRON token, the protocol introduced a mechanism for minting and redeeming IRON that relied on market incentives and arbitrageurs. 

Whenever the price of the IRON token was less than $1, anyone could purchase it on the open market and redeem it for approximately $1 worth of value paid in a mix of USDC and TITAN. 

Whenever the price of the IRON token was greater than $1, anyone could mint new IRON tokens for approximately $1 worth of USDC and TITAN and sell the freshly minted IRON tokens on the open market, driving the price of IRON back to $1. 

To understand the process of minting and redeeming better, we have to introduce the concept of Target Collateral Ratio (TCR) and Effective Collateral Ratio (ECR). 

Target Collateral Ratio is used by the minting function to determine the ratio between USDC and TITAN required to mint IRON. 

As an example, let’s say the TCR is at 75%. In this case, 75% of collateral needed to mint IRON would come from USDC and 25% would come from TITAN. 

The protocol started at 100% TCR and gradually lowered the TCR over time. 

TCR can increase or decrease depending on the IRON price. On one hand, if the time-weighted average price of IRON is greater than $1, TCR is lowered. On the other hand, if the time-weighted average price of IRON is less than $1, the TCR is increased. 

Effective Collateral Ratio is used by the redeeming mechanism to determine the ratio between USDC and TITAN when redeeming IRON. ECR is calculated as current USDC collateral divided by the total IRON supply. 

If TCR is lower than ECR, the protocol has excess collateral. On the flip side, if TCR is higher than ECR it means the protocol is undercollateralized. 

As an example, if the ECR is at 75%, each time IRON is redeemed the user would get 75% of their collateral back in USDC and 25% in TITAN. 

What is important is that every time someone mints IRON the TITAN portion of collateral is burned. If someone redeems IRON, new TITAN tokens are minted.

As we can see, the whole mechanism, although a bit complicated, should work – at least in theory.  

Now, let’s see how the events leading to the collapse of IronFinance unfolded. 

Events Unfolding

Around 10 am UTC on 16th June 2021, the team behind the protocol noticed that a few larger liquidity providers a.k.a “whales” started removing liquidity from IRON/USDC and then started selling their TITAN to IRON. Instead of redeeming IRON, they sold it directly to USDC via liquidity pools. This caused the IRON price to unpeg from the value of the US Dollar. This in turn spooked the TITAN holders who started selling their TITAN causing the token price to drop from around $65 to $30 in approx 2 hours. The TITAN price later came back to $52 and IRON fully recovered its peg. 

This event, although quite severe, wasn’t that unusual considering that the protocol had a history of native tokens sharply dropping in value and IRON unpegging for a short period of time. 

Later on the same day, a few whales started selling again. This time it was different. The market panicked and users started redeeming IRON and selling their TITAN in masses. Because of the extremely quick and sharp drop in the TITAN price, the time-weighted price oracle used for reporting TITAN prices started reporting stale prices that were still higher than the actual market price of TITAN. 

This created a negative feedback loop as the price oracle was used to determine the number of TITAN tokens that have to be printed while redeeming IRON. 

Because IRON was trading off-peg at under $1, the users could buy IRON, for let’s say $0.90 and redeem it for $0.75 in USDC and $0.25 in TITAN and sell TITAN immediately. This situation created a death spiral for TITAN that drove its price to pretty much 0 as the lower the TITAN price was the more TITAN tokens would have to be printed to account for the correct amount of the redeemed capital. 

The TITAN price hitting almost 0 exposed another flaw in the protocol – users being unable to redeem their IRON tokens. This was later fixed by the team and users were able to recover around $0.75 worth of USDC collateral from their IRON tokens. 

Unfortunately, TITAN holders didn’t get away with “only” a 25% haircut and instead took heavy losses. This also included TITAN liquidity providers.

This is because when one token in a 50/50 liquidity pool goes to 0 the impermanent loss can reach pretty much 100%. Liquidity providers end up losing both tokens in the pool as the non-TITAN token is sold out for TITAN that keeps going lower and lower in value. 

This situation exposed a major flaw in the IronFinance mechanism that resulted in what we can call the first large scale bank run in DeFi.

Similarly to banks with fractional-reserve systems, where there are not enough funds to cover all depositors at any one time, the IronFinance protocol didn’t have enough collateral to cover all minted IRON. At least not when the TITAN token used as 25% of the overall collateral became worthless in a matter of minutes.   

The IronFinance fiasco also shows us why DeFi protocols shouldn’t fully rely on human coordination, especially when under certain circumstances incentives work against the protocol. In theory, if people just stopped selling TITAN for a short period of time, the system would recover as it had previously done in the past. In practice, most market participants are driven by making a profit and the arbitrage opportunity present in the protocol caused them to fully take advantage of this situation. This is also why all DeFi protocols should always account for the worst-case scenario. 

Lessons Learned 

As with most major protocol failures in DeFi, there are always some lessons to be learned.

In the case of IronFinance, there are a few important takeaways. 

First of all, we always have to consider what would happen to the protocol in the worst-case scenario. This usually involves one of the tokens used in the protocol sharply losing its value. 

What happens when the protocol stops expanding and starts contracting? What if the contraction is way quicker than expansion? 

Another important element of the protocol design that always has to be fully understood is the usage of price oracles. Could they report stale prices or get manipulated by flash loan attacks? If so, what basic protocol mechanisms rely on these oracles and how would they behave when the oracle is compromised. 

Next lesson, providing liquidity in a pool where at least 1 asset can drop to 0 means that we can lose pretty much all of our capital, even if the second token doesn’t lose any value. 

Another lesson, following celebrities and their investments might be risky. With great power comes great responsibility and unfortunately, even a single mention of a certain protocol or a token can cause people to invest in something they don’t fully understand – don’t be that person and always make sure you do your own due diligence. 

One good indicator of high-risk protocols is extremely high APR in yield farming. If something looks too good to be true there are usually some risks that have to be accounted for. 

Last but not least, building algorithmic stablecoins is hard. I hope one day we can see a fully functioning algorithmic stablecoin competing in size with USDT or USDC, but this will most likely take a bit of time and hundreds of failed attempts. If you want to become an early adopter of such a coin it’s great, but keep in mind that the numbers are not on your side. 

What’s Next

So what’s next when it comes to IronFinance and algorithmic stablecoins? 

At the moment, the team behind the protocol is planning on conducting an in-depth analysis of the situation, in order to understand the circumstances which led to such an outcome. 

It’s hard to say if the team behind IronFinance will decide to fix the shortcomings of the existing protocol and relaunch it. 

Historically, second versions of failed protocols usually don’t get nearly as much traction as their original versions. Yam Finance was a good example of such a protocol. 

After the collapse of IronFinance, there is still a lot of capital sitting on the sideline looking for other high-risk opportunities. It will be interesting to see where this capital goes next. 

So what do you think about the IronFinance fiasco? Are you optimistic about the future of algorithmic stablecoins? 

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So what’s the future of finance? Is decentralized finance better than the current financial system? What problems does it solve? And does it have a chance to improve or completely replace traditional finance? You’ll find answers to these questions in this article. 

The Financial System 

The financial system that we know today went through decades of technological advances. 

The earliest attempts to make finance more efficient started as early as the 1920s with the introduction of accounting machines and punch cards. This was followed by the rise of the mainframe computers that significantly sped up the banking system in the 1950s and beyond.  

The next revolution was the invention of ATMs and credit cards that started being popular in the 1970s. Also in the 1970s, another important element of the financial system, the stock market, started going through a radical transformation. Manual order entries and loud trading pits started being slowly replaced by computers and algorithms. 

From the 1990s, thanks to the growing adoption of the Internet, the computerization of finance got supercharged. Accessing bank accounts, making wire transfers, buying stocks, all of these operations were now possible from the comfort of our own houses. 

Then comes the fintech revolution. PayPal, Robinhood, TransferWise, Revolut and other fintech startups understood the tech-first approach known from other non-financial tech companies and offered their users seamless access to financial services – a completely different experience when compared to the clunky banking user interfaces. 

Despite a century of innovations, the financial system is far from being perfect. 

Settlement of stocks, bonds and other financial instruments takes days to clear and requires a massive amount of human capital involved in the process. 

Key decisions impacting millions if not billions of people are made behind the closed doors by a group of privileged few. 

Billion-dollar banking scandals that surface months if not years after the fact. 

Massive inefficiencies and high cost when it comes to international banking and remittance services. 

Unequal access to financial services with billions of unbanked people across the globe.

Banks hiring thousands of employees just to keep maintaining inefficient processes and being compliant with ever-changing banking regulations.   

A super high barrier to entry for the new players making it almost impossible to start a new financial company without access to the massive amount of capital, stifling innovation.

The whole financial infrastructure consists of siloed systems built with proprietary technologies and algorithms that each company has to make from scratch. 

The beautiful user interfaces provided by fintech companies only cover the fact that the financial system is built on old and inefficient foundations. Something that seems to be instant for the user can take days to fully process behind the scene. 

On top of that, the backbone of the financial system hasn’t evolved much since the mainframe computers were introduced. This is exactly why we need something new, something better, that can address some of these problems.

And this is where decentralized finance comes into play. 

DeFi 

Instead of relying on old and inefficient infrastructure, Decentralized finance, or DeFi,  leverages the power of cryptography, decentralization and blockchain to build a new financial system. 

A system that can provide access to well-known financial services such as payments, lending, borrowing and trading in a more efficient, fair and open way.  

Efficient – as all operations are settled almost immediately. It doesn’t matter that counterparties may be in completely different geographic locations with inconsistent laws and regulations. On top of this, most of DeFi protocols can operate with no or minimal human involvement. 

Fair – as all services are completely permissionless and censorship-resistant. 

Permissionless  – as everyone with a browser and the Internet connection can access them. There is no document verification, no need to provide income statements, nationality or race doesn’t matter – everyone is treated in the exact same way. 

Censorship-resistant – as no other parties can deny us access to these services. Even multiple bad actors cannot change the rules of a sufficiently decentralized system. 

Open – as everyone can build a new defi application and contribute to the ecosystem. In contrast to traditional finance, new applications can leverage the existing protocols and build on top of existing solutions. 

On top of that, everything is transparent and visible on the blockchain. Trading volume, number of outstanding loans, total debt? All of these can be reliably checked on the blockchain. Even better, these numbers cannot be tampered with. 

All of this is possible thanks to the invention of Bitcoin and Ethereum and their underlying technologies. In particular, Ethereum as a smart contract platform allows for creating any arbitrary financial applications. Because of these characteristics, Ethereum became a go-to blockchain for the vast majority of DeFi activities. 

Decentralized finance has recently been experiencing tremendous growth. 

Some of the key metrics are:

Total Value Locked in DeFi – this represents the value of all tokens locked in various defi protocols such as lending platforms, decentralized exchanges or derivatives protocols. 

This number has grown from less than $1B in April 2020 to over $32B in February 2021. 

Another important metric is the trading volume across decentralized exchanges.

This figure has grown from around $0.5B in April 2020 to over $50B in January 2021 – a 100x increase. 

Total value settled on Ethereum has reached over $1T in 2020. This is more than PayPal. 

And all of this is not only limited to cryptocurrencies that, as we know, can be quite volatile in nature. Stable coins that track the value of fiat currencies, such as the US Dollar, also experienced tremendous growth in the DeFi ecosystem. 

The market cap of USDC – a popular stable coin in DeFi – went from less than $1B in April 2020 to over $6B in 2021. Another one – DAI – went from less than $100M in April 2020 to almost $2B in 2021. 

Problems in traditional finance 

Now, to understand the value proposition of decentralized finance even better, let’s go through a few common problems in traditional finance and see how they can be addressed in DeFi.

Let’s start with a recent situation in the stock market – the famous Gamestop saga.

After discovering that Gamestop stock – GME – was overly shorted by some of the hedge funds, users of a popular Reddit group – Wall Street Bets – started buying GME as they believed this could initiate a short squeeze that would result in hedge funds having to buy back the shorted stock, driving the price higher. 

At some point, Robinhood and a few other stock brokers came up with a controversial decision to disable the possibility of selling GME and a few other stocks. 

A situation like this just wouldn’t be possible on a decentralized exchange like Uniswap. 

There is no one who can disable or alter the trading capabilities of the platform. There is no single authority making decisions on behalf of the users. DeFi democratizes access to trading.

This situation exposes another problem – decisions made behind closed doors. 

A group of people deciding to shut down trading? Or maybe a bunch of bankers deciding what the best interest rate is for millions of people? 

In DeFi, interest rates are adjusted automatically based on the supply, demand and risk parameters of certain assets that are configured by the protocol. 

Even if some DeFi lending platforms allow for changing certain risk parameters, all decisions are publicly visible and changes are voted on by multiple people who govern the protocol.  

What about this problem – paying 10-30% of the value of a bank transfer just to send money across the globe? In DeFi, you can send USD-based stable coins for a fraction of that cost. Even better, they will arrive in a matter of seconds.

With the settlement of different assets measured in seconds instead of days, the counterparty risk is dramatically reduced.

Accounting? Every record is publicly available on the blockchain, so accounting becomes super easy and can be most likely completely automated. This can dramatically reduce the human capital needed. 

Unequal access to financial services? A DeFi protocol doesn’t care who you are – it just follows predefined rules that are exactly the same for everybody.

Although DeFi presents us with a unique value proposition, it comes with its own challenges. 

Challenges 

It brings more responsibility to the users who are now truly owning their assets, so they have to make sure they store them in a secure way. There is not a lot of hand-holding here, especially when interacting with new DeFi protocols. 

There are still certain regulatory risks. Although things like KYC or AML cannot be enforced in the DeFi protocols themselves, the regulator may try to force wallet providers or dev teams responsible for certain protocols to add KYC requirements to their user interfaces. 

Scaling is another issue that has to be tackled. The popularity of DeFi resulted in a tremendous demand for the block space on Ethereum. This in turn results in high gas fees for the users. It’s not uncommon to hear about $10 or even $50 Uniswap transaction costs. 

Scaling is already being tackled by Eth2 and Layer2 scaling solutions. You can learn more about it here. 

Hacks are another challenge of the DeFi space that make using certain protocols, especially the new ones risky. 

Various DeFi protocols are also exploring different governance models, however, whales and voter’s apathy are some of the common problems here. 

Uncollateralized loans and mortgages are big areas of traditional finance that are slightly harder to implement in DeFi. Fortunately enough, there are already protocols like Aave exploring different possibilities such as credit delegation and tokenized mortgages. 

Despite the challenges, DeFi is a unique innovation, a 0 to 1 innovation. And I believe that sorting out some of these challenges is just a matter of time. 

Summary

So what will happen to traditional finance if DeFi keeps innovating and growing at this tremendous pace?

Personally, I think that traditional finance will have to adapt quickly, otherwise, they are taking a risk of slowly becoming irrelevant. Like with all other big technological changes, they often happen gradually, then suddenly.

We’ll probably very quickly see some of the incumbents trying to tap into the possibilities of DeFi. For example, by leveraging liquidity or accessing more favourable interest rates in one of the DeFi protocols. This will most likely start with fintech companies that are already involved in crypto but I wouldn’t be surprised to see banks using DeFi in a few years time. 

There are also a lot of areas of traditional finance that can significantly benefit from moving into DeFi in the future. As an example, instead of going public on the stock market, companies could issue security tokens and take advantage of globally accessible liquidity. On top of this, people investing in these tokens could lend them out and make an extra yield on their investment or use them as collateral for taking a loan. 

It’s also very likely that DeFi will become a new backbone of the financial system. With simple user interfaces, most people will probably not even know they’re using it, in similarity to how they don’t know what is happening under the hood of their traditional trading application. At this point, DeFi will just become finance. More efficient, fair and open finance.

So what do you think about the future of finance? How big will DeFi become?

If you enjoyed reading this article you can also check out Finematics on Youtube and Twitter.

So what are derivatives? Why are they important? And what are some of the most popular derivatives protocols in defi?  You’ll find answers to these questions in this article.

Derivatives  

Derivatives are one of the key elements of any mature financial system. As the name suggests derivatives derive their value from something. This “something” is usually the price of another underlying financial asset such as a stock, a bond, a commodity, an interest rate, a currency or a cryptocurrency. Some of the most commonly used derivatives are forwards, futures, options and swaps. 

There are two main use cases for derivatives: hedging and speculation. Hedging allows for managing financial risks. To understand hedging a bit better let’s revisit one of the commonly used examples.

Imagine a farmer that primarily focuses on growing wheat. The wheat price can fluctuate throughout the year depending on the current supply and demand. As the farmer plants wheat, they are committed to it for the entire growing season which presents them with a big risk in case the price of wheat is low when the harvest time comes. 

To accommodate this risk, the farmer will sell short wheat futures contracts for the amount that they predict to harvest. As the time of harvest approaches, the farmer will close their position and incur a profit or a loss depending on the price of wheat. 

If the price of wheat is lower than initially anticipated the short position makes a profit that offsets the loss from selling the actual wheat. 

If the price of wheat is higher, the short position will be at a loss but the profit from selling the wheat offsets that loss. 

What is important to understand is that no matter what happens to the wheat price the farmer will end up with a predictable income. 

To stay in the agricultural world, yield farmers in decentralized finance can also use hedging to offset a potential loss that can occur if the price of one of the tokens used for yield farming loses its value in relation to another token. This can happen, for example, while providing liquidity to an automated market maker like Uniswap and is known as impermanent loss. 

Besides our agricultural examples, derivatives allow other crypto companies to hedge their exposure to different cryptocurrencies and run more predictable businesses.  

The other popular use case for derivatives is speculation. 

In a lot of financial instruments including derivatives, speculation can represent a significant amount of traded volume. This is because derivatives offer an easy exposure to particular assets that may be hard to access otherwise, for example, trading oil futures instead of actual barrels of oil. They can also provide easy access to leverage – a trader can purchase a call or a put option by providing only enough funds to cover the option premium and gain exposure to a significant amount of the underlying asset. 

Speculators are important market participants as they provide liquidity to the market and allow people, who actually need to buy a particular derivative to hedge their risk, to easily enter and exit the market. 

Derivatives have a long and interesting history. From clay tokens representing commodities traded by the Sumerians, through the use of “fair letters” to buy and sell agricultural commodities in Medieval Europe, to the establishment of the Chicago Board of Trade (CBOT) in 1848 – one of the world’s oldest futures and options exchanges.

When it comes to more modern times, derivatives have been one of the major forces that drive the whole financial industry forward since the 1970s. 

The total market size of all derivatives is estimated to be as high as $1 quadrillion which completely dwarfs any other market including the stock or bond markets and of course the tiny cryptocurrency market that has just recently touched the $1 trillion mark. 

Every growing market naturally develops its own derivatives market that can end up being an order of magnitude bigger than its underlying market.   

This is also why a lot of people in the decentralized finance space are extremely bullish on the potential of decentralized derivatives that, in contrast to traditional finance, can be created by anyone in a completely permissionless and open way. This in turn increases the rate of innovation that has been stagnating in traditional finance already for a while. 

Now, as we know a bit more about derivatives, let’s jump into some of the most important derivatives protocols in DeFi.

Synthetix 

Synthetix is usually the first protocol that comes to our minds when talking about derivatives in DeFi. 

Synthetix allows for creating synthetic assets that track the price of their underlying assets. The protocol currently supports synthetic fiat currencies, cryptocurrencies and commodities that can be traded on trading platforms such as Kwenta, DHedge or Paraswap. 

Synthetix model is based on a debt pool. In order to issue a particular synthetic asset, a user has to provide collateral in the form of the SNX token. 

The protocol is highly overcollateralized – currently at 500%. This means that for each $500 of SNX locked in the system, only $100 worth of synthetic assets can be issued. This is mainly to absorb any sharp price changes in synthetic assets and the collateralization ratio will be most likely lowered in the future. 

Synthetix is also one of the first DeFi projects leading the effort of moving to layer 2 in order to lower the gas fees and make the protocol more scalable.

There is currently around $1.8B locked in the synthetix protocol – the biggest number across all defi derivatives protocols by a wide margin. 

UMA

UMA is another protocol that enables the creation of synthetic assets. 

The main difference here is that UMA, instead of highly overcollateralizing the protocol, relies on liquidators, who are financially incentivised, to find improperly collateralized positions and liquidate them. 

UMA’s model allows for creating “priceless” derivatives. This is because the model doesn’t rely on price oracles – at least not in the optimistic scenario. This in turn allows for adding a very long tail of synthetic assets that otherwise wouldn’t have a reliable price feed hence it wouldn’t be possible to create them in Synthetix. 

There is currently over $63M of total value locked in UMA’s smart contracts. 

Hegic

Hegic is a relatively new defi project that allows for trading options in a non-custodial and permissionless way. 

Users can buy put or call options on ETH and WBTC. They can also become liquidity providers and sell ETH call and put options.

Three months after the launch, Hegic had almost $100M in total value locked in the protocol, a total cumulative options trading volume of ~$168M and generated over $3.5M in fees. 

Interestingly, Hegic has been developed by a single anonymous developer which again shows the power of DeFi where, in contrast to traditional finance, even a single person or a small group of people can build a useful financial product. 

Opyn

Another DeFi project that allows for trading options is Opyn.

Opyn, launched in early 2020, started from offering ETH downside and upside protection which allowed users to hedge against ETH price movements, flash crashes, and volatility.

They’ve recently launched a V2 of the protocol that offers European, cash-settled options that auto-exercise upon expiry.  

There are 2 main option styles: European and American.

European options can only be exercised at the time of expiration whereas American options can be exercised at any time up to the expiration date. 

In contrast to Opyn, Hegic uses American style options. 

The Opyn protocol auto-exercises options that are in the money, so option holders don’t need to take any action at or before the expiration date.

Since its first release, the protocol had over $100M in traded volume.

Perp

Perpetual is yet another fairly new entrant into the decentralized derivatives space. 

As the name suggests Perpetual allows for trading perpetual contracts. A perpetual contract is a popular trading product in the cryptocurrency space used by well-known centralized platforms such as Bitmex, Binance and Bybit. It is a derivative financial contract with no expiration or settlement date, hence it can be held and traded for an indefinite amount of time.

Perpetual Protocol, at the moment, allows for trading ETH, BTC, YFI, DOT and SNX.

Trades are funded and settled in USDC – a popular stable coin in the defi space. 

All trades on Perpetual Protocol are processed using the xDai Chain – a layer 2 scaling solution. This allows for incredibly low gas fees that are currently subsidised by the protocol. 

This means that currently there are no gas fees while trading on Perpetual Protocol. Paying the gas fee is only required when depositing USDC onto the platform. 

The protocol has been live for only just over a month but it has already managed to achieve over $500M in volume and $500k in trading fees. 

dYdX

dYdX is a decentralized derivatives exchange that offers spot, margin and more recently – perpetuals trading.

dYdX architecture combines non-custodial, on-chain settlement with an off-chain low-latency matching engine with order books.

Besides that, the dYdX team has been building a new product for Perpetual Contracts on Layer 2, powered by StarkWare’s ZK Rollups that is due to launch in early 2021.

The total cumulative trade volume across all products on dYdX reached $2.5 billion in 2020, a 40x increase when compared to the previous year. 

dYdX has recently raised $10M in a Series B round led by Three Arrows Capital and DeFiance Capital.

BarnBridge

BarnBridge is a risk tokenizing protocol that allows for hedging yield sensitivity and price volatility. 

This can be achieved by accessing debt pools of other defi protocols, and transforming single pools into multiple assets with different risk/return characteristics. 

BarnBridge, at the moment, offers two products: 

Smart Yield Bonds: interest rate volatility risk mitigation using debt based derivatives

And Smart Alpha Bonds: market price exposure risk mitigation using tranched volatility derivatives. 

There is currently over $350M of total value locked in the protocol. 

BarnBridge is also running a liquidity mining program that distributes its token – BOND –  to all users who stake stable coins, Uniswap BOND-USDC LP tokens or BOND tokens on their platform. 

Summary

As we mentioned earlier, the Derivatives Market in traditional finance is huge and it will be interesting to see how big it will become in decentralized finance. 

It is also amazing to see more and more projects launching derivatives protocols and being able to create new and exciting financial products in a permissionless and decentralized way. 

One more important thing – interacting with new DeFi protocols can be risky. So before using any of the protocols mentioned in this article always do your own due diligence as most of these projects are still in their beta or even alpha versions.

So what do you think about derivatives in DeFi? How big will they become in the future? Would you like to see a deep dive into one of the projects we mentioned in this article?

If you enjoyed reading this article you can also check out Finematics on Youtube and Twitter.

Introduction

On the 9th of March 2020, the New York Stock Exchange halted trading for 15 minutes as the result of triggering level 1 circuit breaker caused by a 7% drop in the S&P 500. The last time the circuit breaker kicked in was back in October 1997.

What are the Circuit Breakers?

Circuit Breakers are automatic mechanisms that prevent the stock market from a free fall by halting trading for a predefined time.

The New York Stock Exchange has 3 levels of market-wide circuit breakers.

Level 1 market-wide circuit breaker is triggered if the S$P 500 falls 7% from its previous close before 3:25 pm on a trading day. It halts trading for 15 minutes.

Level 2 market-wide circuit breaker kicks in when the market plunges 13% (also before 3:25 pm). It halts trading for an additional 15 minutes.

Level 3 market-wide circuit breaker comes into effect if the market tanks 20% in a day and can be triggered at any time even after 3:25 pm. If this circuit breaker kicks in, trading is halted for the rest of the trading day.

Besides having market-wide circuit breakers based on the S&P 500 price, individual stocks also have their own circuit breakers, with the trigger level determined by the price of the stock.

Circuit breakers are not only limited to the NYSE. In fact, most of the exchanges including futures exchanges have their own circuit breakers. The noticeable exceptions are the cryptocurrency exchanges that usually do not implement circuit breakers as they are not regulated in the same way as more traditional exchanges.

Why would you stop the stock market in the first place?

The main reason is to stop panic selling. The market usually plunges by 7 or more % based on either significant, unprecedented news or a flash crash. In both cases, it might make sense to take a little break to catch a breath, absorb all the surrounding information and reassess trading strategies.

The other big reason is the Regulator. Following huge market plunges like the one on Black Monday (October 1987), the regulators came up with circuit breakers to try to cool down the stock market and prevent it from a total collapse.

On the other hand, one of the reasons against the circuit breakers is that the price discovery mechanism is significantly impacted during the halting period and can lead to abnormal trading volume and volatility when trading resumes.

A quick history of circuit breakers

First circuit breakers were introduced after Black Monday in October 1987 when the stock market tanked 23%. The initial market-wide circuit breakers were based on the Dow Jones Industrial Average and not the S&P 500. They were also point-based instead of percentage-based. The first time the circuit breaker like that kicked in was in October 1997 (mini-crash). That was the only time in the history of the NYSE when the Dow Jones Industrial Average based circuit breaker was triggered. After that, the circuit breakers evolved and started using a percentage-based mechanism based on the S&P 500 index.

On the 9th of March 2020, the New York Stock Market halted trading for 15 minutes as a result of triggering level 1 circuit breaker caused by a 7% drop in S&P500 on fears of a global pandemic. 3 days later on the 12th of March, the level 1 circuit breaker was triggered again and stopped trading for another 15 minutes.

In both cases, the circuit breakers worked as designed by calming down the stock market and preventing it from further loses.

Extra

Flash Boys by Michael Lewis (a story about high-frequency trading) ► https://amzn.to/38T2Y0N

If you have any questions about the circuit breakers, please comment down below

Have you ever come across a term robo-advisor? Have you ever wondering what that is? The first thing that comes to your mind is probably the “robo” bit, but if you’re imagining a human-like, metal creature you cannot be further from the truth. Robo-advisors are digital, financial advising platforms that make investment decisions without or with a minimal human intervention. They make use of algorithms to allocate assets and manage portfolios. After the 2008 financial crisis, lots of people lost trust in the financial sector and were reluctant to pay financial advisors hefty fees. This is when low-cost robo-advisors came to play and started attracting lots of customers. The other factor that drives robo-advisors is that the majority of millennials are comfortable with online tools, so they expect to have a similar experience when it comes to investing.

How do robo-advisors work?

So how exactly those robo-advisors work? Let’s get into the details.

Robo-advisors collect client’s personal information, risk tolerance and investment goals. Based on that, they choose an appropriate portfolio structure. Most robo-advisors make use of Modern Portfolio Theory to allocate money between different types of assets like stocks and bonds maximising returns while minimising risk. Instead of investing money in particular stocks or bonds, robo-advisors prefer to choose exchange-traded funds (ETFs) to diversify their portfolios even further. Majority of robo-advisors make use of tax-loss harvesting to optimise customers’ taxes. The first thing that a tech-savvy person might notice is the fact that robo-advisors are not that clever. They allocate money based on predefined rules and rebalance your portfolio to bring it back to the base level if there is too much money allocated to one type of assets. Let’s look at this example. Let’s assume you are a fairly young investor and a robo-advisor decides to put 90% of your cash into a well-diversified portfolio of stocks and 10% of your cash into government bonds. If the value of your stock allocation rises to let’s say 95% of the value of your total portfolio a robo-advisor rebalances your portfolio by selling some of your shares and buying more bonds to bring the levels back to 90/10. It is as simple as that. It’s not rocket science at all.

Although the most popular robo-advisors work in this way, there is also a small subset of robo-advisors that make use of AI and machine learning to predict what the most profitable investments in the future will be. These types of robo-advisors are way more exciting, but they also carry a substantially higher risk. Of course, it all depends on how big chunk of our portfolio is actively managed by AI, but from my perspective, it looks like those robo-advisors start to resemble more hedge funds than anything else.

Different types of robo-advisors

As we know from the previous chapter, not every single robo-advisor is the same and there are some substantial differences between them. Let’s have a look at some of the common types of robo-advisors:

• Standard robo-advisors – these robo-advisors work just like described in the previous section. They allocate money between stocks and bonds based on predefined rules. They facilitate passive investment strategy.
• AI-driven robo-advisor – this is the new kid on the block. One of the most popular AI-driven robo-advisor is Responsive that rebalances your portfolio automatically as the economy changes.
• Theme based investing – Motif is a good example of a robo-advisor which allows its customers to have a greater control over where their money goes. Investors can choose from different theme based investments in their Impact Portfolio. For example, Sustainable Planet, Fair Labour or Good Corporate Behaviour.

What are the pros and cons of robo-advisors?

Like with everything there are always pros and cons. Let’s start with the pros:

• lower management fees – robo-advisors offer lower management fees when compared to the traditional financial advisors. The reason for that is quite simple. There is a minimal or no human time required to manage your portfolio and you don’t need to pay machines (besides paying for electricity, space, maintenance and developers’ salaries…)
• low barrier to entry – some robo-advisors can look after your portfolio from as low as $1 which is particularly beneficial for millennials who are, as we know, not very keen on saving money.
• automated process – your portfolio is managed online, your balance and chosen investments are visible all the time and you don’t need to waste time meeting your financial advisor.

The cons:

• lack of human interaction – for some people, especially the older generation, it is a disadvantage.
• managed portfolios are less personalized – most robo-advisors allocate your money based on the personal information and risk tolerance, but they do not treat customers individually like the real financial advisors. This might change with the help of AI.
• lack of active investment – your portfolio is well diversified and passive. There is no space for excitement and some people find it very boring, but as George Soros said: “Good investing is boring”.

What are the biggest robo-advisors?

Globally, there are over 300 robo-advisors looking after people’s money. The US takes the sheer amount of that market with over 200 of them. The biggest robo-advisors in the US are Betterment and Wealthfront. In the UK the market leaders are Nutmeg, Moneyfarm and Wealthify. Also, some bigger players in the investment business started looking into the robo-advisors space and came up with their own solutions or acquired some already existing companies. Robo-advisors industry is expanding rapidly and its asset under management (AUM) is expected to grow to stunning $4.6 trillion by 2022 (prediction by BI Intelligence).

Summary

Robo-advisors seem to be a good solution for someone who’s looking for a passive investment strategy and don’t want to necessarily go into the details of their investments. They definitely fill up the gap in the industry. From the technology point of view, it seems like robo-advisors were inevitable and I’m not surprised they are taking more and more of the financial advising business. In the future, we can only expect more solutions like that and hopefully that will be beneficial for the consumers. I’m also expecting a rise of AI-driven robo-advisors which may dominate the wealth management space.