This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
Derivatives are financial instruments that allow investors to gain exposure to the price movement of an underlying asset without owning the asset itself. Synthetics are a special type of derivative that has gained importance in traditional finance. Together with derivatives, synthetics have become one of the most important use cases for tokenization. This chapter will explain why many token use cases presented in this book are derivatives by nature and why it is important to understand the core concepts of financial derivatives before one can grasp the potential implications of tokenization on money, finance, and the real economy.
Traditional finance distinguishes between two primary types of financial instruments: securities and financial derivatives. Securities include equity instruments (assets you can own, such as company shares), debt instruments (such as mortgages or bonds), and hybrid instruments (such as convertible bonds). Derivatives, on the other hand, are financial contracts that derive their value from an underlying asset or economic indicators (such as interest rates or indices).
Unlike securities, derivatives separate ownership from market risk, allowing traders to gain exposure to price movements without actually owning the underlying asset. Instead, they rely on contractual agreements that can be bought, sold, and traded independently. The underlying asset of a derivative can be equity- or debt-based, another derivative, or even a derivative of a derivative, which adds layers of complexity to their valuation. Common examples of derivatives include forward commitments such as futures, forwards, and swaps, as well as claims like options, credit derivatives (like credit default swaps), and asset-backed securities. Traditionally, derivatives were traded over the counter (as non-standardized financial contracts) rather than on stock exchanges (where only standardized financial contracts are exchanged). However, since the early 2000s, exchange-traded derivatives have become more common, with specialized derivative exchanges and even traditional stock exchanges offering these products.
Derivatives have also become integral to the tokenized economy, with smart contracts automating their creation, execution, and settlement. Smart contracts allow for the programming of all terms and margin requirements of a derivative agreement between counterparties. These contracts can be automatically executed based on external data provided by price feed oracles, which supply information about the underlying asset’s market value. Additionally, automated market makers (AMMs) can facilitate trading by allowing participants to speculate not only on asset prices but also on economic indicators such as interest rates.
Derivatives serve various purposes, including generating market liquidity, accessing hard-to-trade assets or markets, hedging against price movements, and increasing exposure for speculative reasons. A key function of derivatives markets is price discovery—the process of determining the current value of an asset. Reliable price discovery depends on factors like market structure, liquidity, and access to accurate information, contributing to a more efficient market. In traditional finance, robust derivatives markets help predict market risk and enable investors to take informed positions, such as purchasing options to protect their portfolios. This can lead to smoother market adjustments—a benefit that also applies to crypto derivatives.
- Liquidity: In both traditional and crypto markets, derivatives enhance supply and demand for underlying assets, creating favorable conditions that attract investors and deepen market activity. Increased market depth makes assets less vulnerable to price spikes. Liquidity was a significant challenge during the early days of crypto assets and the launch of new DeFi protocols, but tokenized derivatives have helped address this issue.
- Hedging: Derivatives provide a way to offset potential losses by taking positions that negatively correlate with existing investments. Given the high volatility of many crypto assets, derivatives play an essential role in risk management in crypto.
- Speculation: Another common use of derivatives is allowing investors to bet on the price movements of cryptocurrencies or other crypto assets. Investors can speculate on price increases (long trades) or decreases (short trades). While this can result in high rewards, the associated risks are equally significant. Retail investors, unfamiliar with market complexities, often avoid derivatives due to these risks.
- Leverage: Derivatives provide exposure to an underlying asset at a fraction of its cost, allowing traders to magnify potential gains—but also potential losses. Some crypto derivatives exchanges have historically offered leverage up to 125 times the initial margin. While this enables significant returns from small price movements, it also exposes investors to substantial losses. Flash loans theoretically provide unlimited leverage, but as outlined in the previous chapter, practical limitations exist related to the blockchain transaction costs one has to pay in any case for the potential trades involved, even if the transaction fails.
History of Crypto Derivatives
The first crypto futures emerged in 2011 on an online platform called “ICBIT.” These futures were often negotiated directly online, but demand remained low due to Bitcoin's limited adoption at the time. However, as both retail and institutional investors began entering the crypto market, demand for more sophisticated financial products grew. In 2014, “BitMEX” introduced a suite of derivative products, including perpetual swaps—a derivative concept that had existed since the 1990s but was largely unused in traditional finance. BitMEX successfully adapted perpetual swaps for crypto markets, and they remain one of the most widely traded derivative instruments on crypto exchanges today. In 2017, “Deribit” launched the first Bitcoin options, while “LedgerX” became the first regulated clearinghouse and swap execution facility to offer fully collateralized, physically settled digital currency swaps and options. In 2019, specialized crypto derivatives exchanges such as “Quedex” or “Bakkt” were launched, and traditional financial institutions like the “Chicago Board Options Exchange” and the “Chicago Mercantile Exchange” began offering Bitcoin futures. This development marked a significant milestone, providing institutional investors with a regulated marketplace to trade crypto derivatives. The resulting legitimacy drove increased adoption, leading to a surge in both the spot market and derivatives trading volumes.
The COVID-19 pandemic in 2020 accelerated these trends, alongside the rapid growth of the DeFi ecosystem built on the Ethereum network. Both factors attracted a new wave of retail and institutional investors, propelling BTC, ETH, and other crypto assets to unprecedented all-time highs and fueling further demand for derivatives. As the market matured, even centralized exchanges traditionally focused on spot trading began offering derivative products. Platforms like Binance, OKX, Huobi, Bit.com, and FTX expanded their services to include crypto futures, options, and perpetual swaps. In 2021, Crypto.com—one of the longest-standing spot exchanges—launched its own derivatives platform. These developments attracted traditional financial players into the tokenized derivatives market. By early 2022, derivatives trading volumes surpassed spot trading volumes for the first time.
However, increasing regulatory scrutiny in the U.S. and Europe led many derivative-focused exchanges to relocate to offshore jurisdictions. Countries in Asia, particularly Singapore, became hubs for these platforms. Offshore exchanges often operated with looser regulatory oversight, enabling faster onboarding, higher trading leverage, and increased product innovation. Yet, this environment also introduced higher counterparty risks for both institutional and retail investors. While many offshore platforms operated responsibly, others exploited the lack of oversight. This regulatory gap enabled scandals such as the collapse of FTX, a prominent derivatives exchange that was headquartered in the Bahamas and filed for bankruptcy after misappropriating customer funds.
Types of Derivatives & Perpetual Contracts
The flexibility of derivatives allows them to be designed with varying levels of risk and leverage, enabling their use for speculative purposes or as hedging tools. Traditional derivatives include futures, forwards, and swaps, which obligate the parties to fulfill the terms of the contract at a future date. In contrast, options offer the right, but not the obligation, to enter into a contract under pre-specified terms. When used for hedging, derivatives act as personalized insurance mechanisms to mitigate financial risk associated with potential future events. The following derivatives exist in the crypto space:
- Tokenized futures are contracts where buyers and sellers agree to trade an underlying asset at a predetermined price (the “strike price”) on a specific future date (the “expiry date”). Buyers speculate on price increases (also known as “going long”), while sellers speculate on price decreases (also known as “going short”). For example, if Bitcoin’s current price is 25,000 EUR and a one-month futures contract is sold with a strike price of 28,000 EUR, a buyer profits if Bitcoin’s price exceeds 28,000 EUR at expiry, while a seller profits if it falls below that mark. Tokenized futures are often traded “on margin,” allowing buyers to borrow a portion of the contract's value, which amplifies both potential gains and losses. Futures markets tend to have higher trading activity than spot markets, making them more liquid and effective in price discovery for the underlying assets.
- Perpetual futures, also known as perpetual contracts or swaps, are a special type of futures contract introduced by “BitMEX” in 2016. Unlike standard futures, perpetual contracts have no expiry date, allowing investors to hold positions indefinitely, provided they maintain the required margin and pay holding fees (referred to as the "funding rate"). Gains or losses are determined by the difference between the contract price and the spot price of the underlying asset. Perpetual contracts have become a dominant instrument in crypto trading and are analogous to traditional finance’s “contracts for difference.” Decentralized platforms like “GMX” and “dYdX” developed the first decentralized solutions for trading perpetual contracts.
- Tokenized options are another type of derivative that allows investors to buy or sell an asset at a predetermined price in the future without obligating them to execute the trade. Option holders pay a fee, known as a “premium,” for the right to buy the asset (call option) or sell the asset (put option). If the option expires without being exercised, the holder loses only the premium paid. Crypto options are often based on underlying assets like Bitcoin (BTC) and Ethereum (ETH) or on derivatives such as BTC or ETH futures. Just as with regular options, they can be either exercised at any time before expiry (American option) or exercised only on the expiry date (European option).
- Swaps are agreements typically used by companies or financial institutions to speculate on changes in asset prices, interest rates, or other economic indicators, or to hedge against specific risks. For example, mortgage holders dissatisfied with their current terms can enter a swap agreement to adjust their interest rate without renegotiating their mortgage. Swaps were first introduced in 1981 by IBM and the World Bank, initially as customized agreements. Over time, swaps have become more standardized and regulated, with the introduction of instruments like credit default swaps. Credit default swaps gained prominence after 2000 but were heavily criticized for their lack of transparency and their role in the global financial crises from 2007 to 2010. In the crypto space, swaps are less developed, as they are challenging to replicate on blockchain networks. Nevertheless, specialized crypto-specific products like Bitcoin Difficulty Swaps and Hash-Power Swaps have been proposed to address unique needs in the crypto ecosystem.
- Blockchain networks themselves enable new asset classes for derivative products. For example, services like “BitOoda” have structured crypto-specific derivatives such as Electricity Futures, Staking Yield Swaps, Slashing Penalty Swaps, Stability Fee Swaps, Airdrop Options, and Lockdrop Forwards. These derivatives aim to hedge risks unique to crypto markets, such as mining energy costs, staking penalties, or stability fees. While these instruments remain niche, they represent the evolving intersection of blockchain network economics and financial innovation.
- Tokenized insurance represents another potential application of derivatives in the decentralized finance (DeFi) ecosystem. Insurance contracts, like derivatives, allow individuals and institutions to hedge against risk. However, unlike bespoke derivative agreements, insurance products are typically standardized and offered “off the shelf” by service providers. Tokenized insurance could offer immediate settlement, automated yield distribution, and fairer pricing structures. However, for tokenized insurance to reach mainstream adoption, significant network effects are required. Institutions and households would first need to transition to Web3-based infrastructure.
Synthetics
Synthetics are specialized derivatives designed to replicate the risk-and-reward profile of other financial instruments by combining multiple derivatives or financial tools. These combinations are engineered to mimic the cash flow and expected profit of the underlying security or derivative while altering characteristics such as duration or leverage. For example, a synthetic position created by buying a call and selling a put can simulate owning a stock but requires much less capital and potentially offers greater leverage. Many of the token use cases in this book are synthetics by nature: tokenization provides a Web3-based synthetics mechanism for real or digital assets, allowing these tokenized synthetics to be traded and settled over a public, permissionless blockchain network.
Examples include staked-token derivatives such as Staked Ether (sETH) and asset-backed tokens, which operate similarly to asset-backed securities in traditional finance. USD-backed stable tokens like Tether (USDT), for instance, mimic the U.S. dollar, while crypto-collateralized and algorithmic stable tokens like DAI offer synthetic USD price exposure without requiring centralized custody of actual dollars. The use case of DAI is explored in detail later in the chapter on MakerDAO.
From a regulatory perspective, asset-backed tokens that do not constitute securities or currencies might also be considered financial derivatives—similar to asset-backed securities in traditional finance (for example, products backed by consumer loans, credit cards, or auto loans). With tokenized real and digital assets, as well as obligations—such as tokenized art or tokenized mortgages—the token representing the asset or obligation can be traded while the underlying asset sits in escrow via a smart contract or with a third-party custodian. The collateralized-debt positions that generate units of a stable token like DAI resemble collateralized debt obligations (CDOs), whereas tokenized mortgages resemble collateralized mortgage obligations (CMOs).
Wrapped tokens—initially created to address interoperability challenges between different blockchains—are another type of synthetic instrument. A wrapped token is held in escrow on its native blockchain, while a corresponding synthetic token is issued on another blockchain, providing price exposure to the original asset and reducing lock-in effects across ecosystems.
- Liquidity: The above-mentioned token use cases provide liquidity for otherwise illiquid assets and make asset classes more accessible, eliminating the need to directly borrow or short the underlying assets, or buy the entire underlying asset. However, they rely on sufficient liquidity in the underlying asset to deliver economic benefits. By combining tokenized real-world assets with DeFi protocols, synthetics create more liquid markets, facilitating easier trading and fractional ownership. Examples were discussed in earlier chapters. While the underlying asset must meet a minimum liquidity threshold to justify creating synthetic derivatives, these products, in turn, can drive increased liquidity for the asset class itself.
- Inclusion: While traditional synthetic products were accessible only to institutional and sophisticated investors, DeFi protocols democratize access to synthetic financial products, making them practicable for retail investors as well. However, this inclusion requires a baseline level of financial literacy to avoid uninformed investment decisions that can lead to significant losses.
The history of crypto synthetics began with early projects like “Abra,” which allowed investors to hold funds displayed in USD while collateralized in BTC, ensuring price stability regardless of fluctuations. DAI emerged around the same time and remains one of the most widely used synthetic tokens, enabling users to mint stable tokens by locking ETH as collateral in smart contracts. Early projects like “MARKET Protocol” and “UMA,” further expanded synthetic derivatives, offering tools such as position tokens and total return swaps. UMA, for instance, introduced "provably honest oracles" for custom derivative contracts, while “Synthetix” established a platform for trading a wide variety of synthetic assets. Today, a growing ecosystem of DeFi protocols focuses on innovative synthetic products.
Challenges & Outlook
Derivatives in general, and synthetics in particular, play an important role in traditional financial markets and have also become a key component of DeFi. However, the vast potential of tokenized derivatives is accompanied by significant challenges.
- Counterparty risk: In traditional finance, clearing firms mitigate counterparty risk by ensuring transactions settle. In smart contract-based systems, potential counterparty risk needs to be mitigated through preventive mechanisms in the absence of human-managed clearing institutions. Such mechanisms need to be developed for the use case of derivatives that are executed via smart contracts. They are generally referred to as “auto-liquidations,” which are usually triggered when the price of the underlying assets meets certain predefined critical targets. These critical targets are defined in the protocol to prevent investors from having insufficient funds to keep the trade open due to a sudden drop in the price of the underlying asset. However, the design of resilient auto-liquidation mechanisms needs to be refined and is one of the biggest design challenges for various derivative products such as stable tokens. MakerDAO, for example, is a stable token that uses auto-liquidations—DAI vaults are liquidated before they turn under-collateralized. If the price of the collateral assets held in the vaults drops below a critical threshold, market players (so-called “Keepers”)—who are incentivized with potential arbitrage opportunities to monitor the collateralization ratio of all vaults—can trigger a liquidation of a DAI vault if the DAI debt is not sufficiently collateralized due to exchange rate drops. An in-depth analysis of DAI and MakerDAO can be found in a dedicated chapter later in this book.
- Regulatory concerns: Derivatives and synthetics face varying regulatory treatment across jurisdictions, with some regions prohibiting their use entirely. Offering these products over globally accessible, permissionless infrastructure adds complexity, as they must balance transparency with compliance.
- Financial literacy & discipline: The rise of derivatives in traditional finance has fueled speculative activity that often outpaces the real economy, as seen during the 2007–2009 financial crisis. The complexity of derivatives—and synthetics in particular—can overwhelm even institutional investors. Retail investors, often with less expertise and fewer resources, face even greater risks when navigating these markets. Improved financial education is essential to enable sound investment decisions and foster sustainable growth in tokenized derivatives. Specialized AI agents that integrate with derivatives products can mitigate these literacy gaps to a certain extent.
- Market failures: Crypto derivatives are complex instruments typically used by advanced traders. Without sufficient knowledge, retail investors risk contributing to unstable market conditions, especially during speculative bull markets. Historical examples, such as the 2009 financial crisis and multiple crypto market crashes in 2022, highlight the dangers of interconnected, poorly understood financial products.
- Systemic risks & high-frequency trading: The tokenization of derivatives allows for the creation of highly complex financial products, including derivatives of derivatives, amplifying systemic risks that can spread to asset classes that were previously not part of the financial system. The greater the layers of dependency, the more vulnerable the market becomes to shocks. Institutional investors often rely on AI and machine learning tools to manage these complexities, using trading bots to execute high-frequency strategies. Until recently, such tools have largely been inaccessible to retail investors, creating an uneven playing field. Emerging AI agents that plug into DeFi protocols can democratize access to DeFi, enabling retail investors to better assess risks and participate in high-frequency trading. Until then, claims of decentralization and inclusion in DeFi should be approached with caution.
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Footnotes
[1] Source: https://defiprime.com/synthetic-assets-defi
[2] Source: https://crypto.com/university/what-are-crypto-derivatives-options-futures
[3] In the context of futures contracts, “margin” refers to the funds that one must deposit and keep on hand with a broker when opening a futures position. Buying on margin allows investors to leverage their investments better than they otherwise could using only their available funds. In case a margin call is not met within a short time frame, the position may be liquidated or closed. As a result, one could lose more than the initial investment to open a futures position. While buying on margin “leverages” any profits realized from a potential investment, it also leverages potential losses in the same way.
[4] Source: https://defiprime.com/synthetic-assets-defi
[5] Source: https://cointelegraph.com/learn/crypto-derivatives
[6] Source: https://cointelegraph.com/learn/crypto-derivatives
[7] Paragraph source: https://defiprime.com/synthetic-assets-defi