Prediction Markets Over Options
The rise of decentralized finance brings many opportunities to trade derivatives of assets. Because the size of derivative markets can be over an order of magnitude larger than the market for the assets themselves, derivative-based decentralized finance protocols are very important to the ecosystem. In traditional finance, the most common types of financial derivatives that are used for hedging and speculation are options and futures. The contracts are useful in some situations but they are difficult to understand, price, and trade. Many retail investors are essentially frozen out of these markets because they don't have the resources to effectively compete. Blockchain can improve the accessibility of derivatives because of its permissionless manner.
In DeFi, protocols such as Synthetix and UMA are collateralized debt pools and can be used to mint synthetic assets in order to create leveraged positions. There are also on-chain derivative protocols like Opyn and Hegic that offer products similar to traditional financial derivatives. Prediction markets can be used not just to speculate on cryptocurrencies, but also for anything that can be reliably reported upon by an oracle. I am not denying the usefulness and effectiveness of traditional options and derivatives in certain situations. It makes sense that a Bitcoin miner would like to lock in a future price of rewarded Bitcoin to limit exposure to price movement, and an airline would trade options based on the price of fuel because they are not in the business of speculating on fuel prices.
However, there are many instances where this extra complexity is not needed, and that is where prediction markets come into play. For most, prediction markets are much easier to understand compared to the complex options of decentralized financed-based debt protocols, which can result in liquidation if not used carefully. Prediction markets also make it possible to speculate and hedge on anything that can be reliably reported by an oracle. The price of each contract is easily understandable and derivable and markets are easily formed with extremely low barriers to entry. Consider an European call option that gives the purchases the right—not the obligation—to buy one Ether for $2000 one year into the future. Although not exactly equal, this can essentially be thought of as a prediction on whether the price of Ether is going to be greater than $2000 in one year. Most investors are not concerned with the slight differences in these two assets, and therefore would prefer the simpler option. These markets can be easily managed by a DAO with the DAO controlling which assets are able to be used as underlings, the frequency of expiration dates available, and the differences in the strike prices that are allowed to be created. Oracles can be chosen from a list of those that are approved. This creates a permissionless marketplace where anyone can come and participate in a market or form a new market if they are interested in an unavailable market.
These types of options are known as binary options in traditional finance, but they have not gained any sort of traction. I attribute this to the stagnant nature of traditional finance. The decentralized finance space is much more willing to adapt to newer technologies and innovations as they are deployed. I hope to see these kinds of derivatives as part of the decentralized finance landscape in the near future.
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