Decentralized finance (DeFi) has created an alternative financial system that is both inclusive and widely available. With its “stackable” legos of functionality, it has not only replicated many of the trading products of traditional finance but has created new primitives that weren’t possible before.

However, these DeFi trading products can be complex and difficult to understand. Along with the power of DeFi comes the responsibility of understanding the products before using them.

To prepare you for Wave 7 of Linea’s DeFi Voyage, let’s look at some of the most popular complex DeFi trading products, how they work, their uses and risks, and examples of these products on Linea.

Order Book, RFQ, and OTC DEXs

In previous articles, we covered the what and why of decentralized exchanges (DEXs) that act as automated market makers (AMMs). This time, let’s look at DEXs with alternative models that use order books and request for quotes (RFQs).

What is an Order Book DEX?

An order book DEX uses an order book—or, a list of buy and sell orders—to match buyers and sellers at prices they are both willing to accept. An order book DEX displays the buy and sell orders, by price level, with price and quantity details. When there is a match, the DEX executes the trade.

Order books are commonly used in traditional finance markets such as stock and commodity exchanges. Its use is very similar in crypto, except that a DEX executes this strategy while remaining decentralized. Since the DEX operates on a blockchain, it not only organizes and executes the orders, but also keeps a record on-chain (and public) of all executed transactions.

Order books have some advantages. They can offer a more familiar interface for traditional finance users, are often simpler to understand for seasoned traders, and can solve some complex issues with AMMs such as high slippage and impermanent loss. Order books also make advanced strategies such as limit orders more straightforward.

However, order books can also have disadvantages. First, for native web3 users who are used to the simplicity of an AMM where the price is algorithmically set, order books are often unintuitive and complex. Second, an order book can have liquidity challenges due to an asset being unpopular, fragmentation of the assets across exchanges, or simply the DEX being new and not having many users. In these cases, if liquidity is low, the bid-ask spread can be wide, and buying and selling may cause significant price changes that vary widely from market values.

What is an RFQ DEX?

A request for quotes (RFQ) DEX is similar to an order book DEX in that buyers and sellers are matched for trades. However, with an RFQ DEX, there is no order book. Instead, a trader requests a quote for a specific amount of the asset. Market makers then respond to that request with price quotes. The original trader can accept one of the quotes, and then execute the trade. An RFQ DEX can offer “personalized” pricing on an asset.

As with order books, RFQ is a concept from traditional finance.

RFQs are especially beneficial to large trades, where they can be executed with better pricing, minimal slippage, and less effect on the market price. They are, however, highly dependent on the participation of market makers.

One variation on the RFQ DEX is the over-the-counter (OTC) DEX. An OTC DEX has a similar trading model, but with OTC the trades are more focused on direct, one-to-one private negotiations between parties with no public order book and less market transparency.

Derivatives in Crypto

Most of the advanced trading instruments in crypto are some form of derivatives. Let’s now look at exactly what a derivative is and then at some specific types of derivatives you can use in crypto.

What is a Derivative?

A derivative is a financial product whose value depends on some underlying assets (or group of assets). It’s not the actual token, stock, currency, etc., but a layer on top that allows for more flexible investing. Derivatives are contracts between parties that depend on the price of the underlying asset.

For example, futures are agreements to buy or sell an asset at a predetermined price and future date. They aren’t the asset itself but a derivative of the asset.

Derivatives can be used to mitigate risk (called hedging) or to assume more risk (called speculation).

What are Some Types of Derivatives in Crypto?

There are many types of derivatives, but let’s focus on several key types you might use in crypto: futures, perpetual contracts, options, and swaps.

As covered above, a futures contract is an agreement to buy or sell an asset at an agreed-upon price at a future date.

For example, you may believe the price of bitcoin will rise. You could buy a futures contract for 10 bitcoin that says you will purchase the bitcoin at the current price on a certain date. If the bitcoin price rises, you buy the 10 bitcoin at today’s lower price and profit from the difference. Of course, if the price drops, you’re liable for the losses.

One common feature of futures is the ability to borrow capital from an exchange to increase the trading size of your futures contract. This is called using leverage. Some platforms may allow you to buy 2x, 5x, or even 20x leverage on your futures. Of course, you will need to lock in some amount of capital as insurance to get this loan. Leverage is powerful. Gains, and also losses, can be greatly amplified. Traders using high leverage can quickly find themselves liquidated (your position is closed and your insurance capital is forfeited) with even slight price declines.

Perpetual swap contracts (also called “perps”) are similar to futures but with no expiration date. This means you can keep your contract open as long as you want, extending your gains (or losses).

Options are also similar to futures. An option is an agreement to buy an asset at a certain price in the future. However, options give the buyer the right, not the obligation, to buy the asset. The buyer does not have to exercise the option and can let it expire. Options can be call options (the right to buy the asset) or put options (the right to sell the asset).

Why are Derivatives Important?

Derivatives are extremely important for risk management. You can use derivatives to protect yourself against price movements. For example, in traditional finance, a farmer might buy futures to lock in a price for his crop.

In crypto, a trader might use futures to protect themselves against the wild price swings crypto is often known for. For example, a put option might protect a trader against a sharp decline in a token’s value by giving that trader the right to sell their assets at a certain price over a period of time. Although the put option incurs a cost to buy, that cost would be significantly less than the loss of just holding the token, and so acts as a type of insurance against steep declines.

This type of activity, called hedging, is a type of risk management where a trader tries to offset potential losses in an asset by holding an opposite position. If you hold an asset in expectation of its value increasing, you might hedge that position by holding a derivative that will increase in value if the value of your asset decreases. While initially, these two positions will work against each other, you can drop one position and hold the other once the value of your asset shows clear signals of moving in one direction. With hedging, you limit your upside but reduce risk.

Risks Associated with Complex Trading Products in DeFi

Of course, there are risks involved with using these complex trading products in DeFi.

Smart contract vulnerabilities - DeFi smart contracts can have flaws in their code that allow hackers to exploit them. Funds can be drained, and tokens lost or locked.

Protocol risks - Protocols can fail. Whether from technical issues or operational failures, if a protocol fails, you risk losing your funds.

And, of course, some risks are inherent to these financial instruments themselves, especially with leverage and futures. The risks are quite numerous and include defaults, regulations, low liquidity, price volatility, and even amplified losses that can quickly lead to liquidations, and complete loss of funds.

Don’t take these risks lightly.

How to Mitigate risks

So, how do you mitigate these risks? Let’s look at a few strategies:

First, use the same risk management strategies you use for all of DeFi and traditional investing:

• Diversify your investments to protect against one of them failing

• Only invest what you can afford to lose

• Never use high leverage

• Understand your risk tolerance

• Monitor your investments regularly

• Consult a professional for advice when needed

Second, understand what you are doing before doing it. We only have the space here to cover the surface level of these instruments. Take the time to understand each of them thoroughly before you use them, crypto or otherwise. Know how each one works and the unique risks.

Conclusion

DeFi has given us a wide range of complex financial instruments that can be used for advanced crypto trading strategies. And with the advent of L2s such as Linea, they are now accessible to more users than ever. However, while these instruments are powerful, it’s important to understand their risks and downsides. Taking the time to truly understand what you are doing before doing it is the key to success.

Try Complex Trading Products with Linea’s DeFi Voyage.

Bon Voyage!