building blocks of defi derivatives - Arisa Toyosaki

Alright, let's begin. Hello everyone. My name is Arisa and I am the co-founder and CEO of Sega Finance. Sega is a decentralized exotic options protocol, and we have created smart contracts that manage exotic options, which are conditional option statements conditional option statements . So we'll delve a little deeper into our products, but today's topic is the basic components of DeFi derivatives.

This is a very complex topic and I think I can go into a lot more detail about it, and I'm very excited to talk about it with you today. The thesis I want to share with everyone today is this key conclusion: I believe that DeFi derivatives will drive institutional adoption, and this is fundamental to the growth of the entire cryptocurrency ecosystem. cryptocurrency ecosystem. What does that mean? Okay, first, What does that mean?

Okay, first, how have cryptocurrencies grown in the last 15 years of their existence? What are derivatives? And what are DeFi derivatives? It has not been denied that in recent years a capital market has formed around blockchain technology. I think what people don't realize is that we have literally increased almost 700 times since 2019 in terms of our market size for everything that is on chain.

This is a fascinating metric because it simply shows that, as of June 2022, the size of the on-chain markets was essentially the size of a small emerging market in traditional finance or the size of a small commodity market in traditional finance. And therefore, it is largely the size of a legitimate capital market that requires more, you know, institutional attention, more know, institutional attention, more , you know, professionalism. I think this is something that people don't realize, since DeFi is a very large market, but people don't realize this because it's a small point compared to a traditional market. We can see here that in traditional finance, when you look at the market capitalization, it is over $100 trillion, while DeFi, even at its peak while DeFi, even at its peak , was at $77 billion , was at $77 billion . As you can see, although DeFi itself is the size of a small emerging market or a small commodities market, we are very, very small and we are on the cusp of this great growth, and we are very, very excited to see what is going to drive this great growth.

I think people don't realize this. And, well, people in DeFi, I'm sure, realize this, but people outside of DeFi, I think, often confuse the DeFi timeline with the BTC timeline. BTC and, well, blockchain technology has been around for 15 years. So, it has existed, I mean, it's still very early, but it's been going on for a while. DeFi has only existed for 5 years.

And since its early adoption, only about three years have passed, maybe even less. So, in reality, we're talking about an innovation that has occurred in a third of the timeline of the entire history of blockchains. I think that the time that DeFi has existed, the innovations we have made in this space are fascinating. And I think it also shows that, you know, the problems we talk about in DeFi, I mean, I'd almost say it's natural that we have these problems because it's so early on, and I think what will really trigger massive growth in DeFi is institutional adoption. Much of the current use of DeFi is retail, and there are still a very small number of institutions willing to invest in DeFi and DeFi products.

I'll go into more detail about the space issues, but, you know, we need to achieve institutional adoption for mass adoption, and you can see that in the history of BTC. The peak of institutional adoption was also the peak of a major bull market cycle that really laid the foundation for where BTC is traded today. For example, BTC started in 2008, but the first institutional asset manager was formed in 2013 . Does anyone know the name of this first institutional asset manager? Anyone?

Well, it was Panta Capital, and you know they're one of our investors, and they were the first institution to say that all of their investments were going to be in blockchain asset classes. And in 2013, between 2013 and 2016, there was a major cycle of BTC price increases. And then, in 2016, Japan's cabinet was one of the first developed economies to recognize BTC as potential real money . This was once again the peak of institutional adoption. And as you all know, from 2016 to 2018, there was another major market movement and a huge adoption cycle that has now turned BTC into a very important currency in the world.

And this has helped establish BTC as something that every country, every regulatory body, and every institution is talking about today. So, how does this translate to DeFi? And what can we do to make something similar happen in DeFi where we see signs of institutional adoption? I believe they are DeFi derivatives. Perhaps not all of you here today are very familiar with DeFi derivatives.

Therefore, I'm going to delve a little deeper into what derivatives are and how they translate into DeFi. And later in my talk, I'll discuss how this will affect institutional adoption. In their purest form, derivatives are about risk management. I've put a farmer here because the first use case of a derivatives contract was actually in agriculture. Farmers were worried about their crop yields each year due to a highly volatile environment that was affected by the weather.

And so, the first form of a derivative contract was really something that said, "Well was really something that said, "Well , I think the weather this year is looking bad , I think the weather this year is looking bad . So, I want to hedge the risk of, you know, bad weather and a bad harvest by entering into a contract with someone who 's willing to insure my crops 's willing to insure my crops ." So, it's about managing risk. Some might say it's insurance. And what a derivative is is that it's not actually the underlying asset, but a contract that bets on the behavior of the underlying assets.

Here we have different asset classes like stocks, bonds, and cryptocurrencies. And I put dotted lines around these boxes because this dotted line is what represents a derivative. It's a contract wrapped around an asset class. And as the issuer or buyer of the derivative, you don't actually need to own the underlying asset. It's a contract between two parties.

So, an example of this contract in the case of this farmer is, you know, the buyer of the contract says, "Hey, I want to have the option to receive $ 100 for my apples in the next 27 days if I can't harvest." "And you know, if the apples are harvested, then they want the option of not having to exercise this contract. On the other hand, we have this issuer who thinks, ' Well, they'll probably be able to harvest, but I can get $20 upfront .' So, they say, 'Well, pay me $ 20 right now and I can give you that option.'" "So, this contract that helps establish this insurance is actually called a derivative.

And you know, both parties are basically bound by this contract, and in DeFi, this happens in a smart contract. So, in traditional finance , that insurance is done on paper, and then there's a contract value, which is the $20 that the issuer mentioned, and then the $100 is the payout. So, in the DeFi sense, the contract between the two parties is a tokenized smart contract worth $20, and then, if certain events occur, the buyer of this contract can redeem $100 in 27 days. So that was DeFi derivatives in a nutshell. And this is something that's still very much on the rise within the DeFi ecosystem.

I think DeFi derivatives are a very natural evolution in the market, and it's imperative that this happens in the coming years. Any capital market is formed from the creation of an asset. So, in the case of DeFi, the last talk was from someone at Maker Dow, and you know that Maker was one of the DeFi protocols that..." It created the first type of decentralized asset, which, as you know, in its case was a stablecoin. Then, from the creation of an asset, there's a spot market.

I'm sure everyone is familiar with spot markets—you know, uni exchanges, and so on. They created AMMs, clubs, and exchanges. And then there's the lending market. So, money markets are formed on top of spot markets because people start wanting to borrow and people start wanting to lend when they have various assets in their wallets. So, a lending market is formed, and based on a lending market, there's something called an interest rate.

And this interest rate creates a basis for more products to be built upon, like a futures market that allows users to take on leverage. And on top of a futures market, where you take linear leverage, you can take an options market, which creates a non-linear position on how you want to express your view of the market. I know I've spoken pretty fast, but the TLD/DR is that DeFi is a market of capital that has formed and cannot be ignored. There is a futures market and an options market forming in DeFi that is going to be very, very large. So, to become very large, we need institutional adoption.

And the thesis today is that, in fact, I think with all the builders here, if you build more DeFi derivatives protocols, it will actually lead to greater institutional adoption. So, it's not that institutional adoption brings DeFi derivatives, but I do think that the more DeFi derivatives protocols you build in this space, the more institutional adoption we will have in our markets. And I think this is because institutions, to enter a capital market, need certain capabilities, and these capabilities are currently fully available, not really available, or somewhat available in DeFi, and, as you know, the categories are a bit confusing. But I think the first benefit or the first capability is really having a benefit and utility in the products, and for institutional investors, benefit and utility mean good returns. The second is the supply and Liquidity.

So, for institutional investors, they need to be able to invest large amounts in positions. But right now, the DeFi market is still at $77 billion at most. So, it's really difficult for institutional investors who want to take, say, a billion dollars in a position because they would take more than 1% of the market share. So, how do we increase supply? How do we increase liquidity?

I think DeFi derivatives will be able to answer this question. And then the third part is trust and security. Obviously, it 's very different to invest a couple of hundred dollars from your own portfolio than to invest a couple of hundred million dollars from a portfolio that has many stakeholders. So, how do we ensure there is more trust and security in the market so that institutional investors will want to invest? In fact, I think that by creating DeFi derivatives fact, I think that by creating DeFi derivatives , we can generate more trust and security in DeFi.

And lastly, it's about reducing the costs of operations. Right now, we all talk about the philosophy and love for DeFi, mentioning that by implementing more DeFi, we were able to create Accessibility and transparency. These are all very beautiful stories. But when you look at the gas costs, it's quite expensive. And the argument here is that by creating more DeFi derivatives, we can actually optimize costs in the market.

These are all quite interesting points. So I'm going to go over them one by one. The first is profit and utility. I've already mentioned that, for institutional investors, profit and utility mean high returns and making money. What I believe is that, in the current DeFi ecosystem, returns are sometimes a bit scarce.

I'm a big advocate of this online, but, for example, I think Vtokconomics is very difficult to create value in. And I think that with the existing spot market and the lack of a strong money market and a very small options market, it's been very difficult for people to find attractive returns. And high returns don't really mean attractive returns because many of the high returns are very scarce in DeFi. So, by combining DeFi derivatives and options, where there are actually many more opportunities and information that could allow More flexible views in the market can actually generate much higher real returns, which is attractive to investors. So I think that's a key benefit of DeFi derivatives: attracting institutional investors.

And then the second part is better trading mechanisms. With DeFi derivatives, you can implement much more efficient liquidation mechanisms that were previously considered very difficult to implement in DeFi. For example, with leverage in DeFi, existing markets require overcollateralization or reliance on external liquidity sources, and this is very capital-inefficient because, for example, you know you're trying to leverage, but you're still locking up your assets on the platform for the duration of your trade. Basically, you're putting all your assets there and assuming leverage with your own account, or you're relying on LPs, which obviously makes the protocol not very scalable. And as more leverage protocols or more Perplex protocols form, there's liquidity fragmentation.

So it becomes increasingly difficult to leverage as much as you want. With options, you can create settlement mechanisms, for example, where you can create spreads on, say, put options, and by having a put spread, you can create a baseline from which you get settled. So in the contract, in the smart contract, there's a specific point, a specific price point, where your profit becomes zero, and it's established in the smart contract that you'll be settled at this point. Therefore, you don't actually need to overcollateralize, nor do you need to obtain liquidity from external state capital. This is a very interesting idea, for example, because then, for the same 100 USDC that you were putting in and then, you know, trying to figure out liquidity through, you know, external liquidity, external staking to leverage your position, the same 100 USDC can assume leverage without this external dependency.

And you know that your one hundred US dollars is the collateral for a position worth $500. And then, the third part is flexible market views. So, in spot markets, you can only bet Up or down, which, frankly, at a certain point for institutional investors, isn't very interesting anymore, especially in a market where volatility decreases as the market matures. Investors want ways to express their views on the market, not just up or down, but, for example, is it going to move sideways? Is it going to have higher volatility?

Well, you know, you can use derivatives to express views that aren't just directional. And this will allow institutional investors to adopt a much more interesting perspective that will allow the market to mature faster. So all these benefits are driven by DeFi derivatives, which could lead to institutional adoption. The second is supply and liquidity. Actually, this is a bit more of a chicken-and-egg problem.

But I think that by creating more DeFi derivatives protocols creating more DeFi derivatives protocols , you're creating more liquidity in the market, not just for DeFi derivatives, but also for the lower layers, like money markets, as well as spot and mint trading. of assets. So, when you trade an option, for example, you're buying a call option, there's a market maker, or, you know, an individual maker, whoever, who's selling the call option. To hedge that position as a maker , because as a taker, you want to assume that position, but as a maker, you're trying to neutralize it. You actually need to do something called hedging, where you buy the underlying asset if you're selling a call option, and then you also want to buy some volatility to hedge the Vega.

And this kind of hedging requires more, it generates more demand in the market. And so, by creating more DeFi derivatives and tokenized derivative assets, it will actually generate more demand and supply in the spot markets and money markets through these hedges and also something called access, which are like all the positions you hold. It also creates more secondary markets for your tokenized assets. And then that generates more derivatives, because people will have a larger position that they'll want to hedge through derivatives; and then they'll hedge that derivative by having more liquidity of, no, derivative assets more liquidity of, no, derivative assets , and so it becomes this flywheel of the inertia of creating more and more volume in the market. For example, creating DeFi derivatives protocols will increase the volume of each part of DeFi, and that's the key to creating the large supply that institutional investors will want to enter the market.

The third part is trust and security. So, it 's very different to run a $10 million business from your bedroom than to deal with a $10 billion fund where you have many stakeholders. So, my thesis here is that by creating DeFi derivatives protocols , you can actually generate more transparency of flows. You can help create more of them, you can help reduce counterparty credit risks, and you can also help with things like institutional custody. And a lot of this goes back to the example I mentioned about how derivatives can serve as insurance, and insurance provides trust and security.

For example, tokenized derivatives—if you can create individual positions in a tokenized derivative, you can observe the flow of funds within the contract, and that creates more transparency, which generates a sense of security for these institutional investors. In this way, you're not just Investing in something where you don't know what's going on . And then, the second part is counterparty credit risk. As you know, a lot of people are working on this right now, but DeFi derivatives, like credit derivatives, are currently working on on-chain identity issues that help investigate how credible your counterparty is. And so, these types of credit derivatives protocols are actually helping to create ratings and limits for different wallets you interact with.

And the more credit ratings and security measures that are implemented, the more they allow you to understand who you 're trading with, what the other position is in your smart contract. That creates a knowledge base that also helps build this trust and security. And so, as you know, in the next few years, as this DeFi market matures further, these derivatives protocols will actually help create a database of everyone's trustworthiness, which will also serve as a data point for institutional investors. And lastly, institutional custody is something I'm very interested in. And there isn't much of this in the DeFi markets today, but I think the DeFi derivatives will do a lot for institutional custody.

So, for those of you who don't know what custody means, if you're running a $10 billion protocol , or a $10 billion fund, you can't actually have just one person implementing the $10 billion. So, what happens is that there are smaller funds underneath that maybe allocate $2 billion each, and underneath those are even smaller funds that allocate $500 million each. So, there's this whole notion of people allocating the funds for this main $ 10 billion fund. And these funds will have to have custody of the assets. The problem with custody is that it could be lost.

It's scary, like knowing you're giving funds to someone you don't know by sight, like not knowing where they'll end up . But by implementing derivatives protocols, you can do things like insure against the possibility of a custodian of the assets losing the funds, for example. And so, again, this leads to this notion of trust and security where Creating more derivatives that can insure against the loss of funds, the loss of assets, helps institutional investors feel more secure when investing their large sums of money. And finally, my thesis is that DeFi derivatives will help optimize and reduce the cost of all operations in DeFi. This is similar to the trust and security aspect, but for example trust and security aspect, but for example , gas optimization.

Perhaps the engineers here can talk about this much better than I can. But by having DeFi derivatives, you can actually create bilateral liquidity. What that means is that there's more of it; there are many buyers and many sellers in the market, but often in a spot market, it could really skew in one direction. And what that creates is that, you know, when there's a very high concentration in one direction, it increases the cost and the cost of communicating with the blockchain, which could increase the gas price. But if we're able to find ways to match the orders that, you know, happen before everything is written into transactions, that could optimize your gas fee, which can reduce the overall cost of the operation.

And then the second part is on- chain pricing. So right now chain pricing. So right now , you know, on- chain pricing is extremely complex. There are a lot of mechanisms being put in place on exchanges to figure out what the correct price of an asset is. And what I really believe is that by having derivatives, the price of derivatives actually increases the data points of what the correct price of the underlying asset is.

And so it creates more sample sizes. And basically, with the availability of DeFi derivative asset data, you can create, you know, a better pricing system. That should also reduce the cost in the long run. And the last thing is protocol fees last thing is protocol fees . I mean, we also charge fees for all the transactions that take place on our platform.

So, you know, this is something that I expect will decrease over time. I think DeFi derivatives, for example, create really high yields. That was one of my first points. By creating really high yields, there's a lot of revenue potential that comes from just the positions. So protocols should be able to make money by taking these positions instead of taking a big fee for the users' own operations .

And so, with the emergence of DeFi derivatives and really high yields, my thesis is that it will actually reduce the fees currently imposed on users in DeFi protocols, making this whole opportunity attractive to institutional investors. And indeed, yes, retail trading is much less sensitive to fees than institutional investors. So, cost optimization is a huge trigger. And with the emergence of more DeFi derivatives protocols, we can optimize gas, get better prices, and we can also reduce protocol fees. Those were many of the reasons why I believe that developing DeFi derivatives will help generate institutional adoption, which is key to the growth of the entire ecosystem.

Creating a robust DeFi derivatives ecosystem is very, very important, and I hope this is something we've all learned today. Well, I 'll end my talk by talking about where DeFi derivatives are today and where I think they're really headed. This is the DeFi derivatives landscape today. I've categorized it into three main groups. Some of you may have a different categorization, and don't hesitate to let me know.

I think the first part is exchanges. Those are, you know, the front-end platforms where people can trade DeFi derivatives. And then the second part is trading. This is more the back-office work, which, you know, is really important for building blocks to make sure everything goes smoothly. And then the last thing is tokenization.

It's the creation of the actual smart contracts that represent financial positions, and these capabilities vary a lot. But I think, broadly speaking, these are like the three main categories, and I put some representative protocols at the bottom of each category. And I think for each of these categories, you know, I have some ideas. So, for DeFi derivatives exchanges for DeFi derivatives exchanges , these are actually maturing really well, and I almost think they're a little saturated. I feel like every DeFi derivatives protocol I 've talked to is trying to do an exchange, and yeah, you know, I think fast execution, low fees, all of that is really important low fees, all of that is really important .

But yeah, These are all really good products that exist on the market today. So, first we have, uh, perpetual DEXs, which I'm sure you all know, uh, they're like futures that allow you n assume leverage, uh, in, uh, the direction of the market. And then we also have DEX options that are forming, uh, you know, AO just launched last week, and I think there's a lot of interest in also offering non-linear products in a DEX. There are so many, many exchange selections, and that's really exciting, because it means there are more platforms for different types of investors. But I think a really difficult part is actually in DeFi derivatives; trading is still very, very important.

Many of the tools and services in back-end middle office operations are very limited, and uh, especially things like risk management, custody solutions, clearinghouses, uh, you know, insurance. These are the parts of DeFi derivatives that still need work. And these are very difficult problems to solve. You know, people still haven't really figured out chain identity. People haven't figured out, you know, how to find out, you know, chain balances, clearinghouses, and custody solutions.

These are all very traditional financial terms. And do you know how we create custody of an asset in a very large portfolio without it being centralized? Or how we create accountability in a third party that helps settle transactions? This reduces counterparty risk without centralizing it. I believe these solutions are imperative for institutions to deploy larger amounts of funds in the market.

People still haven't solved this problem People still haven't solved this problem . If you're participating in a hackathon and looking for ideas, I know it's already the second day, but here are some ideas I think you could work on. This is my passion and the problem I work on: tokenization. Tokenization is the act of putting DeFi derivatives into a smart contract. It's transparent, accessible, and you know it has some kind of payment.

This area is not saturated, but it is seeing some very exciting innovation. Well, you know, in recent years, we've seen the vanilla options space take shape with the emergence of open, tokenized options, and then, I would say, platforms like Riven Finance, Jones Dow, actually listed these tokenized options to distribute them to users. And then we also saw synthetic delta options, which are more like tokenized linear payout derivatives that people were also listing. And I think Sega's emergence was key; it was a key signal for innovating this tokenization space in DeFi derivatives, as Sega created the first exotic options smart contracts. I'm going to talk a little more about Sega.

Exotic options are a very interesting space. In reality, it is the most advanced type of derivative where you create conditional statements on a normal option and it helps to create products with much more flexible market views. An example of an exotic options position. At Sega, a very popular strategy would be Sega, a very popular strategy would be : I bet that in the next 27 days neither BTC nor ETH will fall more than 50 days neither BTC nor ETH will fall more than 50 % and, in return, I get an APY of 12%. It's like an exotic options position that combines two things.

Combine a basket of options. You are viewing a basket of BTC and ETH options. And it also has something called a knock-in barrier that creates this capital protection of up to 50% capital protection of up to 50% , indicating that you are not actually incurring any loss of your capital during 50% of the market movement. So, even if the market falls by 45%, you still get 100% of your capital and 100% of your profits. This type of product is very, very common in traditional finance.

It had a market size of around $16 trillion and is often marketed as a high-yield savings account or offered to private bank customers in developed countries. Yes, we put it on the chain because we believe it's a natural evolution of the market. It is very important to have exotic options on the chain and we believe it will bring greater institutional adoption to the space by creating safer returns in volatile market environments. Yes, I talked a little more about our product, but with Sega products product, but with Sega products , you deposit USDC into our smart contracts. And we execute these exotic options trading strategies that help you achieve returns ranging from 5% to 50% APY returns ranging from 5% to 50% APY .

And we offer protection against downside risks. In fact, we protect your assets during between 30% and 90 your assets during between 30% and 90 % of market movements, and all of this happens in a chain with a very efficient mechanism. Well, if you're interested in learning more about our strategies, it's on sega.fi. Try it after listening to this talk.

As I mentioned before, we are solving problems in the sector, such as the lack of product innovation, declining yields, and safety. Our mission is to create safer returns in volatile market environments because, when Sega was formed in late 2021 or early 2022, we saw that existing products in DeFi derivatives were all conventional and very risky, somewhat dangerous. We saw that everyone was forking each other's protocols and not really creating their own, not being very creative, and then there were a lot of unprofitable strategies. Therefore, we wanted to create really high returns that were not inflationary, that were not a Ponzi scheme. And we also wanted to make sure we weren't misleading our users.

Well, these are some of the concerns we initially saw, and now we're building on this to create an expansive DeFi derivatives ecosystem that will lead to an expansive crypto ecosystem. Regarding Sega, we have been active on Ethereum since last month and we are also active on Salana. We have completed over $250 million in transaction volume to date. So we're very excited. That makes us number one in Salana DeFi and also number four across all blockchains in the world.

Sega has done quite well and yes, we just launched it on Ethereum. So we're really excited to be speaking at an Ethereum conference today and also this week, it says today, but we actually used the slide like three times. Today we are launching something called leveraged options vaults . I talked a little earlier about the beauty of having DeFi derivatives and creating more efficient settlement mechanisms . We created leveraged option vaults, which are at the forefront of DeFi derivatives innovation.

In fact, they allow you to take a leveraged position in our vaults without the need for additional guarantees or the need to depend on external liquidity. Leveraged option vaults will allow you to obtain magnified returns of 20% to 50% plus an APY, while still having capital protection of between 30% capital protection of between 30% and 50% of market movements. You can get leverage of 2x, 3x, 4x or 5x. It's a really interesting product that you've never seen in any protocol. So, if you're interested in trying our products interested in trying our products , give them a try after this talk, and if you have any questions, feel free to contact me.

I'll be happy to answer you. Thank you so much for listening to today's talk. Try our product. Well, if you scan this QR code, there are a bunch of links about how to get started with Sega. It also provides documentation on our retrospective tests and scenarios, in case you want to learn more about our products in detail.

And our Twitter handle is Sega_Fi. My personal Twitter handle is Orisa Toyo. So yes, please send me a direct message, Discord, talk to me in person at the hackathon. Ask me any questions you have about DeFi derivatives, the DeFi ecosystem, and Sega. Thank you so much.