Forward contracts are a popular tool in traditional finance, used to lock in the price of an asset at a future date. However, in the world of DeFi, forward contracts are not yet a common practice. In this piece, we'll explore why forward contracts have not yet gained traction in DeFi and what alternatives are being used instead. Let's dive in!
What’s a Forward Contract
A forward contract is a type of derivative financial instrument that allows two parties to agree to buy or sell an asset at a predetermined price at a future date. The asset could be any financial instrument, such as a currency, commodity, or security.
Forward contracts are typically used to hedge against potential price fluctuations in the underlying asset. For example, a farmer might use a forward contract to lock in a price for the grain they will produce at a future date to protect against the possibility of a decline in grain prices. Similarly, a company that imports goods from another country might use a forward contract to hedge against fluctuations in the currency's exchange rate used to pay for those goods.
One key difference between a forward contract and other financial instruments, such as futures contracts, is that forward contracts are customized agreements not traded on a centralized exchange. This means that the terms of a forward contract, including the asset being traded, the quantities involved, and the settlement date, are negotiated directly between the parties involved.
Types of Forward Contracts
There are two types of forward contracts - deliverable and non-deliverable.
A deliverable forward contract is a type of forward contract in which the underlying asset is physically delivered to the buyer at the contract's expiration. This type of contract is typically used for commodities, currencies, and other physical assets.
On the other hand, a non-deliverable forward contract, NDF in short, is a type of forward contract in which the underlying asset is not physically delivered to the buyer at the contract's expiration. Instead, the buyer and seller exchange cash payments based on the difference between the contract price and the underlying asset's market price at the contract's expiration. NDFs are typically used for currencies and other financial instruments that are not easily traded or delivered physically.
The main difference between these two types of contracts is how the underlying asset is settled. The deliverable forward contracts involve the physical delivery of the asset. In contrast, the non-deliverable ones involve the exchange of cash payments based on the difference between the contract price and the asset's market price. In general, NDFs are often used for assets that are not easily traded or delivered physically, and deliverable forward contracts are typically used for physical assets such as commodities and currencies.
Why Forward Contract is Not a Thing in DeFi
There are a few key prerequisites that must be in place for a forward contract to be viable:
- Two parties: A forward contract requires at least two parties to agree to buy or sell an asset at a predetermined price at a future date.
- An underlying asset: A forward contract must involve an underlying asset, which could be a currency, commodity, or security.
- A future settlement date: A forward contract must specify a future settlement date at which the asset will be delivered (for deliverable ones) or the net value difference between the contract and the underlying assets will be exchanged (for non-deliverable ones).
- A willingness to enter into a legally binding agreement: Both parties to a forward contract must be willing to enter into a legally binding agreement to buy or sell the asset at the predetermined price on the agreed-upon future settlement date.
- A predetermined price: The parties to a forward contract must agree on a predetermined price at which the asset will be bought or sold at the agreed-upon future date.
If you’ve tried out dydx or Term Structure, you know the scaling solution is already in place to facilitate trades between two parties cheaply on-chain. That means that the first three prerequisites above, namely, requiring two parties, an underlying asset, and a future settlement date, are no longer a hindrance to the adoption of the forward contracts in DeFi. And the existence of legally binding agreements can be replaced by a smart contract in which both parties deposit their collateral so that there will be enough funds to be paid to either side. That leaves us the last prerequisite: a predetermined price.
In TradFi, bankers use the following formula to determine the price of the underlying asset on the expiry date of a non-deliverable forward contract:
F = S0 x erT
- F = The contract’s forward price
- S0 = The underlying asset’s current spot price
- e = The constant approximated to 2.7183
- r = The risk-free rate that applies to the life of the forward contract.
- T = The delivery date in years
The risk-free rate above usually comes from the interest rate of the government’s long-term bond since a government going bankrupt is uncommon; hence the bond issued by a government is considered ‘risk-free.’ However, currently, there is no so-called risk-free rate in the DeFi world, as the major of the borrowing/lending activities uses block-based rates with variable duration.
How Term Structure Plans to Launch Forward Contracts
If this is the first time you’ve heard of Term Structure - it’s a peer-to-peer bond protocol on a ZK-rollup known as “zkTrue-up.” On the protocol, users can borrow or lend cryptocurrencies for a predetermined duration at a fixed rate on primary and secondary markets and use repurchase markets to access leverage. Furthermore, we work with several primary dealers, the designated market makers (DMM) equivalent of our protocol, to provide liquidity and make trades possible.
To sum up, by combing a ZK-rollup, primary dealership, and launching multiple markets simultaneously, we can achieve what dydx has done to perpetual trading, but for bond markets.
At Term Structure, the plan from day one is to build liquid bond markets first and then create new initiatives on top of them, including expirable futures and forward contracts. And as we mentioned above, the risk-free rate is the main blocker to creating forward contracts in DeFi. If we successfully create a liquid bond market on Term Structure, given that the rates on the protocol are fixed for a predetermined date, we can use the rates as the risk-free rates to price forward contracts and sell them to potential buyers.
We know the explanation above is still very high-level. But the current priority for us is to build liquid bond markets. You can follow us on Twitter or join our Discord to stay updated.