Expirable Contracts in DeFi: Contango | TKX Weekly
The derivatives markets always have more potential than the spot markets since derivatives offer various kinds of products for different purposes. In crypto, we have perpetual, options, exotic derivatives, etc. However, there is a niche market that is covered in CeFi but not in DeFi — expirable. Contango is one of the projects that focuses on expirable contracts in DeFi. Let’s find out how Contango achieves that without order books or liquidity pools.
Contango was born in the summer of 2021 at Hackmoney and raised a seed round of $4M at a $45M valuation in December 2021. The round was led by ParaFi, with participation from dlab, Advanced Blockchain AG, as well as Coinbase Ventures, Spartan Group, AngelDAO, and trading firms Cumberland, GSR, Amber Group and CMS. Contango was incubated at Alpha Venture DAO.
What are Expirables?
Expirables are similar to forward in traditional finance. It is a derivative contract to buy or sell an asset at a specific date and price in the future. The main difference between expirable and perpetual is funding fees. Perpetual contracts are standardised instruments without an expiry date, which means holders can hold them indefinitely. Funding fees provide a mechanism to keep futures prices close to the spot price as time goes on. Over a long-term horizon, funding fees will be an unpredictable cost to holders. In contrast, in expirable contracts, all costs are known upfront and predictable.
How does Contango Work?
As mentioned, Contango’s expirables are similar to forward in TradFi. Hence, the model behind Contango is also similar to forward contracts — — the interest rate parity formula:
Contango synthesizes expirable forwards by using spot exchanges and fixed-rate borrowing and lending protocols, replicating the cash flows of expirable positions through the spot market (Uniswap) and fixed rate markets (Notional and Yield) in one transaction:
The fixed-rate protocols (Notional and Yield) used by Contango offer fixed rates to borrowers and lenders through a zero-coupon bond-like instrument. Lending/borrowing at a fixed rate is equivalent to buying/selling a discounted zero-coupon bond. Currently, Contango has integrated the Yield protocol to offer zero-coupon bonds called zcTokens.
Positions in Contango are tokenized as NFTs, which enable other projects to easily build on top of Contango, e.g. it can be used as collateral in other DeFi protocols. In addition, people can trade the ownership of the position on a secondary market.
In terms of the settlement, Contango’s expirables are no different from forward contracts in TradFi. At the expiry, the trader needs to fill up the missing capital to make up for the difference if he/she used leverage in the first place. If the trader is long/short ETHDAI, he/she will receive/deliver ETH.
Contango chooses Arbitrum as the starting point which can fit easily into Arbitrum’s DeFi ecosystem. However, Contango relies on the spot and fixed-rated protocols (Uniswap, Yield and Notional), which can be a double-edged sword:
- Pros: Liquidity (TVL) would not be a problem for Contango because no liquidity is held by the protocol. It leverages other protocols’ liquidity.
- Cons: Contango and Cantago’s traders face risk not only from themselves but also from other protocols. Traders have to consider the extra risk. Moreover, such a model (through intergrading other fixed-rated protocols) might limit Contango’s future expansion.
Expirables is a great product for people who want to hedge with a certain cost. Contango fills up the niche market. For hedging purposes, compared to perpetual, expirables are a robust instrument for VC and investors to lock profit for a new launch project as there are no unpredictable funding fees. However, Contango’s expirables are difficult to cover long-tail assets since enough liquidity in both spot and lending markets is needed.
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Note: TKX Capital do not offer any financial advice for retail investors and we have no affiliation with projects in this research.