Wall Street's credit default swaps have found their way to DeFi

One of Wall Street's most storied products is making its way to the decentralized finance space. 

Opium.exchange, a decentralized cryptocurrency exchange, has rolled out a suite of credit default swaps for the "DeFi" world that are supposed to mitigate the risks associated with DeFi projects and products.  

Credit default swaps (CDS) offer investors a form of insurance (although not technically insurance) against potential losses. In the context of traditional finance, a person might buy a CDS to hedge against a borrower defaulting on a loan. These products have a controversial history as they are viewed as playing a role in the 2008 financial crisis. 

Opium's newest crypto credit default swaps are tied to wBTC, an Ethereum-based token that is tied to the value and backed one-to-one to bitcoin. wBTC is minted by crypto custodian BitGo. The product acts as a form of insurance against the risk that BitGo becomes insolvent. 

"Buy this CDS to protect yourself against (or speculate on) an insolvency event of the wBTC custodian," marketing materials explain. "Sell this CDS if you are willing to take on wBTC solvency risk and earn extra interest on your capital."

BitGo is one of the most established firms in the digital asset industry and has the backing of investment heavyweights like Galaxy Digital and Goldman Sachs. But proponents of DeFi systems would argue that even a trustworthy and competent organization like BitGo doesn't provide the same insurances as a smart-contract based protocol. 

Furthermore, the contract allows users to hedge against the price of wBTC deviating from the price of bitcoin. For instance, if wBTC deviates 10% from the price of bitcoin then that will trigger a 10% pay-out to the purchaser of the insurance. The person on the other side of the trade is betting that wBTC will stay in line with the price of bitcoin. 

On traditional Wall Street, one of the risks of two parties entering into a credit default swap is that there is a difference in understanding of what qualifies as a credit event. A smart-contract based CDS could introduce more predictability to the product since the parameters that determine what defines a credit event corresponding payout are written in the self-enforcing smart contract.  

"Right now we have full control over the protocol and the products on top (e.g. Opium Exchange), but once a buyer and seller enter a trade and collateral is locked in a smart contract, there is no possibility for Opium to interfere — the only way would be attacking the oracles," a spokesman for Opium explained. 

It should be noted that traditional credit default swaps are now subject to more strict regulation than they were before the financial crisis. The Dodd-Frank Wall Street reform legislation effectively pushed most CDS trading onto clearing platforms that are highly standardized and unlikely to witness the credit issues that existed during the crisis. 

The wBTC CDS follows Opium's (and DeFi's) first CDS product, which is tied to Aave's decentralized lending protocol. Aave's credit delegation allows users to extend lines of credit to other users on the platform. Buyers of this CDS contract can use it to cover potential losses of the actual loan or use it to speculate on the possibility of a credit event.

"The Aave contract makes sense," said one early pioneer in the traditional CDS market. Opium's efforts show that it's "OK to bring the best parts of Wall Street to crypto," they said.

Still, even though several market participants noted that the entrance of new derivatives could potentially reduce risks and improve capital efficiency for the DeFi market, not everyone was sold on the merits of the wBTC contract specifically. 

"Everyone with money knows wBTC is safe," one crypto exchange executive said. "Everyone who claims wBTC is risky wouldn't be willing to put their money where their mouth is."