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Which Derivatives Can Benefit Crypto Market?

Blockchain technology is mentioned time and time again as the future of capital markets since it entered the mainstream consciousness. While many people focus on the use of Blockchain technology in the classical markets, in this post we want to take a look in the other direction by analyzing the possible use of traditional financial instruments in the crypto industry.

Before we dive into single financial instruments, we first want to define financial instruments.

A financial instrument is a contract representing a legal agreement involving any kind of monetary value.

Typical examples of financial instruments are stocks, bonds, derivatives and currencies. The Blockchain technology has already found its way into stocks via tokens, and currencies via crypto currencies. The question now is, what other possible applications of traditional financial instruments in the crypto space are there?

Firstly, we can take a look at the most common instrument available for stock market – ETFs. ETF stands for Exchange-Traded Fund and belongs to the passive investment vehicles where an upfront investment strategy gets automatically executed. ETFs are available for a variety of asset classes and offers investors exposure to indices, sectors, qualitative or quantitative factors of stocks and many more characteristics. If you replace stocks in an ETF with tokens from ICOs you can continue using the framework of ETFs in the traditional scene but with a different underlying. This offers the same advantages to investors as ETFs in stocks do. However, the criteria regarding the included tokens in ETFs might be different because ICOs aren’t that simple to categorize. But strategies like, momentum, mean reversion and sector ETFs might be still possible to set up.

When we are talking about stocks sooner or later investors might wish to hedge their downside risk to limit losses during volatile market phases. They are looking for some kind of insurance.

Fortunately, financial instruments that work in a similar fashion like an insurance are available in form of equity options. Options are derivatives and provide the right but not the obligation to buy or sell a stock, an ETF or any other traditional financial instruments. For example, the owner of a call option has the right to buy a predetermined amount of a stock for a predetermined price at some date in the future. This option gets exercised only if the stock trades above the exercise price (this is called being in the money). Similar hedges can be thought of for tokens and the already discussed ETFs with underlying tokens. Options can also be used for speculative trading with tokens as the underlying asset.

Special focus should be placed on the many variables that are predetermined in the option space. Things like execution type, execution price, due date and amount of tokens to be bought or sold can be managed and executed via smart contracts. By agreeing on the details of smart contracts the variety of options can be much bigger in the crypto industry compared to traditional equity stocks. While you are dependent on centralized institutions like exchanges and brokers in the traditional world when it comes to characteristics of options (e.g. 100 shares, due date every Friday or every third Friday in the month, execution price) you can easily create your own option that perfectly fits your needs just by proposing your individual characteristics (e.g. 45 tokens, due date Saturday in 2 weeks, for $43 each) and looking for someone in the crypto industry who wants to take the other part of the transaction. Once you have found someone who wants to participate in this trade it gets executed and settled, depending on which Blockchain is used, immediately and everything afterwards is automatically carried out by the smart contracts with the upfront agreed characteristics for a fraction of the cost of option trading in the traditional markets.

Moving on from the equity side to the fixed income side, we now want to focus on bonds and asset backed securities as financial instruments with possible use for the crypto space. Debt used to be an important finance resource for firms and individuals for many centuries. While equity has already found its way into the crypto space with tokens, debt hasn’t seen any mainstream adoption yet. Partly it can be attributed to the amount of scammers in the market, which on its own presents a new niche for new instruments. An implementation of a Know-Your-Customer (KYC) process seems very difficult. Nevertheless, debt instruments may be a great addition to the crypto space as a financial instrument. It provides an additional source of money for projects similar to tokens but a Blockchain based form of Peer-to-Peer (P2P) lending is also imaginable.

The borrower can set up a smart contract with all the desired terms. It becomes a digital version of a bond indenture clarifying things like credit volume, interest rate, maturity, installments, covenants, etc. After the characteristics of this smart contract have been defined the borrower offers this vehicle to interested investors which lend him the needed funds. Interest and principal payments are carried out automatically once the smart contract is active. If covenants have been defined and a breach of covenants might happen in the foreseeable future lenders can vote on terminating the contract or waiving the covenant. In the process of implementing debt instruments in the crypto industry a link between the smart contract and a bank account of the borrower should be established so that in case of an insolvency the lenders can automatically seize any available funds, assets or future inflows of cash of the borrower.

As an alternative to ETFs of debt tokens asset-back securities (ABS) and especially collateralized debt obligations (CDO) may be another financial instrument for the crypto industry. Instead of a special purpose entity (SPE) issuing such ABSs the Blockchain itself issues them in form of Smart Contracts. In difference to traditional CDOs the crypto implementation should have interest payments and make a collateral manager obsolete. The pool of debt gets selected by specific criteria of the underlying debt (e.g. interest rate, maturity, credit volume) or by machine learning algorithms that cluster debt by more qualitative criteria such as repayment history and - if available or computable - credit score. The selection of debt for the pool by algorithms is only possible if the needed data is available either directly saved in the Blockchain or by a direct connection to a bank account for tracking repayment history.

Credit default swaps (CDS) may also be a useful financial instrument for the crypto industry. They can be used as an insurance against the default of the underlying debt tokens. Fixed income investors in the crypto space can use them as a hedge against debt tokens in their portfolios. The buyer of a CDS would be making regular payments to the seller of the CDS. In case of a default of the debt tokens the seller has the obligation to pay the prior determined “insurance sum” to the buyer of the CDS to compensate him for his loss on the debt position. Again, a CDS can be implemented by using smart contracts that automate all the payments and the recognition of the default case.

In a nutshell it can be said that a lot of traditional financial instruments can be implemented in the crypto industry irrespective of the underlying type – equity or debt instruments. The earlier discussed financial instruments are just the well-known types instruments, while this article hasn’t covered the more exotic instruments like weather derivatives, CDO-squared, or swaptions for example. Similar to the traditional capital markets, if two sides of a trade can agree on the terms of the trade a transaction can be carried out. An advantage of the crypto industry is the theoretically bigger flexibility of terms of contracts. A disadvantage of such flexibility might be a very crowded space of instruments for one asset but with varying characteristics which might lead to some consolidation in the future, and potential complexity of instruments for understanding by non-financial public.

We at Alter Securities work on developing innovative financial derivatives for crypto market. While we will bring all existing derivatives and exotic instruments from capital markets to the crypto world, our main target is to develop a completely new tools which are unavailable elsewhere, which will improve markets and satisfy a wide range of investors’ interests and needs!

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