MARKET Protocol — Explain it like I’m Five
By: Lazar Jovanovic
Tags: Blockchain, Bitcoin, Ethereum, Startup, Cryptocurrency

Bitcoin is often referred as “digital gold”. Gold, like silver and any other precious metals or agricultural goods, is a commodity. Commodities along with currencies, stocks, bonds, and real estate are types of primary financial instruments. To increase the flexibility and efficiency of the trading markets, finance professionals have developed secondary financial instruments called ‘derivatives’, with forwards, futures, options, and swaps being the most commonly traded. Derivatives have two main components, the base currency and the underlying asset. Users make or lose the base currency as the underlying asset moves. For example, the Crude Oil Futures at the CME (Chicago Mercantile Exchange) trade in dollars (base currency) and derive their value from a price of crude oil per barrel (underlying asset).

In the cryptocurrency world, traders have only been able to exchange their digital assets from A to B in one-time or spot transactions for example, like Bitcoin to Ethereum. Blockchain technology is in the maturing process. Its participants should soon have better hedging and price discovery tools at disposal including derivatives. And since many future MARKET Protocol participants may never have been exposed to derivatives, the following example is provided to illustrate how one type of derivative, a futures contract, functions in the real world. Also given is an analogous use case in cryptocurrencies implemented using MARKET contracts to demonstrate their utility for risk management purposes.

Imagine you were a wheat producer and your biggest potential buyer is a flour mill. It would be essential for both parties to find ways to secure future positive cash flow in order to effectively plan and maintain their businesses. If you knew that you could sell a bushel of wheat for $4.5 in the future while current production costs were $3.5 per bushel, you might want to lock in a price of $4.5. If you did not, you risk a price decrease due to unpredictable factors from now until harvest (e.g. oversupply or other adverse market or weather conditions).

The mill holds the same risk but in the other direction, since the price in a few months might go up to $7 when it needs to re-supply. Therefore, it might be beneficial for both parties to enter into a contract that guarantees the delivery of wheat at a specified date and price in the future — in this case $4.5 per bushel. The type of contract just described (future delivery of an asset at a fixed price) is called a futures contract and it is a basic type of derivative. It’s called a derivative because it derives its value from something else — in this case the price of a bushel of wheat.

MARKET protocol contracts are also derivatives because they derive their value from something else, an underlying asset which can be on-chain (cryptocurrencies and tokens) or off-chain (stocks, bonds, indexes).

Translated into the world of cryptocurrencies, one could think of an Ether miner as a farmer and traders/investors/speculators as a mill. Similarly to agriculture production, there are several factors that need to be considered when assessing the profitability of mining a coin, e.g. the cost of electricity, the mining difficulty and the cost of hardware. Since MARKET protocol contracts can be customized by the creator, all of these risks could theoretically be hedged by creating the appropriate contract and finding a counterparty to take the other side of the trade. Therefore, if miners believe they can mine Ether profitably over some length of time in the future at a minimum guaranteed price, they may want to enter into a contract now to eliminate the risk of a future price decline in Ether.

Also, many cryptocurrency traders and miners might want to use their cryptocurrency to gain exposure to traditional market assets or cross chain currency pairs not currently available for trading on regular exchanges. For example, use your Ether to get exposure to Tesla stock. You would never have to sell Ether and open a brokerage account. It would be an excellent way to enable crypto/traditional assets relationships.

How about the ability to hold SALT lending token and partially get exposed to a possible Litecoin price surge without having to buy it (and without having to sell your SALT!)? As a novel price discovery tool for these types of relationships, MARKET contracts could help decrease the volatility of and make utility token valuations become more stable.

So we’ve just learned how MARKET protocol contracts share some similar properties to futures contracts. Yet there are some key differences and advantages to MARKET contracts over traditional futures. These include the ability to collateralize contracts using any ERC20 base token as well as the elimination of third party risk by implementing collateralization via smart contracts. Look forward to these being discussed in more depth in the future. To learn more, visit marketprotocol.io, read our whitepaper, and join the ongoing discussion on Telegram.