Derivatives 2.0: Using Blockchain to help build the world we want
By: Peter Harrigan
Tags: Bitcoin, Banking, Blockchain, Poverty, ICO

A schematic diagram of a working decentralized derivatives exchange…. simplified.

Imagine a world where financial risks can be easily and cheaply transformed into opportunities — opportunities for return, diversification and social benefit — available to anyone in the world who wants them. Imagine that this is accomplished through an intuitive and visual platform that anyone can understand.

The world has changed. We’ve always been social creatures, but technology allows us to expand the circle of people with whom we engage, often spreading that circle across the world. What if our financial systems changed in the same way, allowing us to interact with a greater pool of people, and spreading benefits to people who were previously unable to access them?

Derivatives, an extremely useful vehicle for transferring risk, are perceived as worse than they actually are because of some very real problems. They are perceived as risky because they can be. They seem hard to understand because they are. Their benefits seem to go mostly to people and institutions at the top of the economic ladder because they do. Other, more subtle flaws limit the reach of these tools.

The root of nearly all these shortcomings is in the various derivative structures and those structures reflect the technology that existed at the time of their development. Nearly all the architecture of derivatives pre-dates digital technology, let alone the Internet or Blockchain.

Derivatives no longer need to be structured the way they are. A combination of recent technologies including Blockchain means they can now be built in a way that maximizes both user understanding and market fit, that minimizes both risk and the completely understandable fear that attends it, and that extends their proper application and benefits to a far broader audience. We’ll call these Derivatives 2.0.

Give a man a fish and you’ve fed him for a day.

Teach a man to fish and you’ve fed him for life.

Let a man lock in the price of his fish and he’ll buy a bigger boat, hire a bunch of people, and feed the world (or his part of it, anyway).

The History

Aristotle records the first known option trade in Politics. A few hundred years before his time, Aristotle’s fellow philosopher Thales of Miletus forecast an unusually large olive crop. To profit from this prediction, somehow made by the use of astronomy, Thales “paid round deposits for the whole of the olive-presses in Miletus and Chios”. Later, “by letting them out on what terms he liked he realized a large sum of money”. According to Aristotle, Thales did this to prove the usefulness of philosophy, which he quite clearly did. But one suspects he may have had his eyes on a nice, little condo with great Aegean views, as well.



Derivatives have changed a bit from Thales’ times. But his trade captured a lot of the basics. He had a right to use or resell the olive-presses, but no obligation. There was undoubtedly a specific time range over which his rights pertained. And he did well, not by investing in a specific asset (he didn’t buy an olive grove for instance), but indirectly through the impact of an event. Reading the full story, it also seems he employed leverage, as well.

The Problems



Things have advanced since old Thales’s days in the market, but there are still problems.

Unknowable Risk

Are derivatives risky? Long Term Capital Management (LTCM) was literally run by Finance Ph.D.’s. It had two Nobel Laureates on its board. They still over-extended themselves and blew up so dramatically the Federal Reserve had to step in to protect the financial system. Was their problem that they did not understand the risks? Well, yes, in a sense. But the real problem was the risks themselves. Both futures and options (if you sell them) have unlimited risks. LTCM did not understand how far these contracts could move against their position, precisely because it is impossible to understand how far such contracts can move.

Lack of Transparency

As hard as derivatives were for geniuses at LTCM, they are even harder for the rest of us. The designs of most derivative contracts are logical, following certain paths and limits established at their invention. But they are not intuitive. Many people find derivatives extremely challenging. They are often opaque, even to very smart folks, who were not brought up within the specialized world of finance and trading.

Standardization

In 1864, the Chicago Board of Trade began standardizing forward contracts and trading them on an exchange. Standard contracts become fungible and fungibility means (or can mean) liquidity. It was a revolution that launched an industry and helped the agricultural development of the Mid-west over the coming half-century.

But standardization has its own cost. Many risks are not symmetric. Imagine a bank hedging the real estate risk embedded in its loans, using a simple futures contract based on a real estate index. If real estate drops, the bank will offset some of the losses of loans that are not fully repaid. But if real estate goes up too fast, the bank takes losses on the hedge far beyond the interest it receives. Banks don’t share in the upside so futures just don’t work.

Counterparty Risk

The flip side of standardization is the customization we sometimes find in the over the counter market. Custom contracts can be built and sold to customers. But with the OTC market comes counterparty risk — you need to know the other side of the contract can perform. Generally, counterparty risk seems like a small risk, as counterparties appear to be financially sound. The risk is in the tail of the distribution, though. And when you really, really need the counterparty to perform, that is when they are most likely to fail.

Additionally, there is less liquidity in such trades and that counterparty you traded with knows exactly what your position is. So good luck exiting your trade if you ever need to do so.

Generally, the choice is highly standardized, centralized products without real counterparty risk or fluid, custom OTC products with counterparty risk.

Centralized Infrastructure Cost

Infrastructure costs to develop a new marketplace are huge. If a new product cannot be traded easily in the over the counter market, a centralized exchange must be established, all at very high cost in technology and regulatory work, before any business can be transacted. This creates a catch-22 where the investment will not come before volume but volume can’t come before investment. This restricts the development of truly novel exchanges or products.

Scale Mismatch

For many uses, contract sizes can be too large. Mini contracts are often developed, but this is an insufficient drop in scale for some potential users, especially those in new and underdeveloped markets.

Geographic Limits

Finally, there are huge geographic limits on use. For a large institution, geographic barriers are trivial. But for individuals or smaller scale operations, money cannot flow easily anywhere in the world it wants to go. This limits potential liquidity in emerging exchanges, as well as the ability of individuals to invest or help these new markets.

Derivatives Updated (Derivatives 2.0)

Let’s return to the sort of transformation described in the beginning of this article and imagine what these contracts look like.

Unknowable Risk Become Defined Risks

Instead of a contract where risk is unlimited and cannot, by its nature, be fully predicted, we can have contracts with bounds and limits. This is a world with no margin calls from the system itself (although private lending arrangements are not ruled out).

This does not mean that returns cannot be very large in some cases. Neither does it rule out leverage, as this could take the form of borrowing and lending against a limited contract. There would really be two forms of leverage — a sort of mathematical leverage created by the range of exposure chosen by the user and the lower collateral deposit that results and an external leverage that could come from borrowing and lending to support positions.

Also, it is important to realize that many unlimited contracts have implied limits. That is that counterparties, no matter how large, can only perform within certain bounds. To take a rather extreme example, if the U.S. stock market were to drop to zero, would one expect to be paid in full on a short position?

Creating a system with explicit limits on payouts on each contract does not necessarily limit what can be achieved. But it does create new opportunities. It can be far safer for less sophisticated participants to trade in a market where they know exactly what they can and cannot lose. It also allows for the disaggregation of larger derivative structures into discrete packets that can involve different counterparties.

Lack of Transparency Shifts to Intuitive Design

Custom objects created out of smaller, bounded objects can be presented in a far simpler way. The potential range of outcomes can simply be graphed and presented to the user visually. In this case, a trader with no prior experience could know exactly how much he or she could make or lose on a given transaction in response to any possible move in the underlying index, as well the potential cost or value received if the market did not move.

Standardization Transforms to Mass Customization

In place of standardization can come extreme, mass customization, but that customization can come with liquidity in trading of the sub-elements comprising the custom contracts.

Counterparty Risk is Replaced by Transparent Collateral

Counterparty risk can be addressed by full collateralization of any potential, but bounded payout. In fact, whether a wallet or a smart contract is used, tools exist to view and confirm the presence of adequate capital to perform.

High Infrastructure Cost Becomes Near Zero Startup Cost

A decentralized system built on Blockchain provides the infrastructure for any new market. As long as there is a reliable and acceptable price index on which to base the outcome of contracts, the infrastructure supports the easy and very cheap creation of new marketplaces for the exchange of many types of market exposure. No large, centralized pools of capital are required.

One Scale is Now (Almost) Any Scale

A low-cost blockchain architecture allows for the use of a very small minimum unit. As such, the range of users can scale from very small users making very small trades to extremely huge institutions executing at massive transactions (potentially made of many small parts).

Geographic Limits Disappear, Allowing Global Flow of Investment

And, due to the transnational nature of cryptocurrencies and Blockchain, contracts can be created anywhere, traded anywhere, and include counterparties residing anywhere.

The Derivatives 2.0 World

What would such an infrastructure do to risk management and risk seeking in the world? What will the flow of capital to solve the world’s problems look like?

We cannot entirely predict what this world looks like. The whole point is that users will devise their own uses that we cannot see from here. Moreover, by allowing a system of combination of constituent pieces and recombination of those products, the network will evolve structures that cannot yet be imagined.

But there are some real problems facing the world right now, unserved by the existing infrastructure, that we know Derivatives 2.0 can address.

Developing World Agriculture

Price volatility is a huge problem for farmers in the developing world. It leads to risk aversion, slow income growth, hunger and even income inequality. These regions need new markets but, at the moment, such markets are expensive to build, slow to reach liquidity, and difficult for users to understand. With an infrastructure that allows low cost of development and incredible ease of use, these areas could leapfrog the costs of traditional centralized institutions. And, again given the low costs, the contract units could be built on a scale that is usable for the small grower without any loss of efficiency.

Farmers in the developing world would have access to the price certainty they desperately need to reach their potential.

The capital to fund their counterparties can come from any combination of a number of sources:

· Local traders, who can anticipate the future demand through their own market information,

· NGO’s interested in development,

· High frequency-trading firms with the technological know-how to scan myriad markets for opportunities,

· Young, socially-conscious investors hoping to drive change through Blockchain.

Bank Real Estate Risk

Banks that are not too big to fail (community banks, some regionals) both in the U.S. and abroad are exposed to a one-sided exposure to real estate prices. Real estate index futures or swaps are an inappropriate vehicle to mitigate this risk. Often, this risk is addressed through securitization, but this is a costly endeavor in terms of upfront fees and lost revenue.

Hedging these risks with customized contracts, that actually match the exact real estate exposure in question, would be less expensive, allow for expanded lending, occasionally turn unacceptable loans into acceptable ones, and allow for the creation of new credit products.

At the same time, investors would gain access to new ways of investing in real estate.

Cryptocurrency Financing

Hedging in cryptocurrencies is expensive and difficult. New products are being brought to market, but they are flawed. Bitcoin futures are not a proper hedge against the risk in Ether raised in an ICO, nor are they physically settled for miners (although, this may change soon). Even when Ether futures are released, the margins on the contracts are huge. Options are available in private contracts but, like all such contracts, they come with embedded counterparty risk.

With the bounded risk of Derivative 2.0, however, margins can be constructed to be limited in scope. Moreover, they can be customized to create a mix of premium paid and margin deposited that is affordable for ICO companies and miners, but that meets their risk management needs.

The Future

We can’t know all the directions Derivatives 2.0 will take us. We know there are real-world problems right now it will solve. We know that risk and fear can be replaced with greater predictability (I’ll stop short of saying certainty.) We know they will be more transparent than current solutions. The reach of derivatives, stripped of excessive risk and made both financially and intellectually accessible, will be far wider. Unserved markets will find the risk management they need.

The Derivatives 2.0 world will be richer and more economically integrated. Growth can be faster. Economic meltdowns should be less frequent or less severe.

And for every problem that is solved in the world, a new opportunity for investors and speculators is born, promising new returns and greater diversification. While each contract is a zero-sum proposition on an accounting level, markets are positive sum for the world. And there will be more markets, for more people everywhere.