Fintech

Blockchain And Financial Derivatives

Financial Derivatives

Published on December 17th, 2021

Blockchain is slowly showing its potential in modifying the traditional modules such that they could improve operational efficiency, expand optionality and bring a reduction in costs.

This is quite prominent in the financial services sector, what with the cryptocurrency markets and blockchain customized financial services becoming popular over the conventional methods.

As the on-chain synthetic assets are continually developed, the range of derivatives they offer on the blockchain platform is limitless.

Blockchain’s Next Frontier: Crypto Derivatives

The Blockchain industry has introduced multiple ways through which the Blockchain can alter the traditional system and work on improving operational efficiency, expand optionality and bring a reduction in costs.

This is the most apparent in the financial services sector, where the popularity in exploring blockchain-enabled decentralized finance (DeFi) applications has multiplied in the past few years.

The blockchain sector is continually paving the way to create exciting new, real-world blockchain code solutions that align with the normal investor interests.

In fact, this new technology is being used in the growth of financial products. This has resulted in the blockchain’s adoption in the global derivatives market is impactful and estimated at around $1 quadrillion USD.

What Are Financial Derivatives?

In the financial services sector, the derivative is a financial product whose value is related to the characteristic of any financial asset.

In simple words, the purchase and selling of a derivatives contract does not actually mean the exchange of the asset by itself.

Instead, the derivative value is considered as a function of a pre-established and specific metric that is related to that asset.

As the value of the derivative is based upon the dynamic features of the asset, the market price of the derivative fluctuates all through the duration of the contract. It is affected by the outcomes of the trade.

A derivative can also be based on anything, either tangible or intangible; it should have a characteristic that you can assign a price basis a mutually agreeable framework.

In consequence to this, there are many derivatives-starting from futures to options, swaps, and collateralized debt obligations- which you could put at nearly almost anything possible like the price of coffee beans or the outcome of the next NBA match.

Futures remain the most commonly traded type in terms of derivatives. They are an agreement that you can trade the asset on any future date and can be used as a means to get a major investment position or to gain market exposure to a particular asset without even owning that asset.

Since they are highly flexible, derivatives could give the investors greater optionality and can be used as a tool to improve liquidity and help in managing a vast range of financial risks.

Crypto Derivatives

The crypto industry is relatively new. In the last decade, many crypto investors have tried their hand at spot trading, which is actually the direct buying and selling of an asset at a price discussed beforehand.

But as the interests of the investors in this area is growing, the new crypto-based derivatives have progressed and are providing the traders with an access to a greater variety of future investment strategies.

It was in 2011 that the first crypto derivative was launched in the market, but they were limited to the futures contracts based on the Bitcoin price.

Many years later, the exchanges started offering multiple varieties of derivatives that the investors could later use to hedge themselves against the market changes and profit due to fluctuations in the future price.

Thus by 2020, the crypto derivatives trading market touched a record high. In May 2020, the crypto spot market showed a 24-hour trading volume of $200 billion, while the crypto derivatives market showed a trading volume of around $320 billion. This was almost 60% higher than the spot market.

As the number of institutional investors trying to enter in large-cap cryptos like BTC increased, many experts say that the lead in trading volume lead that the crypto derivatives have over the crypto spot trading may grow further.

With the growing number of crypto-based derivatives is an exciting prospect that undermines the industry’s maturing; these particular financial products still have to operate within the traditional framework that the legacy financial institutions have set.

Thus one of the most profitable syntheses of blockchain technology and the global derivatives market rests in Blockchain’s scope to modify the manner in which the traditional derivative market operates.

Blockchain-Enabled Derivative Trading

Though the crypto market is limited to crypto-based derivatives until now, the number of derivative products that are offered by the traditional financial markets is too many.

This is because derivatives could be tagged onto any real-world asset. But with the further development of the on-chain synthetic assets that duplicate the performance of such real-world assets the variety of derivatives offered on the blockchain derivatives trading platforms is increasing.

In the traditional financial markets, synthetic assets are actually a bundle of assets- or derivatives like options, futures, or swaps- those that mimic the characteristic of another asset when you view them in the totality.

For example, instead of purchasing a specific stock, an investor could buy a call option and sell the put option on the stock, which will give the same net balance as you holding that stock for the time of two option contracts.

In contrast, blockchain-enabled synthetic assets are just digital tokens that represent the derivatives and other assets that are regularly traded in the traditional markets. In many of the situations, these assets provide many unique advantages over the traditional versions:

Permissionless value creation and distribution:

Blockchain has a flexible open-source nature which allows anyone to create new assets without the need for any external approval.

Many platforms offer services that help users who do not have a technical background to develop and exchange their synthetic assets.

Most of these synthetic assets are security tokens that crypto exchanges offer and have to follow the rules of the markets they will operate in. But blockchain technology has the power to overcome the need for having centralized third parties to validate and simplify the creation as well as an exchange of the new financial products- through decentralized exchanges or DEX’s.

These innovations can modify our thinking of what can happen within financial services. But some of the decentralized derivatives can even come under the grey zones in accordance with a following of regulations that may increase the risk for the investors who are trading or holding any of DEX-generated blockchain derivatives.

Enhanced transparency and efficiency: A big advantage of blockchain is its transparent method of storing all the data. This allows the market players to see what all is happening in real-time.

Moreover, variables like an asset’s supply in circulation, custody chain, and the smart contract rules are displayed on the blockchain ledger, and anyone can see it.

So you do not have to maintain the external records of what is happening in the markets. The records are updated in real-time, and you cannot easily modify them.

This helps the traders to make correct and well-informed decisions that guide them in reducing the risks associated with the trade. Plus, the blockchain networks can reduce the maintenance and upkeep required to monitor the existing IT systems that rule the global derivatives trading market.

Some of these traditional systems could be expensive to maintain and implement instead of the automated blockchain protocols that quickly verify and execute the transactions, store the data, and secure all the network functions.

Moreover, the blockchain automation of all the trading documentation could guide in decreasing the prices of assets and reduce the risk of any human errors.

That is why blockchain experts feel that the traditional network infrastructure of financial markets will be replaced by cost-effective, blockchain-based decentralized systems soon.

More access: At present, a large section of the derivatives market is restricted to a combination of hedge funds, commercial banks, and other institutional players, many of which actually charge high fees to create the derivative contracts and implement them.

Thanks to blockchain’s distributed immutable design, the synthetic assets that are launched on any blockchain network could be easy to trade and transfer in comparison to their traditional counterparts.

Moreover, unlike the conventional derivatives market, the synthetic assets on the blockchain platforms also pull the data from the markets that work round the clock using the smart contract-based protocols like the decentralized oracles that help the investors in benefiting from the more extended trading periods unfazed by the restrictions in time zone.

In simple words, the blockchain-enabled assets can bring out most of what is being offered in the traditional markets into the blockchain systems in a manner that increases transparency and efficiency.

Many of the crypto projects have already made a significant attempt to fasten this shift. Two of the significant examples are Synthetix, which is a protocol for the creation of global liquidity for many synthetic assets on UMA and Ethereum.

It helps the users to stake on any crypto or collateral in order to create new assets. As the decentralized exchanges (DEX’s) continue to work on improving their products and take the market share from other centralized platforms, many blockchain experts say that a lot of financial instruments will now move to decentralized markets.

The Upcoming Convergence of Derivative Trading

The global financial derivatives market also plays a vital role in offering market liquidity, creation of investment optionality, and providing other ways for investors to hedge their positions.

By employing blockchain technology to develop the financial instruments and migrate the current products to the decentralized platforms, financial institutions offer the derivatives a stand that they can capitalize on, increasing the market transparency and efficiency such that they can help both the retail and institutional investors in the same manner.

Therefore, as the infrastructure underpinning this interconnected web of decentralized finance platforms continues to mature, the blockchain space and the legacy financial services sector are poised to converge into a more equitable, feature-rich financial ecosystem.

Therefore just like the infrastructure that underpins this web of decentralized finance platforms keeps maturing, the blockchain space and also legacy financial service sector is all set to merge into a high in equity and feature-oriented financial ecosystem.