So far in this series of posts I’ve outlined how blockchains enable open and disintermediated financial system with fair access. I’ve also outlined how decentralised oracle systems enable the values of real-world things to be tracked “on chain”. The combination of these two things enables derivatives to be traded peer-to-peer online via tokens called synthetic assets.
In traditional financial markets, derivatives are traded either via structured products with an orderbook on exchanges, or bilaterally via OTC markets. The options for what one can do with one’s positions are pretty limited. On an exchange you can long or short on whatever products the exchanges offers you, as well as amend and close your position. That’s about the entirety of your options. On the OTC markets you can enter into more bespoke contracts and you can possibly put this position to work for you in other ways as well, but the fragmented and private nature of the market is a big limiting factor. Naturally access to these markets is limited to financial and other large institutions.
On the blockchain things are different. The holder of a derivatives contract has in their possession a token that represents that risk. This token is a completely new form of financial primitive called a synthetic asset. Like all the other cryptoassets, this token is permissionlessly composable, verifiable and transferrable. As a result, it can be used as a building block in all forms of other financial contracts. In the cryptocurrency space it is referred to as money lego. It can be used as collateral to gain exposure to another form of risk or can be lent out for a period allowing the owner to earn a fixed income on top of their position. It can also be used in other financial applications to earn other currencies as part of a liquidity rewards program. If one no longer wants exposure to the risk, it can be offloaded – either partially or in whole – on secondary markets without needing a broker or lawyer to update the contract. These examples are probably only scratching the surface of how people holding financial risk will be able to exploit their assets for further earning potential.
Apart from the money lego benefits, the permissionless, open nature of synthetic assets will likely bring ordinary people into the world of derivatives. Nowadays if people wish to hedge against risks they face, they tend to take out insurance contracts. The insurance companies themselves hedge this risk with derivatives products offered by investment banks. The derivatives market is almost exclusively populated by large firms. For example, most farmers don’t have the time or inclination to sign up to futures exchanges in order to hedge risk. It’s easier to take out a contract with an insurance firm. The division of labour in society is a great thing but a negative externality it can cause is concentrated risk. In finance concentration in the insurance industry represents systemic risk. As a consequence, it is extremely heavily regulated in order to guard against this risk but this onerous regulation, in turn, causes more concentration, which results in less competition and innovation. The inevitable outcome from that is higher prices for consumers.
What if in the future farmers could simply hedge their crop exposure with a mouse click from their bank account with no insurance company or futures exchange involved? Many would correctly point out that a farmer, with no experience in pricing financial risk might not be best placed to do this. And that’s a very fair point that applies to over 95% of people. However, since synthetic assets exist on an open system, it will not be just farmers that will price this risk. Speculators and arbitrageurs that spot mispricing in the market will be operating too. They will move the market to a more accurate risk assessment by placing bets themselves. In choosing a strategy therefore, the farmer need not conduct a risk calculation himself/herself but need only go with the wisdom of the crowd, since, at the end of the day, a futures market is of course simply a prediction market comprised of people’s convictions about future outcomes. Further, the farmer also need not have to navigate the orderbooks of exchanges and need to know about such things as initial margin or maintenance margin. A synthetic asset that hedges risk in line with how the broader market assesses said risk can be purchased with a mouse click. And since that risk can be accessed by bi-passing insurance companies, brokerages and possibly even investment banks, the cost of hedging one’s risk should be much cheaper than it is now.
There are many instances too where people could hedge risk they face that isn’t even serviced by the insurance industry. For example, what if first time buyers struggling to save for a new home in a rapidly market where house prices are appreciating faster than wages could make a leveraged bet on house prices rising with a small amount of their savings allowing them to increase their savings at a faster rate than house prices rise? If prices drop and they get liquidated it will only represent a loss of a small percentage of their savings which will continue to grow in a now declining housing market. Products that track house price indexes do exist now, but they tend to have fixed terms and can only be accessed via brokers, something most people find daunting. As a consequence of this friction, the vast majority of people don’t employ hedging strategies like this one that could help a lot of people get on the housing ladder more easily. Again, if someone, from within their personal online wallet they use for all their financial activity, could simply purchase (and sell) a synthetic asset that tracked a property prices index with a mouse click, I suspect the amount of people executing such strategies would be far greater.
Synthetic assets will herald a future where a much more financially literate populace will manage their finances and grow their wealth more actively and creatively without intermediaries. Many will even create financial services themselves blurring the line between users and producers of financial services. As I said above, someone may purchase risk in order to hedge against another risk they face in life, but they may then lend that asset out to someone that commits collateral in order to earn a further income. Further since people will be able to create synthetic assets that track the value of literally anything that can be measured, we will see a Cambrian explosion in derivatives that will enable humanity to make better predictions about all sorts of threats we face both individually and collectively, from greenhouse gas emissions, to demographic changes, to public debt. Our knowledge of what levels of these things amount to what corresponding level of risk is currently very poor. I suspect with the proliferation of synthetic assets on an open financial system we will have a much better estimates in the future.