Blockchain-Based Derivatives: The Next Frontier in Financial Innovation

Derivatives are like special agreements that rely upon the value of something else, known as an underlying asset. Imagine you and a friend making a bet on the future price of a popular item. The item itself is the underlying asset, and your bet is the derivative. People can use different forms of derivatives to protect themselves from losing money if prices change (hedging) or to try to make money by guessing the price changes (speculation).

Here are some examples of derivatives below:

• Futures: buy or sell something at a set price in the future
• Options: buy or sell something at a set price before a certain time
• Swaps: contract to exchange some sort of financial instrument between two parties

“The Big Short” by Michael Lewis vividly illustrates the dangers of derivatives and their role in the 2007-2008 financial crisis. Lewis’s book highlights derivatives' complexities and potential pitfalls in traditional markets and how a group of Wall Street traders deviated from the consensus of a stable mortgage system and began “shorting” Collateralized Debt Obligations (CDOs). Here is a clip that explains derivatives to understand CDOs better.

The derivatives landscape has evolved since that financial crisis, particularly through the advent of digital asset-based financial products coupled with the potential of blockchain.

This article explores what derivatives are and how the use of blockchain can enhance their market.

Derivatives Market Size

Another critical aspect to consider is the sheer size of the derivative market. The derivatives market is described as extremely large, with high-end estimates placing its notional value—the total value of its underlying assets—at over $1 quadrillion. However, there is considerable debate about these figures.

Investopedia mentions different figures:

• High-End Estimate: Over $1 quadrillion in notional value
• Mid-Range Estimate: $600 trillion in notional value as of 2021
• Actual Netted Value: Approximately $12.4 trillion in gross market value as of 2021

The pool of futures traders has also increased significantly over the last half-decade. The total number of active derivatives traders was 500,000 in 2019 but reached 4 million in 2023, representing a 700% increase in under five years (ICICI Direct).

Despite having the top two stock exchanges worldwide by value of electronic order book share trading, those USA-based exchanges place third and sixth worldwide in terms of the largest derivative exchanges by number of contracts. India has the largest derivative exchange in the world, representing ~80% of the total market.

2007-2008 Financial Crisis: What Went Wrong

CDOs are a specific kind of mortgage-backed security derivative comprising a basket of assets, from mortgage bonds to credit card loans shipped as a bundled bond. The problem leading up to the financial crisis was that the packaged bonds (CDOs) with lower-rated mortgages received a Triple-A rating, which denotes the lowest expectations for default risk. The rating agency's mentality was that by bundling large amounts of these mortgages together, they wouldn’t all become defaulted at once.

As think tank Third Way explains, hedge fund managers received guarantees that they would still receive a return even in the “unlikely event” of a CDO meltdown. They purchased the CDs (an insurance contract) without owning CDOs, which can be thought of similarly to buying flood insurance that only pays out if a property gets flooded. Their bet was well timed as the entire housing market collapsed upon the convergence of subprime mortgages, large consumer debt loads, and crashing home values.

How can the derivatives market be improved?

Despite the substantial source of revenue and volume in the derivatives market, it does come with shortcomings. Digital asset-based derivatives (counterparty risk and settlement time) can improve some of these issues.

Others still need creative solutions to be solved for:

1. Difficult to Value: A derivative's value is based on another product's value, so the value can be difficult to evaluate properly.
2. Counterparty risk: As we explored in depth in our last article, counterparty risk is prevalent in the derivatives market, which the shorter settlement period that blockchain offers could ameliorate.
3. Cost to hold asset: It could be expensive to hold an underlying asset relative to the opportunity cost of buying derivatives. Other factors that need to be considered include changing interest rates and changes in the amount of time to expiration, a non-issue with perps, which can be topped up.

What are some benefits of trading digital asset derivatives?

The oil and gold derivatives are not the first examples of derivatives offered by digital asset platforms. However, previous examples were mostly of digital assets, not traditional investment vehicles. Ernst and Young reported that the size of the digital asset derivatives market hit $1.33 trillion in monthly trading volume in September 2023 alone.

Some of the benefits of digital asset derivatives are listed below:

• Hedge against volatility: Traders use derivatives such as futures and options to lock in prices or mitigate downside risk.
• Leverage: Derivatives often offer leverage, allowing traders to pay a fraction of the total contract value upfront but gain greater exposure to the underlying asset's price movements.
• No Expiry Date: 'Perpetuals' (perps) are a type of derivative that does not expire and, therefore, do not require rollover contracts when a future reaches expiry. This feature can be particularly beneficial for traders, allowing them to maintain their positions without needing constant renewal or adjustment.
• Worry-free Custody: Perps allow traders to gain digital asset exposure without holding the underlying asset.
• 24/7 trading: Unlike traditional markets open during traditional business hours, digital asset derivative markets are open 24/7.
• Price discovery and risk management: Digital asset derivatives provide diversified markets that facilitate price discovery and risk management

Coinbase Oil Derivatives

Fast forward to the blockchain era of digital finance, and a new question emerges. People are discussing when Wall Street will embrace Web3, a term that refers to the next generation of the internet that is decentralized and user-centric. However, perhaps a less considered perspective is “How will Web3 embrace Wall Street?”

After launching Bitcoin, Ethereum, Bitcoin Cash, Litecoin, and Dogecoin futures, Coinbase noticed increasing demand for retail-focused products on an accessible and regulated exchange. Therefore, Coinbase launched derivatives products for oil and gold, which went live on June 3. If Web3 exchanges can offer the same product, will retailer traders start choosing Web3 platforms over their TradFi counterparts, or will Wall Street keep up? Perhaps they will meet somewhere between?

Coinbase's offering of oil derivatives exemplifies how the derivatives and TradFi markets can embrace and change with blockchain technology. Coinbase Derivatives is a CFTC-regulated exchange that announced the launch of futures contracts for oil and gold. The oil and gold derivative products, such as Bitcoin, Ethereum, Litecoin, and Doge, will complement the existing digital asset derivative products suite.

Coinbase’s launch illustrates the platform’s willingness to embrace technology that will change finance. Kadena CBO Annelise Osbourne refers to this type of innovation in her upcoming book, From Hoodies to Suits: Innovating Digital Assets for Traditional Finance.

In Conclusion

The derivatives market has significantly evolved since the 2007-2008 financial crisis. With the advent of digital asset-based financial products and blockchain technology, the market is poised for further transformation.

Coinbase’s recent oil and gold derivatives launch exemplifies this shift, integrating traditional finance with blockchain innovation. The potential benefits–improved transparency, reduced counterparty risk, and faster settlement times—inspire a promising future for digital derivatives. As blockchain technology develops, its impact on the derivatives market and traditional finance will undoubtedly grow, fostering a more efficient and secure financial ecosystem.

Will Wall Street embrace digital assets, or will it get left behind?

Disclaimer: Derivatives are a highly speculative investment vehicle. Please exercise caution and do your own research while trading or engaging with derivatives.