The future of finance might have to wait for old bureaucrats in SEC halls to wrap their head around a new world of open finance where options could be an option.
The sophisticated tool is a favorite of Wall Street Bets due to its incredible leverage at a very limited risk exposure rate.
Hence a 1% price increase or decrease can send dopamine fueled kids into euphoria or despair, bringing with it far less volatility for the rest.
In crypto, however, there are no options, decentralized or otherwise. Partly because cryptos are very volatile by themselves, partly because there are no regulated crypto margins yet with Kraken only recently launching regulated crypto-settled futures and even there, it’s just for Europe.
Meaning the crypto trading space is relatively unsophisticated, but open finance through primarily ethereum based smart contract might be beginning to change it.
What Are These Options?
Options are a right, but not an obligation, to buy something at a certain price. So if you want to buy a house, but you’re not sure about it, you can put down a deposit or a premium giving you the right to buy it if you want.
The seller keeps that premium whether you buy it or not. You enjoy the option for a certain time period to exercise the right.
So let’s say eth is at 100. Someone wants to sell at that price, but isn’t very sure whether he should. So instead of outright sending it to market, he offers you the right to buy it at 100 with that right offered for $10. You can make the decision for him or her at that $10 cost.
If eth goes to 200, then obviously you’re going to exercise the option. So the seller now “sold” at 110, rather than just 100. If eth falls to 80, then the seller lost 10 thanks to your premium, rather than 20, but still has the asset so it’s just a paper loss which may still become a gain.
If the seller doesn’t have the asset then he exposes himself to unlimited liability. While as a buyer you’re only risking that $10 premium. Here’s perhaps a better explanation:
“Suppose the price of AAPL is $100, and an investor who has $1,000 to invest believes it will go up. The investor could buy 10 shares at $100, and if the price rises to $110, selling would yield a $100 or 10% profit.
Suppose instead that the investor had purchased call options with a $100 strike and $2 premium. The investor could afford 500 of these options with $1,000.
If the price again rose to $110, the investor could exercise the options to buy at $100, and then immediately sell at $110 for a $10 profit per option. Since the investor had paid $2 for each option, a profit of $8 per option would have been made.
This means the investor’s profit would have been $8 * 500 = $4,000 or a 400% return. This shows how with the same amount of capital investors can achieve much larger returns using options than by simply holding the asset.”
No wonder Wall Street boys like them, although obviously there can be a downside because if price goes down you might lose the entire $1,000 while with straight stock buying you might lose only $100, but what wizardry can do all this on the blockchain and with ERC-20 tokens?
The New Bankers
After raising about $10 million from Andreessen Horowitz, Polychain Capital, Fred Ehrsam of (previously) Coinbase and some others, dYdX became the first project to offer decentralized margins through smart contracts without having any collateralization requirements.
That’s kind of cool in itself, but far more importantly they’ve proposed a method to allow options trading of digital assets with little more required than a MetaMask plugin.
Such options are currently not live, as much as we wanted to test-run them. Too difficult to code? – we asked Antonio Juliano, the founder of dYdX:
“Not that technically hard, I wrote the contracts for it before I published the whitepaper even. We’ve put it the backburner because we think margin trading has more immediate use cases, and there are some legal issues to think through before launching options,” Juliano says.
The technicalities of how this works are explained in some detail in their whitepaper, but at a high level the seller (writer) of the option creates a contract that says something like: here is 1 eth, you can have it for 125 DAI for three months if you pay 10 DAI right now.
The buyer then pays 10 dai and if he/she actually wants to buy it within the expiry period, a transaction is sent communicating the intention, with the asset transfer then happening automatically through certain smart contracts functions.
“The writer locks collateral in a smart contract and the buyer gets the right to buy that collateral at the strike price before the expiration date,” Juliano says in reducing something fairly complex into a simple end user’s experience which probably amounts to nothing more than a click.
So where are these options? “The US makes it difficult to offer options products (which are classified as swaps – a type of derivative),” Juliano says. “Derivatives regulation is complex.”
Old Laws, New World
“Code is speech,” the Electronic Frontier Foundation told the Securities and Exchanges Commission (SEC) in an open letter recently. “The first amendment also protects financial transactions,” they said.
The more important issue is whether these usually quite outdated regulations apply under the same reason detre to open finance where there is far less trust required.
As an example, in securities laws one needs to keep a registry of stock holders so that you can verify whether a presented stock certificate does actually represent stock ownership or whether someone just printed it in their bedroom.
With tokens, the token is ownership, so there is no reason for a registry under that specific rational for that specific requirement.
Likewise in options if you’re buying the right from someone then logically you want to ensure by the force of law if necessary that the offeror can actually provide the asset at that price, or doesn’t run away with it and so on.
Here with a smart contract, the asset is in the contract. He can’t run away and he can’t cheat because the asset is “imprisoned” by the rules of code and must obey the ifs and thens.
That arguably means there’s significant differentiation to the point certain regulations do not necessarily apply because they refer to completely different circumstances.
Smart young kids, however, understandably don’t want to take the risk of being on the receiving end of a cowboy SEC that has so far tried to avoid the scrutiny of the judiciary where these matters can be independently and impartially adjudicated.
Nor would they want to go through that pretty stressful process, but, if we are to be fair, SEC has largely tried to not be overbearing.
They haven’t really “touched” a “good” project, for example. By black letter law, they could, but there’s the public interest matter.
Presumably they understand that the law is often quite behind and they have stated this space does offer much promise and they don’t want to hamper innovation or force it outside of the United States.
So in this case of options we may have more self-censorship, rather than an actual regulatory threat, but that can be just as bad if not far worse as we might not know what we don’t know, and thus what argument to make. While with SEC actions or statements you can take them apart or engage the political law making process and so on.
Meaning the Securities and Exchanges Commission now has to lay down its policy in detail since they moved into this space like a bull in a China shop and thus owe this space clear policies so that entrepreneurs can know where they stand.
Otherwise we all end up in a situation that we are sure no one wants because there are incredible inefficiencies in traditional finance and some significant trust related problems which can’t be addressed by plain laws as numerous financial scandals have shown, but could be addressed by code.