A derivative is a financial product whose value changes in response to changes in the price of the underlying asset.
We know that there are derivatives on agricultural products, metals, energy products, currencies, shares, stock indices, interest rates, etc.
Financial derivatives are currently an unexplored element in the emerging space of tokenized assets or securities.
Although the launch of Bitcoin futures in the stock exchanges (you can look for it as CME) generates many expectations about the future of crypto derivatives, for now the adoption has been limited.
In my opinion, crypto assets still lack the components necessary to build widely adopted market derivatives.
However, the emergence of security tokens could fill some of the missing gaps and open the door to the first generation of crypto-active-based derivatives.
Lack of adoption
There are many factors that have contributed to the lack of adoption of crypto derivatives, but perhaps two have been critical in making this happen:
The first is that crypto derivatives represent a second layer of volatility and speculation on an already volatile crypto asset.
The main factors that drive the price of cryptomarkets are news and market speculation, and there is no easy way to predict either.
If we also add a mathematical model which is what a derivative is based on to the usage, we are essentially adding a speculative/volatile vehicle over another speculative/volatile vehicle. This is not the best way to start with crypto-derivatives.
Instead now with security tokens representing the value of an underlying asset you remove a layer of volatility.
The second factor is that at the moment there is only a small group of investors who understand both financial derivatives and crypto-currencies, so it is difficult today to provide a liquid and vibrant ecosystem. A negligible target market so far.
Factors for adoption
The emergence of security tokens as a new asset class may be the missing ingredient for the emergence of viable crypto derivatives.
And there are several factors that could justify this:
One would be regulation because from the creation of the token itself to the exchanges, security tokens must be regulated vehicles that provide adequate protection for investors.
Derivatives built on these assets will become more attractive to traditional financial markets over time.
Stable underlying assets:
This refers to the fact that security tokens based on real estate assets, works of art or shares of a private company should behave in a relatively predictable manner and correlated to the underlying assets.
The construction of derivatives on these security tokens adds a layer of mathematical speculation on a predictable/stable asset that is a model that financial markets understand.
As a complement to the previous point, derivatives based on security tokens will also automatically benefit from the mechanisms that exist today to predict and evaluate the price of an alternative asset class, such as real estate or the market valuation of a company.
This should increase the attractiveness of this new financial product in the eyes of traditional investors.
Expanding the investor’s footprint:
Derivative models based on security tokens will allow investors to take advantage of the products and tools they use today with this new asset class.
From that perspective, I believe that security token derivatives will attract a new group of investors who have stayed away from speculation, for example, in Bitcoin futures.
Types of crypto derivatives
As the market for security tokens evolves, there are several derivative products that are likely to emerge in the short term.
Interestingly, I think we are going to see both a generation of derivative models representing security tokens and the first group of derivatives in the token market.
Derivatives that represent security tokens
These are mathematical models that speculate on the price of the underlying security tokens can represent alternative assets such as real estate, art, private stocks, diamonds or many others.
Security tokens that represent derivatives:
We can create tokenization of everything, so it’s possible to create security tokens that represent market derivatives, such as options or futures.
Ideas for the future
What types of security token derivatives will emerge in the first wave? We can extrapolate some ideas from the financial derivatives markets themselves:
The futures market model:
The futures market model: Following the model of forward or futures derivatives in financial markets, we can foresee intelligent contracts that specify the criteria for buying or selling a security token at a specific future time and at a previously agreed price.
The ETF model:
The ETF model (which stands for Exchange Trade Funds) is very viable for security tokens.
We could relatively soon have security tokens similar to ETFs that represent the value of an underlying group of assets, such as property rentals, loans or private shares in different companies.
ETFs are collective investment schemes whose investment policy is to replicate an index. The units of these funds are traded on the stock exchanges just as if they were shares. The name ETF corresponds to the English term exchange traded funds.
The crypto market is currently awaiting SEC approval or not for the first Bitcoin ETF, which would flood the crypto space with many millions of institutional capital.
The swap model:
Like swap models in the financial markets, we can view security token derivatives that exchange the dividends or cash flow produced by two different security tokens to serve as a hedge or insurance against future market conditions.
A swap is a contract in which two parties agree to exchange a series of amounts of money at future dates. Normally, future exchanges of money are referenced to interest rates, called IRS (Interest Rate Swap), although in a more generic way a swap can be considered to be any future exchange of goods or services (including money) referenced to any observable variable.
There are many other types of derivatives that can become important with the appearance of security tokens.
The evolution of this market will take time, but at least now we have a new formula that, thanks to the blockchain, seems to provide the right basis for the widespread adoption of crypto derivatives.
We are moving forward.