Three Non-Trivial Capabilities of Derivatives that can Unlock the Potential of Security Tokens

Derivatives is one of those fascinating financial instruments that are called to play a pivotal role in the future of security tokens. For months, I’ve been really intrigued by the combination of derivatives and security tokens which led me to publish some of my initial thoughts in articles such as this one or this one. Initially, like most people, I thought about derivatives as a product that will evolve with the maturity of the security token space. While I still subscribe to the core of that thesis, lately I’ve been shifting my thinking about crypto-security derivatives from a sign of maturity of the market to an element that can unlock the potential of security tokens.

The shifting (I prefer to call it evolution 😉 ) in my ideas about security token derivatives has been the result of long and deeply-analytical conversations with dozens of sophisticated institutional investors trying to understand their perspective of security tokens. The limited number of sophisticated investors interested in security tokens is, arguably, the biggest threat to the space. If you think about it, the benchmark for security tokens in the eyes of large institutional investors is not utility tokens but securitized products that are traded in public markets.

When we think about the challenges that are preventing large, sophisticated investors to jump into the security tokens space, we typically think about aspects such as compliance, disclosures, governance, etc. Those are infrastructure blocks which will eventually will be built into security token platforms. However, there are other limitations related to the financial architecture of crypto-securities that are a big roadblock for investors. If you analyze a security token from a sophisticated investor perspective, there are three fundamental questions that make it a compelling investment irrespective of the quality of the asset:

1. Liquidity: Can I achieve liquidity in an investment independently of market conditions?

2. Balance: Can I seamlessly get exposure to a balanced, broad portfolio that fits my investment thesis?

3. Insurance: Can I protect myself against underperformance of a specific token?

It turns out that derivatives are a great mechanism to address all of those challenges and make crypto-securities a more attractive vehicle for institutional investors. Let’s dig deeper into the different scenarios:

Liquidity: Margin Trading the dYdX Way

Today, security tokens are being built exclusively as a long-trade mechanism. The folks tokenizing equity in a company are doing so with the expectation that investors will exclusively take long positions in that crypto-security. While that viewpoint makes a lot of sense from the issuer’s perspective it’s not necessarily a healthy recipe for building a financial market. Programmability makes margin trading and short positions a viable vehicle for security tokens. Typically, margin trading is seen as one of the key mechanisms for unlocking liquidity in a financial market. The ability to take both long and short positions with respect to an asset makes it a more viable investment mechanism.

From the crypto-derivatives protocols in the market, dYdX offers one of the most innovative solutions for margin trading. dYdX Margin Tokens are ERC20 compatible tokens move positively or negatively based on the performance of the underlying asset. Each type of margin token has a specified interest rate, expiration date, and amount of held token locked in the position per unit owed token sold through the dYdX margin position.

Let’s imagine a security token[STX] that represents equity in a real estate company. Using dYdX, we can create a margin token mSTX can be created in a way its value increases proportionally to decreases in STX. If the STX drops $10 in value then the valuation of mSTX will increase by $10. Building margin tokens will allow investors to participate in the market taking short positions against security tokens which will represent a multiple increase in the liquidity of the space.

Balanced Portfolios: Composable Tokens the Set Way

In the current market, each security token is its own investment unit. That model is not only incredibly vulnerable to micro-economic market conditions but its also hardly scalable and somewhat counterintuitive to the way most institutional investors deploy capital. Typically, institutional capital is allocated to financial products that represent a macro-thesis(ex: long on Manhattan real estate debt) and that hedge well against different market conditions. Can you imagine having to do due diligence for 200 buildings in a real estate investment trust?

SET Protocol is an ERC20 compatible protocol that enables the composition of different tokens under a single unit. Technically, a Set token is collateralized by the underlying tokens which are trustlessly kept into custody. Issuers can create new Set tokens at any time or redeem the underlying tokens. Set tokens can be composed of other Set tokens which makes it ideal to architect sophisticated financial products.

To illustrate the value of Set Protocol in the context of crypto-securities, let’s imagine a few hundred tokens that represent equity in Manhattan, Dubai and Sydney real estate. If a group of investors have a macro-thesis about those real estate markets and they believe that they hedge well against each other, they can create a Set token that is the composition of the different security tokens similar to a real estate exchange traded fund(ETF). That Set token will allow the investor to hedge against specific market downturns or underperformance of a specific real estate unit.

Insurance: Put Options the VariabL Way

With security tokens today, investors have no way to protect themselves in the case of a poor performance of a given token. While that’s probably ok for small investments, it’s a massive roadblock in order to deploy large sums of capital into crypto-securities. Typically, sophisticated investors leverage derivatives to “insure” specific positions against market downturns. Put options are a classic example of this type of insurance mechanism.

VariabL(formerly StabL) is a new entrant in the crypto derivatives space that proposes an efficient method to modeling call or put options based on crypto assets. The VariabL protocol is very similar to dYdX for margin trading but has a couple of features that make it closer to options than to short trading. VariabL Zero-Sum contracts matches long and short positions in a way that the profits of one trader always match the losses of the other trader. Using Zero-Sum contracts, an investor can create a put option that bets on a price decline on a specific token over a period of time.

In the context of security tokens, VariabL’s Zero-Sum contracts can be used to create the equivalent of a put option that acts as an insurance against the performance of a specific token. Let’s take the example of a security token that represents a pool of real estate leases valued a $1000 per token. In that scenario, an investor can create Zero-Sum contract that bets that the price will go down to $500 in a year timeframe and will sell that token for a fraction of the price. If the token declines below $500, the investor is guaranteed to receive certain payoff above market conditions.

These are some examples of how derivatives might be important ingredients of the next generation of security tokens. By enabling capabilities such as liquidity, balanced portfolios and insurance ,derivatives that make security tokens more attractive to institutional investors and accelerate the growth in the space.