Decoding the DNA of Derivatives

Solving a monumental problem in a monolithic market

Nov 11, 2015 · 7 min read
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Our startup journey didn’t begin in our parent’s garage, a college dorm room, or a dirty apartment.

We started building Hedgy in the spring of 2014 at a bitcoin hackathon — hosted in the bowels of the historic Benjamin Franklin Hotel building — a block away from Napster’s old headquarters in Downtown San Mateo.

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We started by solving a pain.

At that time, the exchange value of bitcoin had dropped 50% from it’s all-time high of over $1,100 roughly six months prior. Anyone that had bought into the hype on the way up, were now experiencing regret on the way down, as the price would painfully plunge by another 50% over the next six months.

In the world of fiat currencies, a volatility event like this doesn’t happen often. Stable assets such as the U.S. Dollar (USD) are backed by the federal government. Thus, artificial safe guards are put in place to keep the market from dropping too much, too soon. However, digital commodities such as bitcoin are not backed by any central government, meaning those synthetic safety nets don’t exist. Instead, they are underpinned by the laws of math and enforced by the rules of code. Together, these digital properties combine to form a protocol suite — much like the internet — upon which tools can be built to protect market participants from unsuspecting volatility events.

In traditional finance, one such tool exists called a forward contract.

A forward contract is a type of over-the-counter derivative instrument that acts as a bilateral agreement between two counterparties, to buy or sell an asset or commodity for a fixed price at a specified date in the future.

When a forward contract is used to protect against downside price risk, it is known as a hedge. Businesses have been using forward contracts for hundreds of years to protect their unique commercial interests from all types of financial risk. That’s why forwards are widely credited for being the backbone of derivatives.

The downside of a forward contract is that it is susceptible to counterparty risk — the risk that the party on the other side of the contract will not live up to its contractual obligation to pay when the contract expires. As it turns out, counterparty risk is a monumental problem not just in the trading of forward contracts, but in several areas of finance. It is also said to be one of the snowflakes that caused the avalanche of the 2008 financial crisis; and a reason why Warren Buffett once called derivatives “financial weapons of mass destruction.”

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Too big to fail.

In 2009, after the collapse of several major financial institutions, counterparty risk in OTC derivatives trading rose to the top of the list of policy concerns. This forced regulators to respond with solutions. One proposed method to mitigate this type of risk was to mandate that individual counterparties enter into collateral posting agreements (margin deposits) with one another. Though effective, posting margin in a bilateral agreement, such as an OTC forward contract, is logistically difficult to do without using a central clearinghouse as a custodian. This poses a conflict for the ~30% of OTC derivative contracts that don’t qualify for central clearing. Considering the size of the market is estimated to be north of $600 trillion in notional value, this adds up.

At Hedgy, the way we think about risk is similar to how a geneticist thinks about a virus. There are approaches to manage or prevent systemic risk, but to significantly reduce or outright eliminate a risk of this type and magnitude means to permanently alter the DNA embedded in the infrastructure.

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Mr. DNA from Jurassic Park decoding dinosaur DNA

At first look, we recognized the correlation between an over-the-counter (OTC) financial market and a peer-to-peer (P2P) technology network. Both exist to reduce the dependence on trusted intermediaries. Both support the freedom of exchanging value bilaterally. Both rely on the strength of the network for integrity.

In fact, the deeper we dug into the problem of counterparty risk, the more we realized that the features of Bitcoin’s underlying protocol and its accompanying distributed ledger — the blockchain — could enable us to offer a less toxic OTC trading experience that traditional bespoke financial contracts simply cannot.

The genesis of our thesis was simple. If we could utilize Bitcoin’s P2P network combined with the blockchain, then maybe we could create a safer OTC forward contract, which would lead to a more open, accountable and distributed financial world.

The Bitcoin protocol has a revolutionary new feature built into it called multisig, which is short for multi-signature address. Multisig uses cryptographic signatures to prevent funds from being sent elsewhere without proper approval. Multisig wallets usually require 2 of 3 signatures (or m of n, ideally where m could equal any number less than n ie: 2 of 3, 3 of 4, 5 of 9, etc…), in order to transfer value from one address to another. The primary benefit of this innovation is that it greatly reduces the risk of theft and fraud.

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Tell your friends to use multisig.

In the traditional sense, multisig can be compared to a lower-cost, programmably scalable form of treasury control. At Hedgy, we realized that multisig can also be used as an effective technique for posting margin and managing collateral agreements without relying on a centralized custodian.

So we wrote a software program on the blockchain that uses multisig HD wallets for collateral management in a way that allows commercial traders to independently create, enforce and physically settle OTC forward contracts with less counterparty risk.

The process we use in which to achieve this function is called the oracle method.

An oracle can be a single independent trusted third-party (TTP) or a collection of distributed entities, which programmatically sign claims about the state of the world using information sourced through external data feeds. Oracles then combine that information with contract code for execution.

In our case, Hedgy is a TTP oracle. The state of the world in which we currently sign is the price of bitcoin (TradeBlock’s XBX Index). Collectively, our system is called a smart contract.

Smart contracts are computer protocols that facilitate, verify, or enforce the negotiation or performance of a contract, or that obviate the need for a contractual clause.

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multisig + oracle = smart contract. Try the demo.

The birth of the Bitcoin blockchain marks the first time in history that smart contracts can be used to codify existing legal agreements into programmable systems that run and scale like software. This means signing, enforcing, tracking and settling complex financial contracts will soon be as simple as sending an email. But in order to cultivate early adoption, smart contracts need to be adapted to the real world by supplementing — not supplanting — contractual agreements with actual legal recourse.

The International Swaps and Derivatives Association (ISDA) was founded in 1985, upon a similar mission as Hedgy, to foster safe and efficient derivatives markets and to facilitate effective risk management for all users of derivative products. As a trade organization of participants in the traditionally opaque market for OTC derivatives, ISDA serves as a beacon of light. In 1992, ISDA published a Master Agreement, which has become widely accepted around the world as a universal template agreement for global OTC derivatives trading.

Using the same principles as ISDA, we created a smart contract template that imitates the function of the Master Agreement, except it’s cryptographically signed and immutably hashed on the blockchain. Our multisig technology combined with the oracle method, is what allows commercial traders from anywhere in the world to use this template to independently create, enforce and physically settle OTC forward contracts on the blockchain with minimal counterparty risk.

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Every contract has a story. We use cards to tell that story. Try the demo.

This particular use of smart contracts is not only the easiest way to hedge bitcoin, but also a safer, cheaper and faster alternative to traditional OTC forward contracts. We call it smart derivatives and we believe that it will lead to a more open, accountable and distributed financial world on the blockchain.

Try the Demo today!

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