Need of risks insurance in the cryptocurrencies market
Big financial institutions are progressively focusing on opportunities provided by cryptocurrencies. Crypto assets market has seen a huge growth in the last 2 years but still misses tools typically used in more modern and developed financial markets. Some months ago, I had the pleasure to meet a Russian dev team involved in financial trading and they impressed me with their plans to build a huge swaps market focused on crypto assets. Below, a brief introduction of their main idea.
The rapid growth of the cryptocurrency market continues. It stimulates the emergence of new technologies which, on one hand push to create the civilized market in traditional understanding, on the other hand — it promotes diffusion of cryptocurrencies transactions to real sectors of the different countries economies.
The first tendency is more regulative: it reduces the profitability of the market, but also stabilizes risks; the second — expansionary: expands an information field and practice of application which significantly increases the activity of traditional investors.
In these conditions, the most important directions for infrastructure improvement of the new market are the risk management, hedging of investment risks and risks at exchanges, crypto-currency hedging of this and connected spheres.
In the system of cryptocurrency functioning and accounting there are no mechanisms of insurance or hedging at the moment.
Let’s have a look at some examples.
Let us suppose that you are an investor in the new project in the sphere of high technologies. Initiators of the project have received from you an approval for 1000 bitcoins on the entire project with the uniform schedule of granting means, for example, on 250 bitcoins every quarter within 4 quarters. Let’s say that in this case you neglect the temporary value of money and you aren’t going to show it to the founders of the project as the expenses (as you plan to finance your own project from own means). You take away from the fund on some step decreasing deposit at a current rate of the dollar to bitcoin 8 million dollars. The deposit rate is modern, i.e. is ridiculously low, but can cover a part of your losses on not discounting of means for the project initiators.
You give an assignment to the bank and transfer to the startuppers the first tranche (2 million dollars) for the exchange to cryptocurrency. Further the project successfully develops and in a quarter the initiators ask you about the second sum. You check the dollar exchange rate in relation to bitcoin and you notice that there was a correction of a course at the level of 7700 and now you need to transfer only 1,925 million dollars to bitcoins. In the third quarter, while reading the press through, you find out that as a result of certain events (one of cryptocurrencies is completely mined out, China has finally forbidden cryptocurrency, next fork has led to legalization of only one chain of bitcoin and so forth) the rate of bitcoin has jumped up to 18000 dollars for unit and the remained 4,075 million dollars on a deposit aren’t enough for you even to finance the third quarter of the project schedule …
We will compare three various schemes of financing on the Table.
Table form. Comparison of various schedules schemes of the investment project financing
The ideal scheme represents uniform financing of the project provided that the rate of bitcoin slightly deviates from the basic settlement — 8000 (for example, fluctuating within several days at the basic mark allowing the investor to choose the time for the profitable exchange).
The real scheme as having described above, has given 2 surprises: the first is a prize in the second quarter (750 thousand dollars on a course), the second –shot down the project (there was an insufficient funding in bitcoins of the 3rd and completely the 4th quarter though dollars are already spent).
In the third scheme, we enter the instrument of hedging. We purchase insurance on changes of an exchange rate (calculation of the price of such insurance for each investor — a separate subject of mechanisms and calculations). In our case costs of an insurance have made 0,1%, i.e. 8 thousand dollars. Insurance has allowed to record a course on all schedule of the project and to supply it with cryptocurrency in the necessary amount.
Let’s notice “rise in price of the project” — 8 thousand and also a certain income from a deposit. Let it be at the low, but nonzero rate (calculated on “ladder”). This gives us 50 thousand dollars during the implementation period of the schedule.
And what if we realize more difficult game plan and we will provide the contract with initiators with the contract clause in which we’ll state that the money financed by us in the project before achievement of profitability point of the project is twice more expensive for the founders, than in the period of profitable work? (These questions, as a rule, arise at the period of business assessment, its capitalization and distribution of shares).
Now, as the skilled investor, you start thinking of secondary tools for your project coverage (compound or barrier options).
Let us assume that investments into the project are planned in the form of project financing, i.e. the new company intends to carry out collectibility of investments to the investor at the expense of those money flows which it plans to receive as a result of the implementation of the project. And at the same time, the project is connected with the generation or service of the third currency, for example, of an Ethereum.
And if the predicted stream of an Ethereum (according to the business plan or in reality) has already nonlinear or probabilistic nature, then it makes your problem of investments preservation and multiplication much more difficult.
How to ensure all risks of currency purchase, exchange rates and an income withdrawal from the project? Or … let our dollars stay on a deposit …?
One more simple example, absolutely habitual and necessary element of the modern global economy is money transfer.
The person X plans to transfer to the person Y the amount which equivalents $20. X transfers $20 to cryptocurrency without the commissions and gets access to all advantages of new means of payment. Namely: simplicity of the the transfer, safety of bitcoin transactions, use of one technology at different software platforms of the sender and recipient, speed at international transfer, flexible control of the commission when transferring, and at last, anonymity.
But how to be with the mentioned super-volatility of cryptocurrency. And if, for example, the diversified portfolio of the ordinary crypto-investor, as a rule, doesn’t suffer in general from such differences, but the simplest technical correction of a course during the day can lead to essential losses of the translation recipient. (We will remind that operations on a transfer of cryptocurrency with a withdrawal from a purse in fiat money still take a long time today). You won’t involve exchange mechanisms on stops operation on course change and on formation of warrants for purchase sale at each, even small translation.
It is obvious that at all advancement of transparent systems of new technologies we have rather archaic links in it.
It is necessary to mention that the community works in this direction, and a number of newly stated ICO is directed to improve and accelerate the exchange and multiple currency service. There are some drafts of hedging of currency set in general, for example, release of cryptocurrency index fund tokens.
However, in our opinion, it generally touches upon a covering of absolutely evident services which are failed today and uses the external device. It is clear that statistics in transactions has not stored yet and it leads almost to the discrete analysis and “manual” methods.
In our judgment, it is necessary to expand the device, use absolutely various sources of information and to apply the fundamental analysis. For example, recording of fundamental properties of different cryptocurrencies about limitation of different currencies issue, the forecast of their mining functions, and the so-called pre-mining currencies (e.g. Ripple) which total amount is extracted in advance and only decreases with the flow of time (i.e. they are beneficial for the long-term investments, but it is unclear what to do with their reduction).
Thus, the perspective sphere for the new smart contracts and projects is the sphere of hedging instruments creation and a risk management, and formation of the secondary transacting principles of auxiliary tools.