The Security Token Derivatives are Coming

A few days ago, I had a very interesting discussion with a group of quent fund managers about the role that security tokens can play in a new generation of crypto-asset derivatives. A lot of interesting points came up in the debate and I thought I’d summarize some of them in today’s post.

Financial derivatives has long been a missing element in the emerging crypto asset space. While the launch of Bitcoin futures in the CME and Cboe exchanges raise a lot of expectation in terms of the future of crypto derivatives, its adoption has been limited. Certainly, initiatives such as Firmo.network or Variabl look incredibly solid but they still need to work their way to mainstream adoption. In my opinion, crypto assets have been lacking some of the fundamental building blocks needed to build widely adopted market derivatives. The emergence of security tokens might fill some of those missing gaps and open the door to the first generation of mainstream derivatives based on crypto assets.

Why Crypto-Asset Derivates Have Failed so Far?

There are many factors that have contributed to the lack of adoption of crypto-asset derivatives but, in my opinion, there are two that have been pivotal to this market dynamic. The first one, is that crypto derivatives represent a second layer of volatility and speculation on top of an already volatile crypto-asset. Think about it, the main factors that drive the price of crypto-currencies are news and market speculation and there is no easy way to predict any of those two. If we add a mathematical model on top of that, we are essentially adding a speculative/volatile vehicle on top of another speculative/volatile vehicle. Definitely possible, but not the most attractive idea to get started with crypto derivatives.

The second factor is the small pool of investors that understand both financial derivatives and cryptocurrencies in order to provide a liquid and vibrant ecosystem. The number of investors that leverage derivative product is a fraction of the market. From those the group that understands crypto-assets it’s a very small number. That has been our target market so far.

Are Security Tokens a Derivative?

You can make the argument that any form of security token can be considered a derivative in-and-out itself as derives its value from the performance of an underlying asset. However, traditional derivative models include other aspects such as time constraints, obligation symmetry or settlement model that don’t quite fit the profile of security tokens. For the moment, let’s assume that there are forms of security tokens that can behave like derivatives while others trade more like first-tier asset classes.

Derivatives and Security Tokens

The emergence of security tokens as a new asset class can be the missing ingredient for the emergence of viable crypto derivatives. There are several factors that justify that assumption including some of the following:

1) Regulation: From the tokens to the exchanges, security tokens will be regulated vehicles which provide the adequate protection for investors. Derivatives built on top those assets are likely to result more attractive to traditional financial markets.

2) Stable Underlying Assets: Security tokens based on real estate assets, art, or shares of a private company should behave in a relatively predictable way correlated to the underlying assets. Building derivatives on top of those security tokens adds a layer of mathematical speculation on top of a predictable/stable asset which is a model that financial markets understand.

3) Price Predictability: Complementing the previous point, derivatives based on security tokens will automatically benefit from the many 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 private company. That should increase the appealing of this new financial product in the eyes of traditional investors.

4) Expanding the Investor Footprint: Derivative models based on security tokens will allow quant investors to leverage the products and tools they use today with this new asset class. From that perspective, I believe security token derivatives will attract a new group of investors that have remained distant from speculating with Bitcoin futures and other crypto derivatives.

What Type of Security Token Derivates are we Likely to See?

As the security tokens market evolves, there are several derivative products that are likely to surface in the short term. Interestingly enough, I believe we are going to see both a generation of derivative models that represent security tokens as well as the first group of tokenized market derivatives.

· Derivatives that Represent Security Tokens: These are mathematical models that speculate on the price of underlying security tokens that can represent alternative assets such as real estate, art, private shares, diamonds or many others.

· Security Tokens that Represent Market Derivatives: We can tokenize everything so there is case to made for tokens that represent market derivatives such as options or futures.

What types of security token derivates will emerge in the first wave? Here are a few ideas:

a) The Forward-Futures Model: Following the model of forward or futures derivatives in financial markets, we can envision smart contracts that specifies the criteria to buy or sell a security token at a specified future time and at a previously agreed price. This security token derivatives can follow the futures model if traded in centralized exchanges or the forward model if traded in decentralized exchanges.

b) The Options Model: Options offer another powerful inspiration for security token derivatives. In this model the owner of the security token option will have the right but not the obligation to buy or sell the underlying security token at a specified price on a specified date.

c) The ETF Model: The debate of whether exchange-traded-funds(ETFs) are derivatives is beyond the scope of this article but, unquestionably, the ETF model is very viable for security tokens. We can envision ETF-like security tokens that represent the value of an underlying group of assets such as real estate leases, loans or private shares of different companies.

d) The Swap Model: Like swap models in financial markets, we can envision security token derivatives that exchanges the dividends or cash flow produced by two different security tokens in order to serve as a hedge or insurance against future market conditions.

There are many other types of derivatives that can become important with the emergence of security tokens. The evolution of this market its going to take time but, at least, now we have a new form of crypto-asset [security tokens] that seems to provide the right foundation for the mainstream adoption of crypto derivative products.