DEFI BLOG SERIES
Master Plan for the Democratization of the Financial System
This article will show a long-term trajectory of Decentralized Finance until a wide range of people can access the financial system using distributed ledger technology (DLT). Decentralized finance may reduce or eliminate the need for a middleman, enabling financial services at everyone’s hand; however, it is still in the early development phase. We want to envision the steps of how it can expand its capability and migrate into traditional finance. This is the second article of the DeFi blog series presented by Secured Finance.
Managing uncertainty risk
Unlike spot exchanges, derivative transactions include future exchanges anchored to the time axis; we need to deal with uncertainty. In other words, the derivative is invented to manage uncertainty risk. Although we cannot predict the future, derivatives allow us to rationally measure uncertain future cashflows across different asset classes and estimate the risk amount. Therefore, derivatives are crucial for managing a business.
Steps to expand capabilities for derivative markets
The following derivative products and markets should be built to connect with the current financial system. In addition to Futures traded on a derivative exchange, we can build OTC markets for Loans, Forwards, Swaps, and Options using DLT. In general, loans are not considered derivatives but included here as borrowing/lending money is a fundamental need within a business activity, which is considered a core component of finance.
Disclaimer: This part focuses on financial market development; therefore, technical development and regulatory compliance will be discussed separately. Not all the OTC derivatives, such as equity, commodity, or weather derivatives are included.
- Secured Term Loan
Collateral is used to cover counterparty risk. Termed loan allows us to plot interest rates on a time axis to make a yield curve. The yield curve brings us discount factors to calculate the present value of cash flow at any point in the future; therefore, it allows us to do mark-to-market for financial transactions and margin call operations to manage counterparty risks.
- Cross-currency Swap
Two different currency loans (borrower and lender) are combined to allow us to hedge currency exposure and carry-trade where we can borrow low-interest-rate currency and invest in high-interest-rate currency. Swap provides effective use of collateral because of offsetting cashflows.
- FX Forward
Loan interest rates can be used to discount forward FX prices. FX forward is useful if we want to lock the FX price now for future transactions.
- Interest Rate Swap
This type of swap is used for asset-liability management (ALM). If loan lenders want long-term, fixed-rate coupons, but borrowers want short-term, floating-rate coupons, we can use an interest rate swap.
- Cross-Currency Basis Swap
A loan lender or borrower can choose their favored currency for a loan to match their needs. The interest rate is a floating rate. As both notional currencies are different, this swap includes notional exchanges. A combination of a cross-currency basis swap and interest rates swaps can produce a fixed cross-currency coupon swap.
- Basis swap
A loan lender or borrower can swap coupon frequency such as 3 months and 6 months. Both swap notional is the same currency and therefore does not include notional exchange.
- Unsecured Term Loan
Collateral may not be required if counterparty risk is hedged with credit default swap, etc.
- Credit Default Swap
This helps the loan lender to hedge the counterparty risk. Credit risks for trading can be calculated by a certain algorithm using past trade history, account balance, and so forth.
- Currency Option
Once various swaps are available, we want to build currency option markets to let participants create structured products.
- Interest Rate Option
It allows financial institutions to make interesting structured products such as callable bonds to boost interest rates.
Stakeholders cooperation for financial stability
Since decentralized finance has a reduced or zero middleman involvement, there is no central bank to ensure market liquidity. Therefore, the market participant’s cooperation is needed to provide ample liquidity to reduce volatility. Secured Finance would be happy to set up a foundation for financial stability and invite all the stakeholders such as financial institutions and corporate investors and miners who share the same benefit of stabilizing the market for healthy economic growth.
This article discussed the importance of derivatives to manage uncertainty and proposed an approach to build OTC derivative markets using DLT. Secured Finance will follow this long-term roadmap, aiming to bridge a gap between decentralized finance and traditional finance, enabling a full-scale of financial services for everyone.
Finally, we are collecting early test pilot users through this P2P Financial Transaction Survey(1min). Please take a moment to complete it, and we will send you the results and keep you on a list for the Secured Finance token airdrop.
How to build yield curve and why it’s important
How ‘Swap’ works and why it’s the largest market
A practical guide for various swaps in business practice
How structured products are made and why it’s profitable
A handbook of Secured Finance derivative solutions
Thank you very much!