Multi-party derivatives trading reshape legacy structures

"There is a difference between what technology enables and what historical business practices enable." - Bill Gates

FOR many years, we have facilitated technological improvements in how traditional finance is conducted; the telegraph, ticker tape, telephone and programmable digital computer laid the foundations for today's computerised trading framework. However, despite these advancements, the power of large institutions combined with legacy structures have perpetuated systematic issues of inequity, a lack of transparency and mistrust in finance. By keeping financial exchanges in a siloed, broker-to-consumer realm, big firms have grown in size by exploiting an asymmetry of information and discriminatory practices, particularly in the derivatives trading space.

This could change, however, with the growth of decentralised technologies, facilitating multi-party smart contracts, bringing increased transparency and independence to the often-dreaded - but significant - derivatives market.

THE LEGACY STRUCTURES

As financial technology has raced ahead, we have actually seen little innovation in the fundamental structure of derivative contracts, which has remained largely the same since 1929. Essentially, a contract is made between a buyer and a seller, through a centralised exchange or an over-the-counter (OTC) market maker - and this continues to be the case. Little modification in the design of these products has meant the industry continues to be hamstrung by severe obstacles - most notably, high costs, opaqueness, and complexity - which allow large financial institutions to profit while creating a pervasive sense of mistrust in the derivative product.

Firstly, derivative trading is generally only reserved for people who already have a lot of money. In order to open an account with a derivatives broker, you'll have to comply with whatever the broker's minimum deposit requirements are. Some small brokers offer accounts with a minimum deposit of US$500 or less, but some of the better-known ones that offer derivatives will require minimum deposits of as much as US$5,000 to US$10,000. In addition, market participants will generally have to cross a number of intermediaries before trading derivatives, including banks, exchanges, brokers, and market makers.

Even when they do get a seat at the table, the complexity of the derivatives put forward (generally in highly technical language) creates knowledge-based discrimination; essentially you can only trade if you are an expert.

This complexity is a major deterrent, and has allowed institutions to market certain products in a distorted fashion; the Collateralised Debt Obligations (CDOs) from the Financial Crash in 2008, come to mind.

Finally, there is a distinct advantage provided to centralised providers who are privy to crowd wisdom. This allows them to overlay information from historical volatilities and prediction models, and augment it with crowd wisdom, giving the centralised providers the power of knowing what everyone is doing, while the investor remains oblivious.

The above issues, combined with the market structures and its operating decorum, mean that the derivatives trader of today is caught in an environment where it is costly to trade, with imbalanced information access, complex tools and contracts. Cue bitcoin.

MULTI-PARTY TRADING

Decentralised Ledger Technology or blockchain was the talk of 2018. Markets were coming and going in swings and crashes. Behind the hype, however, emerged a consistent, strong movement towards decentralisation and financial inclusion. Removing the need for a centralised authority to verify transactions opens doors for entirely new and transformative financial products. In the derivatives market, typically closed and inequitable, the room for improvement is significant.

Multi-party derivatives offer the investor the opportunity to engage in peer-to-peer exchanges, excluding the centralised authority from the equation. Providing this relationship removes the need for trust in a middleman, gives more autonomy and is a democratic alternative to the current market conditions for derivatives.

By using Smart Contract technology, transactions can occur independently from a third party. Investors can participate in collective markets, directly interacting with other participants, staking crypto currency and receive money straight into their wallets, without an intermediary in sight.

For example, take 1,000 people who would like to speculate on the price of gold at the end of the day today. Traditionally, each of these users will find a gold-based derivatives provider, purchase their call or put options and await the settlement when the price is known at the end of the day. Under a multi-party derivative contract, these 1,000 users can directly enter into a common smart contract that governs the price of gold at the end of today. The values are then settled among themselves at maturity (end) time (in this example, at the end of the day). What this achieves is a complete upheaval of untrustworthy, discriminatory and expensive derivative trading to provide a genuinely democratic solution.

For too long, we have put trust in large financial institutions to lead and monitor the massive derivatives market. History has proven that this can result in disastrous market outcomes, as these firms try to squeeze the most from the investor. By utilising nascent blockchain technology, multi-party derivatives offer a practical solution that can reshape the finance world entirely, putting power into the hands of market participants.