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EP 33: ELI5 Derivatives, Repo, PerpFuture
The derivative products
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TLDR below. This is not financial advice.
Finance and capital market can be quite difficult. What are derivatives? What's Repo? What are the different types of derivatives? How can tokenisation bring more value add?
Today, let's solve them and break it down. A simple high school explanation of what they are. We will also share how tokenisation can bring more value add. I'll introduce more about FlexUSD next week, otherwise, this newsletter is too long.
We are only just scratching the surface of how tokenisation can bring about the huge value to traditional finance.
What are Derivatives?
If I get the value (aka derive) of a thing from another thing (e.g. some other asset), it can be considered a derivative product.
Devil is in the details, but you get the general idea.
In traditional financial, sometimes you can buy a stock. Let's say it represents 1% of Tesla, the company.
Sometimes, you can also buy other types of financial products, like an option to buy a stock. Let's say an option to buy Tesla's stock at $630 within the next 3 days. This option is a contract. It does not represent Tesla's stock, but it gets its value from Tesla stock. The option contract (a thing) derives the value from Tesla's stock (another thing).
There are many different types of derivative products. One of the derivatives is leverage.
What is Leverage?
I have $10 worth of ABC stock. I can get a leverage position and get 10x exposure to $100 worth of ABC stock.
This can be packaged as a product, a position or something funky.
This is good because I now only need to provide $10 to get $100 worth of exposure. It's exposure not benefits because you could lose them. Sometimes, you might lose all that $10, sometimes, you might lose more than $10.
Also, a small fluctuation now means everything is 10x the magnitude. A small change in the asset means 10x the change to your position. Sometimes, the small change is huge and you lose your position, aka you lose that $10 you provided. Sometimes, the change is so huge that you lose the initial $10, and you lose extra money. Like this guy with his oil trade in May 2020.
A small note about oil trade in May: There are a lot of individual traders who trade oil contracts go bankrupt because their accounts turn negative. That means they lose more than what is in their accounts and the brokers ask them to deposit more money.
Physical Delivery and Cash Settlement
The reason why oil is brought into the picture is that oil, a commodity (aka thing), is physical. People actually purchase oil like airlines company and truck companies. Some people trade derivative products and some people trade the physical product.
Now, here is the difference. Trade all you want, but when it's time to pay up (aka expiry date), you have to do what is said on the contract.
When people trade, with no intention of using that oil and they just want to profit from the asset, they usually use cash settlement. That means when it's time to pay up, you see the difference between the assets and pay in cash.
This doesn't work for airline companies. They want the physical product — the oil. So when it's time to pay up, they get the actual barrels of oil delivered to them.
Umm, isn't this newsletter about....... tokens?
Wait, I'm getting there.
In crypto, there isn't oil, a physical thing. But there is Bitcoin, a thing but it's digital.
Now, let's bring everything we talked about together.
People trade Bitcoin derivatives. Usually a futures contract. E.g. I'm going to buy Bitcoin at $$$ in Dec 2021.
You can trade it on various exchanges like Bitmex, Coinflex. The difference is the settlement — physical delivery or cash settlement. Bitmex uses cash settlement. Coinflex uses physical delivery.
Which is better? Ah, good question. It depends. But let's not go into those details in this newsletter.
Give me an example
$LISA costs $100. $LISA went up and now costs $101.
In cash settlement, you owe me $1. $1 will be transferred from your account to mine. That is a cash settlement.
In physical delivery, I have to give you 0.01 $LISA.
Why is there a demand for Bitcoin physical delivery?
Now you're asking the right questions.
Bitcoin is mined. Miners receive $BTC.
Can miners use $BTC to pay for dinner? Unfortunately not yet. So what to they do? They are the sellers of Bitcoin's future contract (derivative). Investors will buy these futures contract and pay the miners in money, like $USD.
Miners can use this money to pay for dinner. Or electricity to run the mining farm.
When it's time to deliver, the investors get the actual Bitcoin. If price appreciates (like today), that's good for the investors. They can sell it in the open market and make money.
And what's Repo?
Derivatives is one big topic on its own. Now let's move to Repo.
Think of Aave. Instead of peer to peer lending, it's bank to bank lending. That's basically Repo. It's lending between the big players.
Also, they are usually short term. Like 8 hours. Aave and Compound has longer lending terms, like 30 days.
This is good, because
Lending between big players = higher interest rate = more money earned by lenders
Lending between big players = usually a real demand for money needed. There's no "fake demand", but when you look at Aave and Compound, there is no real need for someone to be borrowing there. Interest rates are quite low in traditional banks.
And who uses them? Who are the big players in crypto?
Repo is a product that people have different use cases.
Chinese miners want a short-term loan from bitcoins for dollars, as BTC is extremely bullish. (Like today.) They need dollars to buy a house or pay bills. Instead of selling BTC for dollars, they can borrow based on collateral and receive USDC instead.
Some companies need different exchanges that offer loans. For example from Celsius, which offers cash when collateralising a mortgage. Or they have Bitcoins and they can use them as collateral for highly liquid current account. You basically need short-term liquidity.
Value of Tokenising Repo
Repo exists and it makes banks rich. But you and I can't have access to it. 😢 By tokenising it, people like you and me can have access to it.
P2P lending in Aave and Compound is fantastic. Repo has higher rates than P2P lending, so that's fantastic x2.
Tokenising Futures Contract
We talked about the futures contract. It is a derivative. That is to buy something at a future date. You either settle it in cash or physical delivery. We talked about that already.
One innovation that exists in the tokenised crypto space is PerpFutures. Perpetual futures do not exist in traditional financial markets.
That means perpetual futures contract. It's not quite the same as futures contract rollover.
Basically, it has no expiry date.
Bitmex invented PerpFutures. Check it out here.
We see at the expiration date of the futures contract, you have to settle by that date. So you have to make a decision whether to top up your account or receive physical assets. And you must manage your position. Perpetual futures do not have such things. This is suitable for those who do not want to manage real or physical assets but want to make a profit because of the change in the value of these assets.
Next week, we will dive into FlexUSD. How to combine all these derivatives with Repo, tokenising it and accrue actual value from the USD you hold! Stay tuned.
Token economics is more than just token allocation to founders. The value of the token lies in changing the way things work. Like tokenising repo to give access to retail investors. Or innovative way to create perpetual futures contract.
Next week, we look at how we can bring them together, and use a token to get the maximum value out of this for people like you and me. Aka, introducing FlexUSD. An interest incurring USD token.