ETH Derivatives and Market Structure

Transcript

thanks a lot for having me and thanks for everybody for attending today um so first a quick disclaimer this is not investment advice as usual so and you shouldn't rely on what i say anyway um so today we're going to talk about um derivatives and market structure we have a high level overview of you know what's going on in c5 and d5 the bridges between the two and you know the goal is to give you an idea of why derivatives are important how they're being built and what are the key components that are required for the to build this ecosystem um so just to have an idea who has treated derivatives

uh previously and who thinks they understand derivatives i wouldn't claim i understand them very good okay so let's get started so first let's start with a little story for those who are not very familiar with derivatives and uh to really clearly illustrate the purpose that they serve uh so this is bob um bob attended uh if cc last year he was really excited so all his friends did not get covert uh so he was quite happy and he thought okay next year uh i want to meet my friends again and i want to invite them for dinner um i know there's going to be a bull run some get out of money so i'm going to make a

lot of money so i want to spend that some of that money to invite my friends for dinner so he goes to chef yes there's going to be a b c d d deferred derivatives so he goes to chef and um and chef goes uh uh yeah sure let me ask my farmer because i'm gonna need to to cook for you so chef goes to alice and he asks okay i'm going to need to cook for bob how much is that going to cost me and alice says well right now you know for my for my thing i'm harvesting is about 1 8 great so he goes back to to bob and says well i can do the catering that will cost you two eth

so bob says great sends it to eth to chef and one pandemic later we're here has anyone been invited by bob so bob goes uh um is waiting for for his guest to come and chef goes to alice again and says hey could i have the food and uh alice goes well it's been tough this year you know the the uh the heat everything it's gonna cost you actually to eat so chef goes gives it two eats gets the food and doesn't have anything left for him right so he's signed a contract with bob so he has to deliver on this

but still now the price of the food he was supposed to get has increased so he doesn't have anything left to eat and to feed his family his kids bob is sad so now what if we introduce derivatives what could chef do to try and mitigate that risk and make sure he doesn't get eaten at the end of the day um so this is what chef is going to do chef is going to get into a futurist contract that will allow him to have some predictability of his cost far into the future so same so bob goes and says how much how much do you quote me chef goes and starts and

gets into a futures contract and says gives the same quote to eth but now he has some predictability so one year later uh chef goes back to alice and says hey i need my food alice again comes and says well the prices have increased it's going to be to eat so chef pays the 2 eth but chef had gone into this futures contract so there was somebody a trader there was somebody in in in front of him who wanted to trade with them wanted to potentially speculate or you know knew what the pro had some views on what the prices of the of the food would be and so somebody lost money and now is paying

jeff uh chef the uh the the difference so now it's very nice because alice made her money chef made his money and everybody is invited to bob's party so what uh for a little bit more context i work at keiko and what we do is we provide data on all these types of of derivatives we focus on market data so very high level what we do is we connect to all the centralized now also decentralized marketplaces and we're going to go collect all the prices we store them we normalize them standardize them across marketplaces and then redistribute them one is one interesting thing is we get data on chain

uh that we bring to our platform and we also get data from our platform that we post and publish on chain on on oracle systems and as we'll see oracles if you want to have derivatives on chain are a key part of the of the ecosystem so in terms of simple derivatives we'll get a little bit more into this so what um what bob did what chef did was get a futures contract with a maturity which is next year for the next cc and as you can see there is here a little index price which is the price at which he was going to pay for the food and there's a couple more field that we

won't get into for now then there is something very interesting called the perpetual futures it's now it's typically easier to buy a contract on something than buying the something itself and this is exactly what goldman sachs does when they offer you to buy crypto or get exposure to the asset class and what's really nice with the perpetual futures is it doesn't really have an expiry so it's sprawling perpetually so you don't have to go in and out of positions and roll it so basically what you would have to do before would be okay this is have these futures for next year and then getting closer to the maturity day you need to roll your futures into a different future so this is what solves a perpetual futures

and then once you have a very liquid market on futures you can build on top of it options and options give you uh the option to buy at a later date which is something chef could have done as well right and the beauty and the of all this is when you use options you can ha actually if you have infinite strikes and you can actually discretize any type of payoff using options and as i said why oracle are so important is because every time there is this index price because derivatives derive from an underlying asset uh and so you always need to have some reference price of that asset uh to price your derivative

okay so more on derivatives so what do you do with those derivatives so we've seen bob he used it to to hedge some risk because bob's job is to cook and to cater for people his job is not to think about what the prices of the food is going to be in a year from now um there are other things that you can do you can also if you're doing some goal-based investing you can sell some upside let's say i want to buy a house in the future maybe i don't care about you know getting infinitely reach rich what i want is maximize the probability for me to be about able to buy the house so what i could do is

write some uh get into some option contract to sell the upside let's say you know i don't care if bitcoin goes past or ethereum goes past a hundred thousand dollars uh so i'm going to sell all the upside and if the prices go up more than a hundred thousand dollars sure i'm not going to earn anything more the difference is well somebody paid me for that upside so today i have more money and so i have more money to invest and so even if i have a lower return on my money i've increased the probability that eventually i'll be able to buy the house i wanted to buy and there are a lot of other things right one of which being getting access to leverage what way is

leverage really useful sometimes is because if you can have some very low risk strategy that has very low returns and so if you want to amplify those returns obviously increasing the risk as well to scale your strategy you need to be able to take on leverage and this is what hedge funds do what they've always done and what they'll keep doing why futures are also important is because they're easier to trade they have higher liquidity usually they have much lower transaction fees so buying getting in and out of your positions is cheaper and this is because of this as well this goes into price discovery and as uh was said

in the previous talk today um a lot of the price discovery in traditional markets happens in the futures uh in the futures market not on the spot markets and it allows for you know very fine tuning of risk you allow for reshuffling of the risk across market participants and basically what you do is some sort of matchmaking for risk it's people who know have more information or think they have more information can take on one risk or another and that allows for market participants to really focus on what they know and what their added value is to the system a good example of that is you know you have the where the food example but a minor uh what type of works is it you know what

what is bringing the miner it's bringing hardware is bringing computation power to the system uh so should they really be bearing a lot of price risk hash rate risk and all other types of risk um speaking of liquidity and how prices form because you always need that reference price that your derivatives contrast is based on that's been a really big question and even in centralized finance and you know in crypto finance as we as people have tried to build etfs uh and traded products you need to understand how price discovery goes and and what is

the right price if somebody comes to me what price should i should i give them and there have been issues with fake volumes and that's you know this study by uh that was presented to the uh sec uh was made by bitwise and and clearly showed that some volume was was uh really fake did not by fake i mean it doesn't represent uh economic trades and the in terms of the role of derivatives in price discovery this is okay what is leading the the changes in prices is it on the spot market on what exchanges and does it come from the service market and what role does it play and so why is this important to understand this because

this really tells you how prices form and this uh this is key in having a stable service market as well and right now on the d5 side is much younger right as we as we can see here the total value logged right now is about couple billion don't have the trading volumes but the it's still very early on because you need futures market to be really mature and to build options on top of it and there's a lot more complexity in trading derivatives and in trading spot markets so the some of the so recently if you looked at the top projects here they are in derivatives um we won't go into all of those i think

there was a quite a lot of mentions of ribbon and open um uma uma is doing also great things and have a very interesting approach uh with their priceless oracle so basically what they're doing is uh they have some form of consensus around what the price should be and that only gets triggered from um cryptonomics so basically you have incentives to not cheat and and uh and hopefully you know the if you don't provide the right price you'd be paying more than what you've what you'd gain well you don't see the impact on the

market well every time i mean so what the question is what it so nexus mutual though the way it works is like a mutual uh if the mutualize the risks so people can come in into a pool and and the risk is shared that allows them to provide insurance right at some point if you start having something of really large sizes you you do you will impact the market wouldn't you and because you know some of those participants

whether you know if there starts to be a really big discrepancy uh with the with the rest of the market people would be exiting their positions or or that would have some impact so not being sure exactly or maybe there's something more about the uh the mechanics of how that works but i would my impression would be that if you have really large volumes and you start having something that are really important you'd have at some point all systems are start getting getting back to reality right so you'd have people trying to head you're trying you you drive people to trying to you know buy the underlying and you'd have squeezes i mean there you'd have you'd have interactions with

with reality outside of nexus visual so um c5 and d5 so on a lot has been done on the c5 side right and there are big wall street names or uh financial names like the cme um that have been trading for long time options on bitcoin they've recently introduced futures on ethereum and why futures only i don't think they have options yet because as we said the first thing you need to do is build that liquidity of the futures that is then used to build the options contract so right now still at the futures at the future stage

just to show you how early of the market this is um and then when you build your options well when you have an asset that hosts prices doesn't vary much in time it's it's easy you can set up strikes and these are not necessarily going to very much in in time well when you have some an asset that varies a lot um in time you you need to to make sure that you adjust those tracks you have different maturities etc and this is where there are very interesting propositions that are being made in in the d5 space is what if you could you know outsource and have a decentralized options marketplace like open for example and then you can have insurance but you know after all insurers can be is just an option right

uh you can buy insurance by writing an option so if you look on open and this is where you you also see how you know people are trying to reinvent the user experience uh in those in those options uh marketplaces another good example was uh uh etero which i think was really interesting they they even have all the they even have uh uh literature on on what you're buying and try to give you an idea and you have this little uh slide range where they show you the payoff uh that that you get depending on the price of uh of the underlying so you can play around with this right to wrap your mind around it trying to democratize and make people

understand what is behind this so as we mentioned you need to have a vibrant futures market and that's all about liquidity because what you're doing you know when bob when chef went to uh his futures trader uh to get to for the trader to buy the risk he needed to have a seller in front to buy to get to get the rest so you need to have this liquid you need to have uh this matching that goes on between bidders and and uh and buyers uh well and and sellers um who will buy or or exchange that risk so what's typically done and if you go

back to the history uh at the beginning there were um market designated uh market makers that were the only ones who could market make then that went started with a double-sided order books that got open and anyone could do market making and so this is what goes on in most of the centralized exchanges also on decentralized exchanges um some of the decentralized changes is you have uh bidders you have bids and asks people willing to buy people willing to sell at different prices with different quantities and when there is a match between the two uh transaction forms and a trade displaced and this is how markets work and you can you can see you know here

the bid the bet the best ass the different strikes on there a bit for for their option markets uh you can see that around if you look around the price at which the uh the the underlying is you'll have more liquidity um if you go further away sometimes you don't even have any any data because there is there hasn't been trades and so this is what the options market for for ethereum looks like for the august strike the august maturity um and if you try and think based on different types if you look at sport markets if you look at futures if you look at options and you want to gouge the liquidity in those markets what you can look at is the spread uh the spread is basically

the difference between the best bid and the best ask so the prices of which people are willing to buy and sell um and this is what you would get is uh futures are very liquid with the most liquid being the perpetual futures on bitcoin in ethereum uh then you have spot markets in the middle and options which are less liquid because there is uh less trading activity and now if you had an entire layer on how those things interact between c5 d5 all the custardy aspects you get a lot of risks that are being taken into the system you have smart contract risks you have custody risks and so being able to split those risks and split and slice and and help everyone interacting with the entire ecosystem is

is important and is exciting um and one final note on this is it's all about user experience what you know to in my mind what uniswap did beautifully and you can see in the screenshot is people just at the end of the day just wanted to exchange uh assets and they just made it easy so will we see this also for for options and help people market make so just to summarize um the um [Music] the the key ingredients that you need for for having a vibrant derivatives is liquidity you need to have the furthest futures liquidity uh to build on top of it

and how in building derivatives system is is not it's not easy it takes time it takes also you know understanding of the risk that you're taking um making sure you have uh all the liquidation systems in place uh if you want how much collateral should be posted prices vary a lot also what's interesting in uh crypto is the uh the quote asset is not always defined right i mean it's is all is always changing so when when you look at all the synthetics and the synthetics protocols they have very often there they have to do to build a stable coin why because when you go and buy a stock of tesla you know

it's a stock of tesla but actually implicitly is denominated in u.s dollars uh so in effect you're sort of having pairs but that are simplified into because they're always denominating the currency you're used to using and crypto that's different because very often you can have things donated in in ethereum and btc and other stable coins and so you need to to build the uh all the interaction with the interaction between those and the key component of this is having prices you can rely on and building uh trusted oracles in a decentralized setting is challenging as we've seen but even in the centralized markets having proper valuation tools having price feed that are reliable

making sure that you can audit and see you know what how the prices are calculated you know what is the composition what exchanges are you including in the mix are you taking a view up are you taking excluding outliers there are many questions there as well and so there are a few pawns that are intended on the right uh on the right um the just to summarize a lot of this has been driven for optimizing yield optimizing trading strategy uh optimizing the way you you manage risk we're still early there is a lot to be built not only on the trading side on the

options market making side but also even on the on the protocol side and and making sure we have you know good smart contracts and a lot of innovation hopefully will follow it's all based on liquidity because you need uh very liquid underlyings um and what's fascinating is you know if things become so interpretable and you start getting i don't know iot data uh on chain and what what will be able to hedge as risk can we go even beyond what's possible today and finally one big thing is you know all these they rely on network effects so what that means is you have distributions with fat tails what you expect is very large returns on

the few of your investments so what that means is things are not normal and i don't know if some of you know about the actual smarten model so be careful about the mathematical assumptions when you price those derivatives especially options because if there is a rare event you might get eaten and this is the purpose of those few memes which is remember about fat tail if you have long tail risk you need to get that into account in your price um and in this case uh so when you look at rare events it goes from where to getting ruined and in this case the ruin is the one that

gets eaten um and so one very serious uh two very serious quotes taken from cnbc so very reliable source yes please remember to put on your swimsuit and that will open for questions no questions you