skew. & Crypto Garage trade peer-to-peer Bitcoin-settled S&P500 derivatives
This article describes the details of the press release from skew. and the Coindesk article.
Abstract
Skew. and Crypto Garage (CG) entered into an S&P 500 derivative contract that is settled in Bitcoin, using the P2P derivative protocol based on the Discreet Log Contracts (“DLC”). In April 2019, we have previously executed with Blockstream a P2P derivative settled on the Bitcoin blockchain.
As an extension of the previous transaction, Skew. and CG would like to confirm if there are Bitcoin investors interested in seeking exposure of assets from traditional finance.
Motivations
In traditional finance, investors can gain exposure to equity markets or commodities market using derivatives such as futures, options and swaps. The derivatives are used to replicate the performance of the underlying asset. Investors use derivatives to hedge an existing position or speculate on the future movement of the underlying asset. The underlying asset can be flexible and linked to a single stock or a single commodity, like crude oil.
The well-established underlying assets are typically traded on an exchange in its local currency. There can be cases where an investor would like exposure to assets like US equity or Japanese equity but due to regional restriction may not have access to a US or JPY account. On the other hand, a Bitcoin investor has no regional restriction but currently the product offering to invest in traditional asset class using Bitcoin is not prevalent.
We hope to change this by conducting a Proof-of-Concept trade with Skew. on engineering a BTC settled contract on one of the most commonly traded derivatives in traditional finance, an option linked to the S&P 500 futures. Our intent is that this transaction will draw interest from BTC investors in conducting derivative trades on other traditional asset classes, such as a crude oil derivative that is settled in BTC.
Financial Contract Specifications:
We implemented the S&P 500 derivative that is settled in BTC as a quanto option. A quanto option is a type of derivative in which the underlying (S&P 500) is denominated in one currency (USD), but the derivative itself is settled in another currency (BTC) at a fixed rate called quanto conversion rate. A quanto option is appropriate for our use case where an investor can have exposure to S&P 500, but without the corresponding BTCUSD exchange rate risk.
A quanto option has an embedded currency forward with a variable notional amount, where the notional amount is the option payout in USD and the currency forward rate is the quanto conversion factor.
Considerations for the option seller
For the option seller, the challenges of hedging a quanto option is managing the exposure of the BTC/USD FX forward. The amount of USD exposure to hedge into BTC at the quanto conversion rate varies on the movement of the S&P 500 price, the correlation of S&P 500 and BTC/USD and the price volatility of BTC/USD.
As can see in the figure above, the correlation between the 2 assets ranges from -50% and 50% with a median correlation of -3% in the last 3 years. An option seller would need to carefully consider what correlation to assume in its pricing and closely monitor the realized correlation when managing their hedging portfolio.
Terms and Condition of the Quanto Option
On September 6th, 2019, Skew. and Crypto Garage (CG) agreed to enter into the option transaction as described below. For pricing, we have used well known quanto option pricing methodology under a Black-Scholes model framework.
As mentioned in the blog of the Blockstream transaction, the P2P protocol assumes both parties pre-deposit collateral directly to the Bitcoin blockchain where the collateral distribution at maturity is based on the output of the Oracle. The pre-deposit collateral is determined by the maximum profit & loss of the derivatives, which needs to be pre-defined. In this particular case, as the option seller, CG is the only contributor of the collateral and posts the maximum payoff value of the derivative.
Maturity Payout
On September 20th, the option transaction matured with the payoff result as shown below.
In the next section, you can confirm how the derivative was broken down into Bitcoin transaction specifications using the DLC protocol.
Bitcoin Transaction Specifications:
The transaction is divided into 3 parts:
- Fund Transaction (“Fund Tx”): The fund transaction comprises two inputs and two outputs. The first input is the option premium paid by Skew. to CG, which CG receives immediately. The other is the collateral posted by CG which gets locked within the DLC.
- Contract Execution Transactions (“CETs”): A set of transactions each representing a possible outcome for the settlement date is created on trade date.
- Closing Transaction (“Closing Tx”): Once the Oracle publishes the reference rate, one of the CET output becomes spendable. CG can then broadcast it, which enables Skew. to directly receive their payout. CG then creates a Closing Tx using the Oracle’s signature in the input to get back the remaining collateral.
Anyone can check each transaction in a block explorer (such as blockstream.info).
- Fund Tx: Initial Collateral posted by CG and Skew.
TX ID: afb9276cd578f96a1ba7fd45116ccbbe9ad5041da609ad5593f62a3cfb4d5fbd
The collateral each party posted is the maximum profit and loss exposure each counterparty has for the respective derivatives trade. In this transaction, CG posts about 0.0467 BTC. This collateral posted includes the transaction fee for including the transaction in the blockchain. The transaction output for the collateral fund is locked with a 2-of-2 multi signature address.
The input from Skew. is used to pay the option premium to CG. The option premium payment is represented by the second output of the Fund Tx.
This transaction is linked to the following items, that is already mentioned in the “Financial Contract Specifications” section .
The slight difference between the transaction information and the financial contract is the transaction fee needed to broadcast the transaction on the Bitcoin blockchain.
2. CETs: CG and Skew. have thousands of signed Contract Execution Transactions (CETs).
TX ID: 09e430468bca724cc01ec4fb1f9e66e1e3965ae3030e9510582f4660e9c232eb
The purpose of the CETs is to pre-record all the possible settlement payoffs of both counterparties. Each counterparty is holding a set of CETs with the same settlement payout but with different signature requirements: the input of each CET is pre-signed by the other counterparty.
At the maturity date of the derivatives trade, the Oracle broadcasts the S&P 500 futures reference price and produces a signature. With the reference price, either CG or Skew. broadcasts the corresponding CET that matches the Oracle.
For this transaction, CG first finds the corresponding CET. When broadcasting the transaction, CG signs the input in order to unlock the funds from the 2-of-2 multi-sig (Skew. pre-signed the input of every possible CETs at the beginning of the transaction). As a result of the CET being broadcasted, Skew. immediately receives the option payout. For CG to receive its payout, CG will need to broadcast the Closing Transaction.
3. Closing Transaction (“Closing Tx”)
TX ID: bb2f4fb7c2c2ae0fae60d0efc763fab817d64bfef2a4f30d5584f752effc676d
For CG to receive its payout, it needs to take the corresponding CET and the Oracle signature and its own signature as the transaction input. From the transaction output, CG receives the Net Transaction Amount, which is the posted collateral minus the option payout.
If one of the counterparty tries to cheat and picks a payoff scenario differing from the rate quoted by the Oracle, he/she loses all its funds and those funds will go to the other counterparty. Let’s say CG broadcasts the incorrect CETs, then CG will not be able to complete the Closing Transaction because the Oracle signature would not match with the input of CETs. The funds from the Closing Transaction can be recovered by Skew. after the time locked period and Skew.’s signature.
Conclusion
Crypto Garage and Skew. co-designed and transacted an equity derivative that is settled in Bitcoin using the DLC protocol. We confirmed the validity of the concept and at the same time see the potential for broader product offering for Bitcoin HODL-ers. As long as there is a reliable data source to obtain a price feed, a P2P derivative can be linked to various underlyings from traditional asset classes such as commodities and bonds.
We think that this type of trade could be of interest for investors with regional restriction for a foreign currency, to enable them to trade asset classes denominated in that foreign currency. The trade off is that for such an investor, there would be a premium cost to enter into a quanto option under the DLC protocol. This cost could be justified as an access cost since a BTC investor would normally not have the ability to trade the traditional asset they want.
We are happy to discuss new ideas related to P2P derivatives.
If you are interested in developing crypto finance products, we are hiring software developers and engineers! Please contact us at info@cryptogarage.co.jp.
Let’s architect Crypto Finance!
Disclaimer
Skew. and Crypto Garage are neither a regulated or a licensed financial company. This transaction is strictly a proof-of-concept transaction and does not and is not intended to constitute investment advice or an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. Although every effort has been made to provide complete and accurate information, Crypto Garage Inc. makes no warranties, express or implied, or representations as to the accuracy of content. Crypto Garage Inc. assumes no liability or responsibility for any errors or omissions in the information contained in the website.
