On the Importance of Crypto Derivatives

(Why Your “Stable” Coin Ain’t Stable)

October 26th, 2018

 

Crypto = Dutch Tulips Still

While attending a panel at a crypto event recently in New York, we were asked at what stage we each thought the crypto evolution to be in.

This question gets thrown around a lot — all the time to be exact.

It’s quite simple to answer.

It has been my observation that those in the crypto-sphere who have become quite well off thanks to the surge in prices in the past 18 months, have invariably clouded judgment as to the long-term potential of decentralized/tokenized applications as well as fixed supply digital currencies not backed by any central entity.

I ventured relatively late into the crypto rabbit hole when it was nearly full and overflowing, and thus arguably have a better outlook than those who have been convoluted by a dearth of crypto riches.

The simplest measure of actual crypto traction therefore, are the answers to two basic questions that the reader can ask themselves:

(1). What do I currently use for purchases?

(2). What do I currently use to pay my bills?

The answer is obvious — CREAM (i.e. cash/fiat).

Bitcoin et. al represent speculative, shiny objects whizzing in the air that people naturally ogle at, not unlike shooting stars but perhaps less ephemeral.

Hence we have our answer to the question posed at the beginning — we are still in the speculative tulip stage, where there are no apparent use-cases besides being shiny objects for speculation.

Vol Trading and Hedging

The hyper-speculative nature of a new asset class generally comes with variable and violent price swings.

Thus, the naturally above-average price movement attributed to such shiny objects offers volatility-oriented funds like ours a plethora of opportunities that we readily exploit.

One way is to simply trade the underlying price volatility (or currently lack thereof) using a variety of techniques with bitcoin derivatives — namely options and futures.

The other of course is to offer hedging services for crypto investors who are hodling on to the belief that BTC et. al will replace central banks, yet, ironically in the meantime still need to pay their bills in fiat.

Hedging originated officially in the mid-1800s, where farmers needed to lock in the prices for grain as the bounty of their yearly harvests were generally unknown.

Futures contracts — a type of hedge — enabled farmers and their clients to lock-in grains’ prices up to a certain point in the future, thus eradicating price uncertainty no matter the quality of the future harvest.

For crypto investors and founding teams, incorporating a hedging strategy to manage their treasury holdings is paramount for long-term survival, as the significant market decline in 2018 has ruthlessly revealed.

There are various types of hedging strategies one can employ, from simple/conservative — using only futures, to more dynamic/aggressive — using futures + options.

Un-Stable Coins

An alternative to hedging via derivatives of course is utilizing crypto “stable” coins, of which a plethora have just arrived onto the market.

The great irony of stable coins is that they are only as stable as their magic algorithm that enables them to function, or even more ironically — if they are truly hard-asset backed to actual cash, their stability is tied to the financial solvency of the issuing entity (making them no different, and even more risky, than an everyday FDIC-insured bank).

Indeed, Gemini’s apparently 1:1 hard asset-backed stable coin rose to ~$1.19 last week.

Crypto “stable” coins are inherently unstable, and thus not suitable for hedging.

Rather than offering these quite literally dime-a-dozen stable coins, it would behoove those within the crypto-sphere to create a robust derivatives market, in order to enable and ensure proper handling of price volatility.


Until next time. 

Brian Koralewski is the Founder and Managing Member at Austere Capital. 

You can reach him directly at brian@austere.capital

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