Derivatives on Blockchain: Key Concepts

Derivative products, hedging mechanisms, and the road to stable tokens.

Since we launched the VariabL alpha in September, we’ve received some invaluable feedback from our participants and the broader blockchain community — everything from video tutorials to animated screenshots to hand-drawn graphs. All of your comments and questions have been immensely helpful, so thank you.

Some recurring questions have come up about both the nitty-gritty of derivative products and VariabL’s mission at large, so we wanted to take a chance to answer some of them for you here and clarify exactly what we do, and how we do it.

First off, what the heck is a derivative product?

Derivatives are the ground of financial stability in financial markets. They are used to transfer risk from one person to another. You can think of derivatives as insurance contracts on the variation of a value, expressed as an underlying asset. This underlying asset can be something such as the price of ether in USD.

The logic of a derivative contract is actually quite simple: on one hand, a lot of people, companies, and institutions are looking for a risk-free financial environment, where there is no significant variation in the price of specific assets. On the other hand, individuals, companies, and institutions are looking for financial variations because they want to speculate on and benefit from them.

For example, a company that supplies rice will want to ensure that the price of rice will not be overly costly in 2018. The company wants predictability and is willing to pay a fee for it. On the other side, traders will want to speculate on the price of rice and will not care whether the price goes up or down, only that it will change a lot (following their predictions). Traders are actively looking for volatility.

So there are two kinds of actors in the derivatives market: the person who wants to hedge, i.e. cover their risk, and the person who wants to be more exposed to risk, i.e. the speculator. The speculator is counterparty to the hedger and literally takes the hedger’s risk.

In practice, the hedging party will neither lose nor gain money during the duration of the derivative contract, and the speculator will either lose or gain more than if they did not enter into the contract.

So what exactly does VariabL do?

VariabL is a non-custodial exchange for peer-to-peer derivative products. It’s designed for individuals and applications that rely on cryptocurrencies as a decentralized store of value. VariabL uses ether as a collateral to provide trustless hedging mechanisms.

We’re building both the infrastructure and the marketplace to create and exchange derivative products directly on the blockchain, using blockchain assets, smart contracts, and state channels for maximum transparency and security. We are using the Ethereum blockchain to secure the funds and afford maximum transparency and we manage the rest directly (orderbook, price oracle, etc). Currently, we’re focusing on hedging mechanisms through specific derivatives, namely contracts for difference (CFDs), and stable tokens.

Our alpha is a derivative product that replicates the behavior of classic margin trading. This means that you can speculate on the price of ether against USD. If you are right, you can double you initial deposit in USD value. If you are wrong, you risk your deposit and nothing more.

In practice, you decide:

how much ether you will bet

if you bet on an increase (you are long) or a decrease (you are short) on the ether price

if you want to double (x2) or quadruple (x4) the effect of the price variations (for the ongoing product)

The VariabL platform uses ether as a collateral to provide trustless hedging mechanisms.

After you make your choice, you place your order and you are matched with a trader who bets the exact opposite, which means that you are competing with each other. Who will be right? Time will tell. Today, our products expire after a short period (24h), but soon you’ll be able to choose your contract duration.

As an example, let’s say that you enter a VariabL derivative contract when 1 ETH is worth $1000 and you think the the price will go up. You bet 1 ETH, long, X4. 24 hours later, the ETH price is $1,200 — a 20% increase. As you were long, you win, and as you decided to go X4, you will receive a 80% increase in price, which means $800 (i.e. 0.66 ETH). You have 1.66 ETH worth $1,800.

Had you kept your ether on your wallet, you would only have 1 ETH worth $1,200.

As you see, our first product, albeit among the most advanced in the field, is still quite simple and faces some limitations. What if you want to bet with a higher multiplier? What if you want to close your position before the expiration time?

Well, good news. The VariabL platform is still a work in progress, and soon, you’ll be able to bet with a higher multiplier, close your position before the expiration time, and much more in the next versions of our products. For the past six months, we have been singularly focused on improving our derivatives and scaling our infrastructure with the implementation of state channels.

In the meantime, we have been hosting trading challenges on our alpha that gathered more than 500 testers. You can still trade on the exchange and be rewarded with VariabL Contribution Tokens.

For more information on the way we are using the Ethereum blockchain to secure our derivative contracts, check out our deep dive on derivatives and stable tokens.

I get how one can use the VariabL platform to speculate on the price of ether. But how is it a hedging mechanism?

Great question. This is where things get tricky. Today, in order to understand how to cover your risk using our platform, you need to have a bit of financial or mathematical background. However, we are in the process of creating a very simple interface so users can enter into hedging contracts without bothering too much about the underlying contract. But let’s break down how hedging works for good measure.

When you are looking for financial stability of an ether against USD, what you’re really doing is shorting the price of ether against USD.

Entering a short on ETH-USD price means that you are hedging yourself against the risk of losing money if the ETH price is down against USD. You are also losing the opportunity to gain money if the ETH price is up.

Here’s how it works in practice:

Let’s say you have 10 ETH that are worth $10,000 today (i.e. $1,000 for 1 ETH). But you need to pay someone $10,000 in two months, so you want to be sure that you will still have $10,000 at the end of those two months and you are ready to forego any potential gain to ensure this. Good news! If you enter a short x4 for two months (meaning that any variation of price is replicated 4 times on your contract) with 2.5 ETH, you are safe.

Let’s see:

If the price is up by $100, you are losing $1,000 on your short (2.5 [ETH] * 100 [$] * 4 = $1,000), but you are winning $1,000 on your 10 ETH, so you still have $10,000.

If the price is down by $100, you are winning $1,000 on your short but you are losing $1,000 on your 10 ETH, so you still have $10,000.

So, in order to hedge your currency risk, you need to take a short on the value of the asset you want to secure. You can do this on VariabL, but with one limitation for now. On our current product, you need to put additional assets in deposit to secure your initial deposit. We plan to change this aspect in the future.

In particular, our infrastructure will allow users to easily create so-called “stable tokens.” These tokens will have a $1 USD face value and will be exchanged on the blockchain. Underneath the token is a financial derivative on the price of ether, so that when you want to redeem the token, the contract is closed and you get exactly the equivalent of ether that you would have bought with the equivalent amount of dollars.

Stable tokens will be one of many features on our future platform. We will develop, step by step, a fully-fledged decentralized derivatives platform that will allow for the creation of futures, options, and even new kinds of derivatives altogether.

Sounds good. What’s your roadmap?

We are just wrapping up the research that was required to implement the first production version of VariabL, and we are now moving to the product development phase, leveraging the work done on the alpha. We are very confident that we will be able to release our first product in 2018 with an efficient infrastructure and stable tokens.

In the meantime, sign up for our newsletter to stay in the loop for our future product releases, and join the alpha to try our product. We need your help to create a fair and secure financial world.