Smart-Contracts in Financial Derivatives
Introducing Smart-Contracts
One of the most common phrases following the blockchain technological disruption without a doubt are Smart Contracts, which is a crucial concept implemented and embedded in different blockchain use case scenarios, where it is also important to understand that smart contracts are the engine that drive blockchain solutions, enabling a fundamental shift of power and project execution into a more secure and robust channel in the hands of the peers depended on each other to “unlock” this contract, which are not to be confused with the legal form of contract or traditional contracts because of the features and elements they both possess differ. The differences stand that the traditional contracts are associated with the HOLD-UP problem arising from the possibility that one party will unilaterally abuse with the power on hand for personal gain at the expense of the other party, thus requesting the guarantee of an intermediary to avoid an outcome as such.
Therefore, to vaguely introduce smart contracts, we call them so due to their ability to self-execute under certain conditions which are set in predisposition and are expected to be met by the participating parties and all this written in code to automate the process and reduce costs by eliminating the centralized intermediary associates (middle-men) providing an immutable and verifiable action.
Smart contracts as a concept were first introduced by cryptographer Nick Szabo in the early 90s where he describes that contractual clauses can be embedded in a distributed ledger, and it would ideally be expensive to breach that contract. As he describes a primitive form of a smart contract is the vending machine as a contract bearer, meaning that anyone in possession of the coins requested by the machine can exchange with the vendor through a secure mechanism to unlock the requested item. Therefore, this concept further promotes the smart contracts on a digital environment with the ability to manage the initial assets.
Whereas, the Blockchain technology stands as a facilitator of such environments, through a distributed ledger amongst different peers to uniquely maintain and edit it without exercising central control, thus enabling smart contracts to rely on consensus mechanisms as contractual practices that validate the changes from the trusted parties and at the same time to prevent unauthorized changes in the ledger. Aside from that, Smart contracts become complete with Ethereum’s approach as a more complicated activity to run and deploy them on top of its virtual machine the EVM or other platforms similar to it that come with a different approach on consensus and finality like NEOs DBFT or the Athereum approach on the Avalanche consensus (AVA) notably as a response to a much weaker concept of smart contracts or such activities on top of bitcoin due to its limitations on Turing-completeness. However, the approach designed, comes from a blockchain strategy to create single data in cryptographic chain with “messages” and computations instead of just UTXO’s that can only either be spent or unspent transactions; and no other implications that would ideally facilitate more complex decentralized organizations.
Taking into consideration either one of these enhanced blockchain platforms as a smart contract platform which store data in their full nodes, perform the computations and maintain the consensus, a smart contract is written for example in solidity or serpent high-level programming languages of the Ethereum virtual machine (or other programming languages depending on the platform we wish to issue) where the contract can be “ignited” and pay them units of ether (Ethereum cryptocurrency). Although, every operation on the EVM has a fixed cost of “gas” as an execution fee.
Smart contracts "core" role.
Smart contracts are here not to replace the existing form of contracts traditionally used to legally conduct an agreement between the involved parties but to enhance this service through a robust ecosystem where individuals, institutions and computers can contractually interact with one another on peer to peer basis. Adding to that, the smart contracts must possess crucial elements of security, enforcement and immutability of the rules set.
Smart contract applications in financial derivatives
As of now there are plenty of options to run smart contracts on public blockchains, one of the popular applications of it are financial derivatives and stable-coins, as this is particularly easy to implement.
To shortly introduce financial derivatives as a complex and obscure financial security with a reliant value deriving from an underlying asset serving the business purpose of hedging, transforming risk and engagement in speculative investments . However, to have an implementation as such on the blockchain, the goal is to leverage its advantages on trust minimization and intermediary elimination, an example of a financial derivative on blockchain would be linking it through a data feed “Oracle” to ensure price updates as a contract facilitator for the underlying asset, subject to the external references on price tickers, which are used as a trusted source, to confirm the going rate of the pairs with respect to the smart contract that hedges on volatility of the cryptocurrencies towards a fiat based currency such as the USD.
To further illustrate this we would initially have two parties that would both have an input of designated xxx amount of cryptocurrencies, Party A to have an input of xxx amount, Party B to have and input of xxx amount, after which it has to record the value of the inputs (cryptocurrency xxx) with respect to USD ($X’) from the up mentioned data feed as a price fetching tool in terms of $X’ where after a certain time (Mature, every contract must have a time of validity) the parties involved are able to trigger the contract, allowing the one or the other to do so, that they would be able to send the $X’ worth of xxx cryptocurrency to either one based on the rules written in code.
- A -> inputs xxx amount of “coin”
- B -> inputs xxx amount of “coin”
- The USD value of the xxx “coin” is recorded from the Oracle -> Confirming price of $X’
- If the contract was created by A it waits counterparty B to accept it.
- After a period of time, allows either party A or B to "trigger" the contract to send xxx “coin “worth of $X’ to implement the transfer.
However, to mention again the financial derivatives are a common practice to prevent any financial escalation, issuer backed assets are represented as an asset backed token that signifies its value on another asset which is not necessarily on the blockchain but as a representation of ownership of the underlying asset such as Gold or oil known as commodity-backed or, or fiat-backed such as those pegged to USD in a value of 1:1 the case of Tether (TUSD).
Besides being of high-potential this form of smart contracts in financial derivatives of the cryptocurrency, markets face the issue of high volatility, of which investors prefer security and convenience thus willing to avoid large losses that would potentially cause uncertainty and confusion deterring them to further use this form to mitigate risk.
Note: Backed stable-coins are not necessarily immune to volatility rather subject to the risk and volatility associated with the backing asset.
More so, this approach is not fully decentralized since a fully autonomous derivatives market is complex and the underlying infrastructure is still missing, besides, the peers are engaging on a smart contract without an intermediary the “Oracle” data feed is still depended on a centralized source to determine the price of the underlying asset prone to central price manipulation and be it an exchange or any other responsible entity to publish the price. Therefore, the idea is to have a fully functional decentralized exchange (DEX) on assets to be able to implement a more robust and point-to-point decentralized financial derivatives process to provide the real-time price feed.
Conclusion remarks
Smart Contracts facilitate the financial derivatives market on the blockchain to disrupt the financial industry and drive the DeFi idea towards greater adoption, although scalability is still critical by the time this article is being written. Nonetheless, the fundamentals of a more secure environment to conduct business on asset and financial security remain promising. More so, due to the code embedded in a smart contract when dealing with derivatives as the algorithm mutually executes for both parties eliminating the asymmetry and the hold-up problem for one party to access the collateral. It is important to note that based on the details in code the miss-conduct between parties are ruled out by its design, mitigating the counterparty risk. This approach tends to naturally be in par with the legal and regulatory framework of financial derivatives, since its architecture is as such that puts the smart contract at the center of the transaction in an immutable and transparent manner for the peers conducting the agreement as well as the legal entities to monitor the process on a distributed open ledger that ultimately is risk saving and reduces costs.
