Since Matrixport introduced crypto structured derivative products in Q3 2019, many companies followed and launched similar products. Structured derivatives are widely used by institutions, both in traditional finance and now in crypto assets.
Booming structured products
Various types of products have been created in the crypto market with specific yield curve. Investors, especially institutions with large fund size, set their target yield curve before investing, and also prepare counter measures as a hedge. Such counter measures can be amended afterwards, but to prepare for them during the investment planning phase would be more efficient.
Here’s an example situation when structured derivatives can be the solution. Suppose an institutional investor wants to start mining crypto coins, but definitely wants to avoid any potential losses from price drop. By buying a put option, 90% of the principal will be secured.
Another example is of large funds who seek relatively stable return and forecast the price won’t rise too much. They prefer to sell a call option and get premium, as this could make the overall cost lower (buy put fee — sell call fee). Even an increase in price will not affect them much as their yield curve target will be met.
Such hedging approach is commonly used in manufacturing and agricultural industries, to control raw material cost or secure profit over a period of time.
Institutions taking part in the crypto market
With the growing size and regulations being introduced in the crypto market, more large funds are entering crypto market, which brings more demand for structured derivative products. We see two types of very promising financial institutions, one is crypto native institutions with wide coverage (like exchanges, mining pools, lending platforms), and the other is traditional finance native institutions with close access to fund (traditional sell-side, banks, etc.).
The two types of institutions (although there may be some overlap) are very promising, but not 100% ready. Crypto native institutions do not have full understanding of finance products and their applications, while traditional finance native institutions need more crypto market knowledge. This article aims to help the crypto native institutions to better build up their business, by introducing them to the market framework, business process and the required skills / infrastructure.
As an OTC dominant market, structured finance derivatives market participants basically can be categorized into three types: buy-side, sell-side and custody.
Buy-side, sell-side and custody players
Buy-side mainly refers to the institutional investors mentioned above, buying financial products to meet their yield / risk target. Exchanges can cover some ‘vanilla’ demands; however professional sell-side institutions are the counterparties for complex structured derivative products (also known as exotics).
Nowadays crypto structured derivative products mainly serve as account management strategy. Buy-side has to trust the sell-side, because all the principal goes to sell-side. With the growth of crypto market, there will be other products where buy-side will need to put only part of the principal as collateral to sell-side. Traditional finance market also starts on trust, but when trading volume outgrows credit, mutually trusted institutions emerge to play the middleman role, i.e. banks.
We still see crypto market at its early stage, as there’s no sizeable custodians in structured products. While custodians’ key functions like risk exposure calculation, profit (loss) calculation, are split from sell-side institutions, let’s take a perspective of sell-side business process.
Key business process
Sell-side institutions need professional talents to fulfill sales, risk control, trading and settlement roles. The internal business process includes 4 key functions — RFQ (market making), Trading, Risk control and Settlement.
RFQ (market making): the cost of financial products can be calculated based on key parameters like expiry date, underlying, collateral rules, redemption terms, etc. But the full quotation should consist of additional costs (e.g. sales, operational costs, etc.) and profitability margin. The quotation usually comes from market makers, which can be done by sales negotiation which is the manual way, or as automatic response to RFQ by API integration. Some sell-side institutions own internal market making team so they can directly quote.
Trading: sell-side institution takes over the risk upon confirmation of the quotation and order with investor. Sell-side institutions have different risk appetite and approaches. They might hedge the exposure fully to purely earn fee, or take the full exposure, or hedge part and take part of the exposure. They can also hedge with different financial products (spot, futures, options) or venues (exchanges, OTC desks).
Risk control: sell-side should be clear on its risk exposure before any deal with their customer. Their hedging operations need transparency on risk parameters such as margin, β risk, profit/loss stress testing and collateral requirements from potential price fluctuations. When the threshold value is reached, the planned strategies (auto hedge, lower position, etc.) should be triggered to lower risk.
Settlement: upon expiry or investor’s redemption, sell-side institution will calculate profit/loss from contract terms and current market situation, and settle the account with its investor.
Sales is also a key function because sell-side has to sell their product after all the product design and risk control. There are usually two types of sell-side institutions — one covers all the business process, and the other only focuses on selling and settling. Some institutions in the crypto market however, only build their own sales portal, and give the remaining tasks to their partners.
System support is necessary to support scale
Upon the growth of business scale, each step mentioned above will need system support. Some institutions focus on sales, and outsource RFQ (market making) / trading / risk control to a 3rd party service provider because it involves much work and re-inventing the wheel in this process, which makes little sense. The concentration, thus, can be on the core value proposition of building the right asset for the right customer (buy-side), at the right pricing.
In this early stage market with less competition, profitability in crypto market tends to be higher than traditional finance. The key success factor of sell-side is customer resources and product design while the core value add comes from financial engineering, to cater their customer’s yield demand. However, as there’s mature derivative pricing theory which has been migrated to crypto asset, there’s no need to reinvent those wheels. So, the efficiency comes from utilizing mature 3rd party crypto derivatives infrastructure, and focus on pricing model selection and asset building.
The trading, risk control and settlement functions, as proved in traditional finance, are well packaged into a system product. The key differentiating criteria is the use for trading venues, asset types, and also the reliability of the system.
For example, risk control role in sell-side essentially is to pick the risk parameter, set threshold, and define the hedging / de-leveraging operations when threshold is reached. All the parameters can be picked from a pool, and the risk appetite can be shown by the threshold setting and operations. It must however be noted that the parameters for each institution’s use are similar and are limited. These parameters can all be customized in the system to cater to every one in the user base. With increasing user cases, the parameter pool will get more exhaustive.
1Token system helps sell-side institutions to focus on their core competences
3rd party vendors are good at building systems with vital features mentioned above (complex but limited, need stability, etc.). With increasing variety of client integration cases, the system will cover wider scenario of trading venues and financial products. As an institutional crypto asset management system provider, 1Token covers all main assets in crypto market, structured products being one of them.
1Token system benchmarks front-back office system in traditional finance market, supports all the business process from quoting, trading, risk control, clearing/settlement and wallet/wiring (exchange to exchange, address to address etc.). 1Token aims to enable all companies to focus on sales, quotation, and macro risk rule setting, by managing the operations with 1Token’s system. Hence, enabling all institutions to focus their time on revenue generating strategies and leaving all other daily management tasks to the 1Token system.