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mattdd
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Joined: February 22nd, 2018, 2:41 pm

How would Blockchain or DLT impact derivative pricing models?

February 22nd, 2018, 2:50 pm

Hi all,

How would Blockchain or DLT impact derivative pricing, e.g. models, hedging, risk management, etc especially for credit derivatives?

Lets discuss!
 
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Traden4Alpha
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Joined: September 20th, 2002, 8:30 pm

Re: How would Blockchain or DLT impact derivative pricing models?

February 22nd, 2018, 5:17 pm

Counterparty risk: To the extent that the derivatives or underlying are linked to anonymous counterparties in unknown jurisdictions, the counterparty risks may be especially high. These might be mitigated by automated smart contract escrow systems which eliminate the risk but change the capital structures of the deals.

Settlement time/reliability risk: If the experiences with Bitcoin are an indicative, some of these systems offer no set time of settlement and even some chance of trade settlement failure. Another issue is the extent that the parties can manipulate the chance of settlement ex post.

Transaction cost dynamics: If the DLT is capacity bounded, the cost to enact a trade can grow without bound especially if the parties want to avoid a failed trade. That will surely affect the use of dynamic hedging.
 
mattdd
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Joined: February 22nd, 2018, 2:41 pm

Re: How would Blockchain or DLT impact derivative pricing models?

February 23rd, 2018, 4:15 pm

Thanks Traden4Alpha.

What do you mean by "but change the capital structures of the deals"?

For your 2nd point, the "settlement finality" problem can be removed in ledgers with other consensus algos(non-POW, etc.) 

For your 3rd point, I guess a better Blockchain/DLT solution in financial world should not be capacity bounded, and should not have the high transaction fees such as in Bitcoin case right now. 
 
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outrun
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Re: How would Blockchain or DLT impact derivative pricing models?

February 23rd, 2018, 5:02 pm

If you make the ledger non anonymous then you would know who you're dealing with, which would reduce the counterparty risk in the derivatives price. Or many other can be resolved with collateral?
 
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Traden4Alpha
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Re: How would Blockchain or DLT impact derivative pricing models?

February 23rd, 2018, 5:02 pm

Capital structure: Without a central entity that can vet and legally obligate counterparties to behave, the need for escrowed collateral goes up and the availability of margin goes down. If one has $X in cash for trading, the number or size of positions might be much smaller in a DLT market than in centrally managed market. Moreover, high-quality traders will prefer centrally managed markets where they get favorable terms based on their identities and credit worthiness in a known legal jurisdiction. That means that DLT markets will have a larger portion of low-quality, under-capitalized traders. It would quite be an Akerloff lemon situation, but there will be some assortment by participant quality.

No doubt "settlement finality" can be improved although non-POW seems prone to other risks of fraud, flooding, gaming, etc. And it would seem to be very hard if not impossible to have both a distributed system and hard real-time performance guarantees.

Capacity bounds and transaction cost issues seem a bit more intractable to me. If you can find a trustworthy central marketplace provider thats running 1 copy of the ledger on 1 CPU, they are always going to be faster and more energy efficient than some amorphous network of N copies of the ledger running on N CPUs with all the added overhead of network synchronization between them. BitCoin's initial promise of disintermediating traditional financial services firms and offering lower transaction costs was based on BitCoin not offering the same services such as dispute resolution and repudiation of transactions. Otherwise BitCoin would always be more expensive.

Obviously, the key word is "trustworthy" and that's no small hurdle. There will be competition between centralized versus decentralized system with centralized touting speed + consistent performance and decentralized touting trust assurance + access to a broader array of untrustworthy counterparties.