Structured products and DeFi ecosystem DeStrops — next step at the evolution of structured products
Introduction (description of risks in the market, importance of structured products)
There are many instruments in the financial markets that address the different needs of different investors with different capabilities and experiences. The main objective of structured products is to offer investors an investment option that maximizes their predictions and expectations while mitigating the associated risks. In order to be able to change the risk/return ratio, one has to use a combination of several financial instruments.
It is logical to ask — if there are instruments that can limit risk while maintaining potential returns, why aren’t they talked about on every financial-investment corner? The answer is that the use of complex financial instruments requires a high degree of skill and experience, as well as a certain amount of capital. Regulatory requirements such as professional certification and minimum investment amounts are designed to ensure that investors understand the risks involved.
In addition to legal restrictions, there are infrastructural constraints on the use of structured products. Several exchange-traded instruments have restrictions on the minimum amount or term of capital employed, which affects the other elements of the structured product.
In contrast to such requirements and practices, the crypto market for structured products has more flexibility in creation and use, and a lower entry threshold for participation on the investor side.
Structured Products market capacity in classic finance
Among the variety, the possible structural product options can be grouped as follows:
- Structured products with capital protection — a combination of an instrument with low risk of default and periodic payments and an option purchased using the number of payments from the underlying asset.
- High-yield instruments — when participating, the investor buys a volatile asset (e.g. a share) at a discount and is limited to a maximum conversion price after a certain period of time. It is a kind of analog of a deposit with an interest payment at the beginning of the term. The deposit in this case is not stable money, but an underlying asset.
- Structured products with participation — are used for different types of follow-up for/against the price of the underlying asset. They are used when there is no possibility to interact directly with the underlying asset or when there is a need to limit some of the market risks.
- Leveraged structured products — involve using a significant amount of capital to buy call or put options
- Hybrid structured products — structured products related to equity indices or volatility.
According to estimates by Bloomberg Professional Service, the market for structured products in 2019 was around $6.9 trillion, surpassing the size of the ETF market ($5.3 trillion) and Hedge Funds ($2.9 trillion) although significantly behind the overall derivatives market (estimated at $700 trillion). It is rather difficult to estimate accurately as most structured products are sold outside organized stock exchange trading (as part of private banking or brokerage services).
According to the presentation for the FCA (Financial Conduct Authority), the main motivations for investing are lack of time to actively manage capital, desire to invest a significant portion of funds with minimal risk and maximum return opportunities, lack of competence to independently design efficient structured products, lack of access to professional financial market instruments.
According to Lowes Financial Management’s investment fund data for 2018, none of the 318 FCA-certified structured products lost investor funds. This key difference — saving money while maintaining the prospect of higher returns — is the main advantage of structured products, especially when the market growth phase is over and the market is in correction or consolidation.
Structured products on crypto market
The rapid growth in crypto market capitalization in 2020 and 2021 due to CVD19 restrictions and monetary policy easing by central banks in developed countries led to a maximum interest in cryptocurrencies from institutional and large retail investors. The more BTC grew in value, the more investors wished to get involved in this new economic segment. Due to the innovative nature of the industry, there has been no established global policy on cryptocurrencies — each country has adopted its own rules.
Consequently, in response to the rush of demand, investment companies issued various types of structured products tied to the movement of BTC or ETH. The most famous example is the Grayscale trust, which accumulated 640k BTC and 3m ETH on its balance sheet. Another option is the SIX crypto exchange from Switzerland, which together with VanEck, a large investment holding company, took advantage of favorable jurisdiction to issue several dozen (50+) tradable notes (structured participation products) linked to BTC and ETH, with trading volume of over 4.5 billion in 2020.
Now, what about the investor who does not have access to trading in such products due to capital restrictions (the minimum purchase amount is often several tens of thousands of dollars) or because of tax jurisdiction or nationality? A decentralized finance (DeFi) system is then the simplest and most straightforward solution.
Structured crypto-market products in the DeFi ecosystem.
For a long time, the ability to invest in crypto assets has been limited to a “buy low — hold high — sell high” formula, which is simple but highly volatile and unpredictable in terms of resulting gains and losses.
However, with the development of decentralized applications (DAPPs), many other uses of cryptocurrencies have emerged, ranging from providing liquidity to exchange pools of decentralized exchanges (Uniswap, Curve, Cake, etc) or yield generation protocols (Yearn.finance, AlphaHomora, Belt) to placing funds on lending platforms (AAVE, Maker, Venus).
The main advantages when working with DAPPs are:
- Control over funds (funds are held or pass through smart contracts rather than company addresses as in the case of centralized exchanges)
- Flexibility in use (user can choose which protocol to utilize, taking into account profitability and reliability)
- Transparency (all interactions and movements of funds are reflected in a public blockchain registry)
- Accessibility (as there is no need for the protocol to keep other people’s funds, the user does not have to go through KYC and provide documents to a third party)
Deltatheta and Decentralised Structured Option-based Products (DeStrops)
At the moment, the decentralized options industry is going through a period of maturation and rapid growth. The number of funds raised in the market was more than 1 billion (20 protocols) at the beginning of 2022 (compared to 50 million and 3 projects at the beginning of 2021). Structured product platforms account for around a third of this amount. Ribbon, Friktion, Thenatus are the biggest players in the field. The vast majority of strategies used in the operation of these protocols are based on regular (often automated) weekly strategies to sell options at 0.1 delta — covered call & secured put. The platform work consists of creating a smart contract to store the tokens, running a fundraising campaign, and arranging an auction to sell put or call options to a major market maker. The projected returns range from 30% to 70% per annum, depending on the strategy. However, despite a certain amount of innovation, the market has been quick to exploit the weaknesses of this system. As one market participant observed, the tight time-to-start strategies have led to a significant reduction in premiums from buyers, which has halved potential returns from 54% to 27%. The DeStrops team, together with Deltatheta, plans to change the current situation by taking into account the problems of current platforms and proposing alternative ways to address them.
What is planned to be implemented?
- Expansion of the trading strategies list. In addition to the “Covered call” and “Secured put” already used in the market and the sale of “tails”, a “delta hedging” strategy will be implemented — to ensure the underlying asset against price fluctuations. In addition, the possibility of switching between strategies within the platform is being considered.
- More ways of generating additional returns on the underlying asset. The market leader, Ribbon finance, currently offers the option of using yUSDC (third-party protocol stablecoins) and stETH (Ethereum placed in non-revolving storage of the blockchain’s second version). The DeStrops platform plans to implement several models for working with liquidity delivery protocols on decentralized exchanges (Uniswap-style), lending protocols (AAVE, Maker).
- Extensive interaction with alternative decentralized yield insurance applications — e.g. Strips.finance allowing the prospect of funding insurance on a loan or underlying asset.
- Multichain implementation. At the moment, the decentralized derivatives segment is most active on the Ethereum blockchain and Solana. Through Deltatheta’s infrastructure, the DeStrops platform will be able to launch on Polygon, Aurora (with Near) and Binance Smart Chain.
- Cross-chain execution. The current standard is 1 option strategy vault = 1 blockchain. The DeStrops team plans to develop an accounting and execution module within a single platform and fragmented single underlying asset vaults.