ICOs raised an estimated $5.6 billion in 2017 fueled by the emergence of an entirely new class of digital assets — cryptocurrencies. As the cryptocurrency market continues to progress, the underlying blockchain technology has sparked interest in tokenizing traditional financial assets as the trust-minimized and decentralized nature of the technology offers combined transparency, automated execution, and security concurrently.
Compared to the traditional financial markets, that include equity, debt and derivatives assets, the $5.6 billion raised by ICOs is minuscule. The derivatives market alone (on a notional contract basis) is estimated to be worth $544 trillion. The opportunity for blockchain technology to revolutionize how financial assets are traded, secured and stored is vast and yet to be fully discovered.
Platforms like Level01 aim to introduce and connect financial assets to blockchain technology by creating a hybrid, Peer-to-Peer (P2P), brokerless, marketplace for derivatives trading. So how could the financial market’s ecosystem benefit from blockchain technology and how would such a platform work?
The Traditional Ecosystem of Financial Markets
The derivatives market is considered one of the most significant developments in modern financial history and derivatives are one of the core financial assets classes along with equity and debt. Derivatives allow investors to hedge risks and gain exposures to the price of underlying asset(s) (other asset classes and instruments) without actually requiring the investor to purchase or sell the asset.
Derivatives like options — subsequently can encompass all of the financial asset types. They are contracts between two parties that reference a fixed (strike) price of an underlying asset that allows them to realize profit or loss as the market price of the underlying asset moves. Notably, derivatives can be traded on regulated exchanges or OTC markets. Most retail investors do not have direct access to trading derivatives on financial exchanges and the access is even more limited to the Over-the-Counter (OTC) markets. Moreover, while OTC markets generally can offer more opportunities and diverse sets of derivatives, they are less regulated than exchanges and present higher risks to investors.
Trading of financial assets in their current form is inherently limited in numerous ways. Access to markets by retail investors is dominated by brokerages. While brokers are supposed to act as trusted third-parties, the lack of transparency is dangerously high, compliance is inefficient and hard to enforce, while operational friction and transaction costs are still significant. Also, it is worth mentioning that a notorious lack of transparency in the OTC derivatives market played a major role in the 2008 Financial Crisis which led to an increased pressure to move more derivatives onto exchanges.
Centralization and high barriers to entry also confine the derivatives market to institutional investors or knowledgeable retail investors who have experience navigating the nuances of these markets. The operational and transactional friction of trading financial assets is also exorbitantly high with transaction fees, withdrawal delays, and market manipulation common or frequent.
Benefits of Building Financial Assets on The Blockchain
Blockchains and smart contracts built on top of them are ideally suited to provide solutions to common problems limiting traditional financial markets. Smart contracts are designed to reduce transaction costs, enforce economies of scale, alleviate counterparty risk and enable trust-minimized, transparent execution of agreements over a decentralized blockchain network.
Tokenizing assets is the process of converting a financial asset into a cryptocurrency token with a programmable, digital wrapper tethered to a blockchain that can be traded on secondary markets and can be hardcoded to remain regulatory compliant. Tokenized assets on the blockchain as smart contracts (i.e., represented by a standard such as Ethereum’s ERC-20 token contract) can lead to automatically enforced compliance, removal of third-parties (brokers), greater access to derivatives for investors, substantial reduction of transaction costs, and enhanced transparency. Tokenizing assets can even provide greater liquidity to traditional financial markets by increasing market depth through enabling interoperability of diverse assets. This effectively removes traditional frictions by standardizing token interactions and providing access to 24/7 cryptocurrency markets that settle quickly with a blockchain as the underlying layer.
Tokenization of assets can provide a broader and richer access to investment products, solutions and even asset classes to investors. A broker and underwriter dominated industry (underwriters are high-paid investment bankers that perform issuance of securities) could be revolutionized with a highly automated, decentralized and significantly cheaper blockchain infrastructure. Imagine bringing new investment securities directly to the public market, rather than a selected few individuals at a fraction of a cost compared to what it currently costs to launch a new IPO.
Solutions that focus on bringing financial assets on-chain are already emerging with some serious momentum. Polymath’s ST-20 security token interface allows for programmable equity by building in customizable parameters for security assets. The Level01 platform strives to offer a new paradigm in derivatives trading by removing the middlemen and creating a trustless P2P derivatives exchange implemented to ensure timely, guaranteed and trusted derivatives settlement on the blockchain.
While full suites of blockchain-based derivatives may be on the horizon, Level01 offers the opportunity to trade some of them in their popular current form in a decentralized environment that provides the full benefits of blockchain technology.
Level01 – The Trust-Minimized P2P Derivatives Brokerage
At a high level, Level01 is a decentralized P2P derivatives exchange that uses a hybrid on-chain/off-chain architecture and is powered by its proprietary Fairsense AI analytics. Level01 empowers users to take control of derivatives trading by offering a transparent, non-custodial yet collateralized (guaranteed) execution and settlement of derivative trades, such as options.
The hybrid architecture of the Level01 platform is important for 2 primary reasons:
- Platform allows contracts to be settled on-chain to provide maximum transparency and guaranteed settlement of proceeds upon maturity of the contract.
- Mitigates scalability deficiencies of current blockchains by utilizing a centralized off-chain trade matching/price discovery service engine.
As part of the modular design of the Level01 trading platform, real-time and historical data feed will be provided by Thomson Reuters via a third-party Oracle service integrated with their API.
The FairSense AI technology will power the price discovery mechanism of the Level01 platform by using cross-stream analytics typically only available to institutional investors. This naturally reduces the barrier to entry to the derivatives market for the platform’s users by empowering them with analytical tools otherwise not available to retail investors. Further, FairSense will provide fair value pricing to all contracts to enhance P2P liquidity and reduce problems associated with illiquid or fragmented markets that hurt retail investors.
StellarX Decentralized Orderbook
StellarX is a recently launched front-end interface for plugging into the Stellar blockchain. The Stellar blockchain functions as a universal order book where assets including stocks, bonds, fiat currencies, and cryptocurrencies can all be seamlessly traded.
StellarX uses “tethers” for fiat currencies and traditional financial assets such as bonds. These tethers are a temporary placement for the eventual transition to an open order book where all listed assets are natively connected to the Stellar blockchain. Notably, StellarX has zero fees and instant settlement due to the underlying federated consensus model of the Stellar blockchain.
The StellarX platform is entirely P2P and is a non-custodial interface for all of the listed assets.
Decentralizing traditional financial markets and leveraging the blockchain for its transparency and automation provides numerous benefits to reducing transactional and operational costs. Tokenization of assets presents an opportunity to further lower the barriers to entry for mainstream investors and create more flexible, digital financial assets. Platforms like Level01 provide the solutions to trust-minimized P2P trading of derivatives of today and the tokenized assets of tomorrow.