Decentralized Derivative Markets: A Conversation With Vega Protocol’s Tamlyn Rudolph
What’s your background? How did you get involved in crypto/blockchain?
TR: I traded energy derivatives for 15 years, across power, coal, gas, weather and carbon markets. During this time I witnessed rapid technological change with the emergence of solar, wind and battery power which led to communities and individuals emerging as “prosumers” and seeking a more active role in the energy markets. Unfortunately, the underlying market infrastructure was not built to adapt accordingly and remained inefficient and expensive to access.
As a trader, I had been interested in the cryptocurrency industry for many years. However, it wasn’t until we were designing Vega in 2018 that I began to truly grasp the enormous potential of the technology for revolutionizing markets. Blockchains are remarkably useful with the context of monetary systems due to their ability to improve the time consuming, trust reliant tasks of financial reconciliation by orders of magnitude. We are harnessing this characteristic to build software that can run the truly global, integrated markets of the future.
What value does Vega Protocol bring to users?
I actually wrote a blog about the top 7 benefits of Vega to traders, here:
Where do you see Vega Protocol five years from now?
TR: Five years from now, I believe Vega’s protocol will be running a significant number of “long tail” derivatives markets that are used by individuals and businesses to hedge crypto and non-crypto financial risks. Vega will be a destination for entrepreneurs and communities to craft and create their own markets and launch them into a truly global liquidity pool.
Markets are not currently truly global. The existing financial markets are run by monolithic entities in the major cities of the world and are siloed and inaccessible to most businesses and individuals. Whilst the emergence of computerized trading has increased connectivity between markets, the centralized control means that innovation and growth is stifled and slow.
Innovations like Bitcoin and Vega break down the barriers of access and connect all entities globally through a single financial protocol. This means that markets are able to be accessed by anyone at any time and excitingly opens up a world for low cost experimentation by anyone, rather than the purview of the few.
Broadly, I see three key areas that are ripe for innovation using Vega:
1. Emerging industries
Legacy markets typically lag emerging industries meaning that as new risks emerge (e.g. as data breaches, Covid-19, Ethereum gas prices), the ability to hedge those risks is often many years after individuals or businesses are wearing the costs.
A special example of an emerging industry is the blockchain industry itself. Vega’s fully on-chain derivatives mean that individuals and small and medium enterprises (SMEs) with native blockchain based exposure - such as blockchain miners, on-chain fund managers and crypto “whales” can hedge their price risk without needing to use an “off-chain” entity.
2. Increased inclusion
Legacy markets have not adapted quickly to globalization and much of the world does not utilize the sophisticated risk management tools that markets offer. In the past 20 years, there has been a rapid increase in the number of small and medium enterprises (SME’s) and these entities are increasingly dealing in global trade, yet are often excluded from hedging their risks on the financial markets due to their relatively smaller size.
Because markets on Vega can be created with smaller minimum order sizes, the ability to craft a market to suit SME’s will open up these markets to the millions of previously excluded businesses. Moreover, the truly global nature of Vega means that a SME in Africa could be trading out their currency risk with an options trader in Singapore, all without needing to have facilitated the typical business relationships for such activity.
3. Targeted risk
It’s currently expensive and difficult to create and operate a derivatives market and consequently most existing ones are blunt tools for risk management. Lowering the cost of creating and running markets increases the ability to design markets for highly targeted risk. An example proposed to me by a professional market maker was for “balance sheet futures”, where the underlying drivers of value can be accessed more directly.
This also allows for ephemeral (flash) markets that can be created in response to a very localized situation (e.g. for managing traffic congestion). With the global liquidity pools able to underpin such markets, it’s foreseeable that we evolve to be far more targeted and responsive to the way we manage risk.
What are the most common misconceptions you hear about derivative markets?
Misconception #1 - derivatives are a recent invention
Many people think that derivatives are a 20th century financial innovation, but in fact the first written record of a derivative contract dates back to Ancient Babylonian times. The Code of Hammurabi (1792-1750 BC) has 282 laws. Below is the text of its 48th law:
“If anyone owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for the year.”
This is an ancient example of a put option, whereby the farmer has the ability to exercise the right to renege on their mortgage interest payment, should the harvest fail. Historians report a long lineage of the use of derivatives in Ancient Roman times through the present day. This is significant in what it shows us about our human desire to manage risk. This is not a new phenomenon, but something inherent in the way we approach life and business.
Misconception #2 - derivatives caused the global financial crisis
Greed caused the financial crisis, made possible through misaligned incentives, a lack of transparency across the financial system and of course, outright lies.
Derivatives have been a financial vehicle through which much value was lost and this has caused widespread distrust of them, with Warren Buffet in 2002 famously calling them “weapons of mass destruction”. An excerpt from his memo is revealing:
Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. On a micro level, what they say is often true.
I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.
Buffet’s astute observations of the macro risks point to the dangers of derivatives within a concentrated and opaque financial system. Extending this, many commentators have pointed to the role that “moral hazard” played in the financial crisis. The baseline concept is neatly described in this Business Perspectives paper : if I can take risk that afterwards you have to bear, then I might be encouraged to take it; on the contrary, if I am thinking to take a risk that could have consequences just on myself, of course I will act in a more responsible way or have at last a second thought about it.
In the current economic system, traders and bank executives are incentivized to take excessive risk because they do not bear the negative consequences of losing money, particularly for companies that can expect to be bailed out - aka “too big to fail”. Because the risks are non-transparent at either the individual company level, or across the connected system as a whole, accountability is not enforced early, and the distrust of the system and the underlying instruments is an understandable response.
However, open technology like Vega offers a counter paradigm, where the micro benefits of derivatives for individuals and businesses can be facilitated within a decentralized governed macro system that is much more resilient to moral hazard abuse.
Misconception #3 - only sophisticated institutional investors have use for derivatives
All individuals and businesses exist with a world of uncertainty and therefore wear financial risk. Managing this risk is undertaken by varying degrees, such as entering into insurance products or fixing home loan rates. These are, in fact, examples of derivative products and this behavior demonstrates a willingness to lock in certain outcomes using such instruments. I believe that if the financial overhead is not prohibitive, greater access to derivatives will allow even more risk management such as hedging currency and supply chain risks.
What’s next for derivative markets in 2021?
TR: In 2020 we saw significant growth in derivatives trading, across traditional and crypto markets. I expect the shift of volume to centrally cleared venues as continuing given the credit implications post GFC for institutional investors.
Furthermore, I expect 2021 will continue to show growth in the uptake of derivatives in emerging markets, continuing the trends evidenced in India and Brazil. The National Stock Exchange of India is now one of the largest and most liquid single-stock futures markets globally. This has allowed investors to make capital efficient equity type investments as an alternative buying the stocks directly.
Crypto and DeFi:
Crypto derivatives have grown approximately 4 - 6x in the last year, with futures markets dominating the product offering. With the recent launch of Ethereum futures on the CME and numerous announcements of institutional adoption of the asset class, I expect the derivatives volumes to continue to grow across centralized exchanges and in the OTC markets.
In parallel, numerous derivatives type products were launched as decentralized protocols (“DeFi”), with a strong focus on over collateralized lending and an emergence of on-chain AMM liquidity pools (which are particularly useful for illiquid markets). While interesting and experimental, these protocols are neither capital efficient, nor do they utilize fully decentralized professional-grade execution.
I believe that 2021 is the year we see capital efficient, order book decentralized derivatives protocols such as Vega emerge and compete with the centralized crypto alternatives. It’s my expectation that as the blockchain community starts to understand the power and potential of permissionless market creation, will see an explosion of experimentation in blockchain native derivatives (such as Ethereum gas futures).
Further to this, I also expect 2021 to be the year we see traditional derivatives markets traded on-chain; single stock, index, commodity and currency futures traded on decentralized protocols and settled with stable coins.