Synthetic Cryptoassets: Did Everyone Suddenly Forget 2008?

I ended my thoughts in “Iatrogenics and Derivatives on the Blockchain” around market fundamentalism and the concerns I have over the implementation of CDS on the blockchain. 1 Applying sophisticated technology is not exactly a strength of the financial system. CDS should be banned.

The financialization of poorly understood assets that were complex, opaque, and fragile led to the 2008 Financial Crisis. Yet, there are those who are calling for derivate products in crypto markets along with a stablecoin to eliminate dry powder risk and streamline trading.

Many are advocating for crypto derivatives because new derivative products would legitimize the crypto market by increasing mainstream attention, liquidity, and trading. This is a pure liquidity play by those who do not have real skin in the game. It’s horrific to allow retail investors to be sold complex, volatile, and often leveraged financial products based on tokens with underlying market integrity issues, but also substantial technical and fundamental questions. 2  The ease of regulatory capture—particularly in areas that want to be the next Silicon Valley (whatever that means) —compounds this concern.

There is currently no consensus around a valuation framework for tokens. Additionally, there are complex debates around consensus mechanisms. I’ve been thinking about what an efficient market hypothesis valuation framework would like with option pricing for cryptoassets. First, I’m firmly against the Black-Scholes pricing formula. Ok, let’s say Efficient Markets are real. Applying k, vega, and sigma to the early days of Facebook is equally absurd to applying those greeks to Ethereum today.

Furthermore, for many bitcoin owners, bitcoin is already synthetic in the sense that the majority of owners store through centralized intermediaries and not their own wallets. As transactions with crypto derivative products increase, it would leave many traders overexposed to DDoS attacks and centralized risks because of the necessary derivative clearinghouses. Speaking of which, there has been no discussion on the roles of those clearinghouses too. The current standards for crypto exchanges today are absolutely not appropriate.

Furthermore, idea of truly synthetic bitcoin and bitcoin futures, which has the appeal of size and liquidity, will add unnecessary volatility towards markets. None of this would actually impact the price of bitcoin or adoption of crypto. Again, it’s a liquidity play by those that lack skin in the game.

As I noted before, the problem of a derivative is that if the underlying asset has mild fat tails, the derivative produces far fatter tails. The basis risk for crypto assets is higher given that tokens already have massive fat tails.

I completely understand that the crypto community wants to guard against excess regulation. But I think it’s prudent that advocates should be tilted towards preventing any more negative press around crypto markets; a massive crash caused by synthetic crypto assets would undoubtedly set the movement awry.

Decentralized networks and permissionless innovation is the future of the internet. I believe derivative products are also key risk management tools that would be important for the open finance vision. However, I think the rush to add complexity to the technology and the ideas surrounding them would be very bad.