Synthetic Tokens and Perpetual Future Contracts: The Future of the Derivatives Industry.

Everyone talks about the tokenization of real assets, but I'm more excited about the tokenization of liquid assets, especially the tokenization of financial derivatives.

The derivatives industry, both the OTC (Over-The-Counter) and ETD (Exchange-Traded-Derivatives) one, moves more money than anything else you could name me.

I am truly passionate about how synthetic tokens and perpetual futures contracts based on both L1 and L2 blockchains could transform the industry by making derivatives pricing very simple and cryptographically guaranteed, eliminating the large number of dealing intermediaries needed to set prices in today's fiat markets.

This is a simple research paper describing the potential for blockchain derivatives to outperform and replace the exchange-traded and over-the-counter fiat derivatives markets.

Traditional derivatives must change. They are dangerously centralized, preventing sufficient innovation, transparency and ethics needed in today's trading industry.

Content

• What are ETDs and OTCDs?
• What are synths and perps?
• How do synths and perps function?
• Which are the benefits of synths and perps over fiat ETDs and OTCDs?
• Use cases of synths and perps
• Which industries could they completely disrupt in the next 5 years?
• Some of the DAOs, companies, and protocols building the industry

What are ETDs and OTCDs?

Before starting to explain on-chain derivatives, let's recap what ETDs and OTCDs are.

Exchange-traded derivatives (ETDs) are financial instruments traded on an organized exchange where the value is derived from the price of an underlying asset. These derivatives mainly include futures, vanilla options -extremely popular in the US-, and exchange-traded notes. ETDs could completely be based on synthetic tokens in the next 10 years.

Over-the-counter (OTC) derivatives are financial contracts that are traded directly between two parties (bilateral contracts) outside of a formal exchange or regulated intermediary. These derivatives mainly include CFDs, spot FX, exotic options, or swaps. In the US, they call swaps to nearly all OTC derivatives. OTCDs could completely be based on perpetual future contracts in the next 10 years.

What are synthetic tokens an why could they replace ETDs?

Synthetic tokens are blockchain protocols adhered cryptographically in real-time to oracle-based decentralized databases. These databases, and not the supply or demand of the token, function as the underlying price of the instrument.

Unlike traditional derivatives, where the pricing must be manually configured by a group of liquidity providers, clearing firms, and market makers, the price of a synthetic tokens is mathematically guaranteed by a hybrid smart contract pledged to the underlying database.

A great analogy to understand synthetic tokens are indexed ETFs, which their prices are represented by the price of the underlying index, and not supply and demand.

Nevertheless, the indexed ETF manually owns an underlying mutual fund or other kind of open-ended equity fund which, at the same time, owns a basket of the equities of the index. This is why this financial instrument is not synthetic, but rudimentary.

In a synthetic token, the token is literally pledged to the underlying database without the need of complex financial engineering. The token is cryptographically guaranteed by a hybrid smart contract, and the liquidity is supplied by an AMM.

Synthetic tokens allows to create, indeed, an unlimited amount of financial instruments -as there are an unlimited amount of databases-, allowing investors to follow trends in all kinds of on-chain and off-chain data structures without complex financial and regulatory engineering.

As we will dig in later, synthetic tokens allows to harness an unlimited amount of trends such as local real estate prices, population fluctuations, public debt increase, real-time net-worth fluctuations, any kind of leveraged security over on-chain or off-chain instruments without margin risks, as well as an unlimited amount of non-volatile exotic derivatives.

Benefits of synthetic tokens

• Easy financial engineering: Synthetic tokens are pledged in real time to an underlying database and this connection is cryptographically guaranteed by a hybrid, cross-chain smart contract and funded by an AMM. In contrast, traditional exchange-traded derivatives requires sophisticated mathematical models, stochastic calculus, Black-Scholes models, and market dynamics. Pricing, valuation, and risk management demand specialized knowledge in quantitative finance.
• Avoidance of supply and demand pricing: Free float securities, -securities which their prices depend on the fluctuations of supply and demand-, have a few problems. First, their prices nearly never represent their value -mostly always are overvalued or undervalued-, and second, their prices are easily manipulated by institutional players. In fact, this is what happen with most liquid assets; they are always or in a bubble or in a recession, and can be manipulated by the strong hand. Synthetic tokens always represent the underlying database value.
• Decentralization allows an unlimited amount of derivative possibilities: Synths could be decentrally pledged to any kind of database from companies such as Statista, the World Federation of Exchanges, Bloomberg, or the International Monetary Fund. In contrast, traditional fiat derivatives can be issued only in centralized exchanges and are subject to strong regulatory rules.

Examples and references:

• Synthetix (SNX): Ethereum-based protocol for creating and trading synthetic assets.
• Uniswap: Decentralized exchange using AMM for token swaps.
• Compound Finance: Lending protocol enabling lending/borrowing of cryptocurrencies and synthetic asset creation.

Use cases - Synthetic tokens brainstorming

• Blockmas token: a token adhered in real-time to the Total Token Market Capitalization

Invest in the entire blockchain market capitalization with a single token and benefit directly from the coming liquidity penetration of central banks, CBDCs, and institutional players in blockchain technology.

The Blockmas token could be a token adhered to 1:1, in real-time, to the Total Market Capitalization Index, in $T (trillions), so that if the market cap is $2T, the token price is $2.

With $120T in WFE traded security assets, around $20T in central bank reserves, around $20T in institutional real assets, and an outstanding $1.200T in financial derivatives, the tiny blockchain market capitalization of today's token market is less than 2% of global wealth and has an outstanding probability of growing aggressively with annual compound interest over 10%.

Cryptocurrency holders could not benefit directly from an increase in CBDC liquidity, while investors in the blockchain market cap of this synthetic token yes. In fact, investing in the blockchain market capitalization is investing in blockchain technology per se.

• Billionaire tokens: a security token adhered in real-time to the net-worth of some multi-billion dollar entrepreneurs

With billionaire tokens, investors could replicate the net-worth in real-time of the world's wealthiest entrepreneurs (by Forbes or Bloomberg), as well as replicate the Global List of them.

There is absolutely no need to engineer your own investment portfolios if you can replicate the best ones.

• Population tokens: a security token adhered to population fluctuations

Population growth or declines are easily predictable trends in economics and social studies, and now investors could benefit directly from their trends.

With population tokens, investors could both expose themselves long and short to the population variations of the main nations worldwide, including bullish trends as India, Nigeria, or Indonesia, and bearish trends like Japan.

• Debt tokens: a security token adhered to public debt

Debt is the epicentre seed of our monetary system, and now investors could harness the ever-growing public debts of nations worldwide.

• GDP tokens: a security token adhered to GDPs

With a GDP compounded growth of 6.1% for more than 20 years, investing in the GDP growth of now mainstream emerging markets like China, India, or Brazil could have been an profitable investment for conservative investors.

Nowadays, there are tens of GDPs growing or declining massively, including in Sub-Saharian Africa and Southeast Asia, and investors could harness their trends with synthetic tokens.

• Real estate tokens: a security token adhered to local real estate prices

Imagine the possibility of investing in real estate asset trends in any corner of the world from the comfort of your home. With real estate tokens, investors could invest in real-time trends of real asset trends such as land, residential, industrial, commercial, alternative, or tourism real estate, on all continents.

• X10 tokens: security tokens multiplying x10 the volatility of underlying assets

Invest leveraged with a X10 multiple without worrying about margins in the main blockchain and fiat investment products, both long and short.

• Value shares: a security token adhered to company's internal growth

Imagine an equity market adhered in real time to the EBITDA and earnings of their companies with a decentralized committee deciding which multiples to establish for each industry, so that companies are valued in public markets such as in private markets: in a more rational way.

Perpetual Future Contracts

Perpetual future contracts are blockchain over-the-counter derivatives without an expiration date. Perps are, fundamentally, the same as CFDs -the leading OTCD outside the US- or swaps -as they call OTC derivatives in the US- but in the blockchain space.

If you are a US resident, you may have forgotten how CFDs work after the SEC CFD ban in 2009, but they are no more than over-the-counter derivatives without an expiration date. So they are like futures, but over-the-counter, and without an expiration date. Perps are like on-chain CFDs.

OTCDs are, without doubt, the most controversial derivative type in the financial industry. This is where the Wolf of Wall Street is real, but in financial centres such as Cyprus or Malta. Over-the-counter means the liquidity pool must be created outside a regulated exchange, and mostly all OTCDs brokers indirectly or directly control that liquidity pool -profiting from their client losses.

I have a complete article outlining A-book vs B-book execution. All I have to say is that on-chain perps allows to create OTC derivatives where the A-book execution is guaranteed by an AMM and all traders are connected to other traders under a p2p basis.

Benefits or perpetual future contracts

• A-book-only Execution: In a DEX utilizing an AMM for perpetual futures contracts, trades could be executed exclusively via the A-book model. The AMM protocol facilitates trades by matching orders within the liquidity pool, ensuring decentralized execution without an intermediary. Trades occur peer-to-peer, directly between users, with the AMM algorithm determining prices based on the pool's liquidity.

Examples and references:

• DydX
• Uniswap
• Sushiswap

Conclusion

In summary, synthetic tokens simplify the financial engineering of exchange-traded derivatives and perpetual future contracts add transparency to the over-the-counter derivatives industry. These transparency and simplicity increases the scalability of derivatives, which work mainly with models from the 80s.

As we have written, some of the most influential perpetual future contracts organizations include DEXs such as Dydx or Uniswap, while in the synthetic tokens space, you can find Chainlink or Synthetix. Innovations implemented by these organizations could be the ones that replace today's functioning of CFD brokers, futures brokers, vanilla options brokers, exotic options brokers, exchange-traded derivatives issuers, and over-the-counter derivatives issuers.

References:

• Buterin, V., & Poon, J. (2017). Plasma: Scalable Autonomous Smart Contracts.
• Luu, L., & Teutsch, J. (2016). Making Smart Contracts Smarter.
• Kuo, T. T., & Chang, C. C. (2020). The DeFi Applications and Platforms: An Overview and Evaluation Perspective.
• References:

• Bartlett, R., & O'Connell, J. (2020). The Role of Execution Policies in Contracts for Difference Trading. Journal of Financial Regulation, 6(1), 87-105.
• Dai, J., & Sornette, D. (2021). DeFi and the Future of Finance: Understanding Decentralized Finance. arXiv preprint arXiv:2103.01263.

Francisco F. De Troya

Algorithmic trading & derivatives professional

LinkedIn / TradingView / Github