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Smart Contracts Will Disrupt the Derivatives Market

 4 min read / 

The derivatives market is one of the largest in the global finance world. Virtually every asset type can be traded on the derivatives markets in the form of futures or options. We have commodity and currency futures, which represent the biggest pool in the futures market whereas various stock options and indices are traded in the options markets. However, trading in these markets attracts some of the highest fees charged by brokers and other intermediaries, thereby making it more difficult for investors to make money.

Over the years, most of the trading took place in centralised exchanges like the CME Group and Eurex, but advances in technology have helped to revolutionise the market. The commodities and futures trading market has been disrupted by various trading technologies with more and more traders gaining access via online trading platforms, among other interfaces.

CFDs Give Forex Traders Access to Several Derivatives Products

Traders can now trade various derivative products via platforms offering contracts for difference (CFD) trading, which includes among others, commodity and currency futures. For instance, most of the top forex brokers operating in Europe have CFDs trading on their platforms as do Asian and Middle-East-based brokers.

However, in the US, CFD trading has been restricted since the global financial crisis of 2008. Traders America depend on the CME Group and other centralised exchanges to gain access to the commodity futures market.

Smart Contracts Could Change Derivatives Trading

Nonetheless, this could change soon as the disruptive force of the distributed ledger technology continues to alter various markets. Blockchain has already had an impact on virtually every industry and now could be the right time to target the derivatives market. Some analysts believe that the concept of “Smart Contracts” could be used to implement the change needed.

Smart Contracts utilise the same technology that contributed to the success of the cryptocurrency market. In a nutshell, they are self-executing, self-enforcing contracts that allow the parties involved to transact business transparently, accurately and efficiently on a secured platform, and algorithmically run on a distributed ledger technology.

They are best suited to markets that are built on systems with clear rules and quantifiable terms of agreements. Some good examples include the insurance industry, real estate, and banking among others, and governments are beginning to embrace the prospect of utilising this technology to make transactions in various sectors more efficient.

Government Institutions are Embracing Blockchain

The People’s Bank of China announced last month that it was launching its first “blockchain-based platform, dubbed the Blockchain Registry Open Platform (BROP) for the purpose of bypassing the extensive bureaucracy in the country’s banking system,” Bitcoin News reported.

This is probably the path that many startups and trading exchanges will have to take to disrupt the derivatives market. Derivatives investors use the same concept to trade commodity futures and stock options, and implementing the technology used in smart contracts could make these markets more accessible to retail traders, as well as making it less costly to trade.

At centralised exchanges, commodity futures trading is expensive because of the high fees charged by brokers that act as intermediaries. This gravely affects the efficiency of transactions. However, with smart contracts, all these obstacles could be bypassed, and this might be the key to reinventing the derivatives market.

There are a Few Critics of What Smart Contracts Could Achieve

Nonetheless, there are some who foresee bottlenecks in the idea of using smart contracts to trade commodity futures and stock options. According to a report published by Coin Desk last year, smart contracts may see limited real-life applications in the near future. The report quotes a research paper released by the International Swaps and Derivatives Association (a New York-based trade group for over-the-counter derivatives firms) and London-based law firm Linklaters LLP, which casts a cloud of doubt on incidences that smart contracts may be effectively used to execute transactions.

The authors of the paper argue that

Certain operational clauses within legal contracts lend themselves to being automated. Other non-operational clauses – for instance, the governing law of a contract – are less susceptible to being expressed in machine-readable code. Some legal clauses are subjective or require interpretation, which also creates challenges.

Conclusion

In summary, it is correct to say that smart contracts can disrupt several markets. However, this might take longer than is widely anticipated. Some of the industries tipped for disruption must catch up with emerging technologies first.

Nonetheless, these bottlenecks are not set in stone, and as more governments and corporate organisations continue to embrace the use of distributed ledger technologies, they will eventually be bypassed. It is not a question of if smart contracts will disrupt the derivatives market, but when.

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1 Comment

1 Comment

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  1. Georgio Stoev

    April 11, 2018 at 9:27 PM

    CFDs and other OTC products offer by some brokers are not appropriate for most retail clients, IMO. With leverage of 40-50 times and financing costs of up to 8% monthly they are much more costly than listed futures or options, where average commissions and fee vary but are in the vicinity of $3/contract plus exchange fee.

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