Tracer Drop Episode #02: Perpetual Swap Applications

Perpetual Swap Applications

Agenda

  • Retro: Loaning out the Treasury (outstanding discussion from last week) - Treasury Management
  • What are perpetual swaps - where did they come from, why are they only feasible / desirable now?
  • Why are they significant?
  • How can they best be used
  • What are we most excited about?

Call Recording Link: here

Call Notes

Retro: Treasury Diversification

  • Interesting idea in terms of treasury management; what if you could use the treasury to loan to other projects ?
  • The idea, through governance, would be to make loans to other projects within the Tracer ecosystem that are viable, interesting or otherwise added value to said ecosystem
  • This ties back into a central question; what should we do with this treasury that we are busy holding?
  • Ideally, you want to have a very large (huge) and visible treasury, which some people may perceive as lazy capital and inefficient
  • RMIT holds the opposite view; hold vast amounts of capital which signals that you do, indeed have funds
  • In terms of investments, and similarly loans, if you start lending it out, there is the risk you may not get it back
  • RMIT is not convinced with loaning funds out and would prefer the use of grants, in terms of financing, paying people to do something
  • In terms of lending to insiders, this again is not a good idea
  • You do not want the treasury to be stolen, and the most likely people to steal are insiders
  • The ideal situation is one where, the treasury can be seen and acts as a signal of quality, however it is difficult to spend, loan and invest; in short it is difficult to use that money

Perpetual Swaps

  • Perpetual swaps are a type of futures contract

  • Perps have been a part of modern financial products for a while, however they have exploded in the crypto space

  • A perp is a future that doesn’t have a terminal contract, it goes on in perpetuity, forever

  • This is important because it is convenient, allowing you to not have to roll over contracts and the ensuing hassle

  • This is interesting in the crypto space because perps were developed as a hedging tool

  • Initial insight was that there were many relatively illiquid markets for derivatives where you missing either an easily observable asset price

    • Eg: Real estate market - can observe the flow of the asset (rents), but not the stock of the asset
  • Instances where these markets are relatively illiquid and difficult to create derivatives, compared to equities (deep, liquid and the underlying asset is price)

  • With a normal future there would be a delivery date, if you were holding you would receive the good

  • However, if you were simply trading on this market adding liquidity you would have to sell out and buy back in again

  • Swapping from one contract to another exposes you pricing risks, whereas what a perpetual future or perpetual swap does is that eliminates that pricing risk component

  • With a perp you never, ever have to take delivery, you simply trade in and trade out and get the hedging benefits without ever having to acquire the item

  • The main benefits are; 1) you don’t have to take physical delivery of goods and 2) you don’t incur the risks and transaction costs of swapping in and out of contracts

  • Futures can be used to hedge risk, however they can also be used for speculative purposes, i.e. take on risk

  • A lot of what’s occurring in the crypto space is a combination of:

    • Not wanting to deal with actual custody of perceived risky assets, such as Bitcoin
    • Wanting to long without actually acquiring the underlying asset, which lowers transaction costs
  • Here you’re not necessarily trying to hedge against the price of Bitcoin, you want to speculate either long or short, and use it as a way to add leverage

  • Two simultaneous things are occurring:

    • Hedging is dealing with future uncertainty and missing information, essentially offloading future risk
    • Simplify the transaction costs and offload transaction risks/custody risk
  • Combine these two simplifications, you can do a third thing which is start to add leverage and speculative power

  • This all converges beautifully in the crypto market where people want all of these features

Oracles

  • In futures the price is ultimately derived from the spot market price, because you will receive the good which can then be sold on the spot market
  • This is not possible in a perpetual swap, because you never receive the good
  • Behavioural finance believes that farmer markets are not efficient in an informational sense, and the solution is to drive more information and data into the market
  • Here is the problem and here is the reason why this works well in the crypto space, because all information is local
  • Trying to communicate local data to a broader audience you run into trust problems
  • This is a wonderful blockchain application, you can overcome the trust problems in communicating local data
  • You need to have this local data, and then you need to put his data in a market, price it and trade it
  • However you run into two problems:
  1. Illiquid information
  2. Measurement problems
  • Consider the housing market, there are infrequent trades and consequently infrequent prices, nobody is ever going to price this on a market
    • In this original instance, Robert Shiller (the inventor of perpetual swaps) created an index of housing prices
  • More or less, what he essentially did was creatine oracle, a standardised mechanism of bringing a price feed to the market that could be traded
  • The challenge in this space is to think about what sort of local information can you create an index of and bring to market that people can trade?

Applications of Perpetual Swaps

  • Obvious cases are prices
    • Eg: could take the CPI and PPI and strip out the component pieces and re-order it/recombine and index and trade it, such petrol prices
  • Wages
  • When Shiller wrote his house price index in the early 1990s, the quality of data, compared to today was of a much, much poorer quality
  • We now have incredibly high quality data feeds and all sorts of indice, and most importantly there is a trusted mechanism whereby you can bring that data to market, i.e blockchain
  • Now is the time to be getting into this space, the amount of data and information that is flowing into the markets is massive and the cost of innovation is low
  • With perpetual swaps, you have something you can hedge against really any price feed or any feed in general that has some continuous output
  • RMIT from a speculative perspective is most excited about NFT and DAO futures
  • However, the big and unexplored use cases revolve more around hedging, rather than speculation
  • In terms of hedging, you are thinking about what are the big, illiquid risks that everyone is taking on, and that they don’t want to take on, but can’t offload because there is no market with which to do so
  • Two or three, big, huge ones:
  1. Career risk, you want to hedge against robots, hedge your career which has required a large amount in human capital in acquiring skills and education and the unhedged risk is the automation of your job
  • Need some kind of index of development of that technology that is pointed at some kind of asset which can then become a perp which can be bought
  1. Regulation risk; regulation is a cost, specifically with long-lived assets (20,30,40 years), you don’t know what future governments are going to do with your asset
  • Need a regulatory quantity, possibly quality, that enables a feed to be built

  • If you can construct an index that measures the flow, or the cost/quantity of something that is going to incur a cost on your asset, there is another perp use

  • Important for the crypto space to realise is the sheer number of indexes

  • The main point is, it’s not just that these indexes exist, it’s that through perpetual swaps there is a way to incentivise the production of those indexes

  • If it is suddenly profitable to more regularly/accurately update these indexes, then these indexes, and their data is only going to get better and better

  • More information is going to be driven into the economy, which in turn makes it richer

  • Unclear now which indexes are going to be valuable, however the market mechanism is cheap, you can easily create a market and test its viability

  • Costs of failure and experimentation have fallen

  • Only limited by your imagination and the ability to find a suitable data set/create your own data set

  • The big use case for speculation revolves around scientific and technological development

    • Venture capital scenarios where you are betting on early stage businesses/technologies etc
    • These have the characteristic of not wanting to actually buy the underlying asset, and then take up a position
    • You want exposure to something where the feed is not the value of the asset but something more abstract, such as number of citations, or number of people working on the project etc
    • You need an index that tracks activity

Conclusion

  • What is exciting about perpetual swaps and what Tracer is building, is the clear recognition that it is information that is the absolute centre of economic innovation, and subsequently economic growth
  • It’s not only about using information that currently exists within the economy, but incentivising more information and better information, which in turns makes the economy wealthier
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