Full collateralization a problem for CfD market?

StephanTualStephanTual London, EnglandMember, Moderator Posts: 1,282 mod
Someone kindly pointed out to me today that since 'trustless' exchanges require full collateralization, you lose one of the big CfDs advantages which is leverage.

Does anyone have any idea how to get around this?

Cheers!

Comments

  • que23que23 Member Posts: 14
    I'm told this issue is high on the priority list and people are working on it.
  • StephanTualStephanTual London, EnglandMember, Moderator Posts: 1,282 mod
    Slightly off topic, but while wondering about how to peg digital assets to physical ones not necessarily in one's possession, I found this thread on the Colored Coin group. It describes a modification to the User Backed Currency concept found in the Mastercoin white paper and is quite interesting: https://groups.google.com/d/msg/bitcoinx/3-OlSmMOVVI/RDKp3GgfOAcJ
  • rmsamsrmsams Member Posts: 10
    I think you're conflating two concepts. There is no obvious way to claw back variation margin from a CFD cpty, so in that sense, yes, both parties must post all of there margin up front. But this isn't 'fully collateralised' in the usual sense of the term, which means you have enough collateral to finance a 100% change in the price that is tracked. Nothing stops trustless exchange of, say 5x leveraged CFD in crude oil. It's just that your PnL is still bounded by the margin posted and contract will settle if there is >=20% change in price, with one party being paid all the margin posted.

    Not sure who is working on this, but there is really no "solution" in the sense of replicating what exists in the present financial system where the winning side of a derivatives trade is 'guaranteed’ to be made whole. Someone must absorb the losses of a leveraged party who goes bankrupt. Either the cpty on the winning side of the trade absorbs it (in which case, it's what is currently possible in trustless exch), or someone else does (broker, exchange, ... taxpayer). I don't think socialising leveraged losses is part of the current financial system that we want to replicate in the trustless world, even if we could.

    Important to keep this in mind when discussing the possibility of trustless derivatives to provide hedging of risk within the trustless system. Derivatives and short-selling do not reduce overall risk, they just move around who bears it. And since capital is finite, if there is leverage (which means derivatives or short-selling), there will be a scenario where the losing side goes bust and the winning side’s PnL is capped.

    There are of course lots of possible schemes whereby loss absorbing ether gets loaned out at a fee, and schemes where loss absorbing ether is “promised” by a party with a track record for making variation margin calls. But I’m pretty confident that this second credit-based scenario will not flourish. The trustless world brings into relief that many conventional derivatives are really credit instruments in disguise (cpty risk is assumed away in no-arbitrage arguments).

    I predict trustless exchange will coordinate around contracts where gains/losses are bounded up-front.
  • w0bb1yBit5w0bb1yBit5 Member Posts: 17
    The days of unmargined, uncollateralized derivatives passed with Dodd Frank and EMIR post the 2007 financial crisis. The more-or-less universal model is the futures market. You post initial collateral and pay out price changes periodically (daily). The central clearinghouse stops out anyone who fails to pay up using their initial collateral to make the other party whole and transfers the contract to a new party at the current market. As long as the market is liquid, the solvent participant gets to play the whole contract to expiry. There is no reason this could not be done ex the clearinghouse (which is of course a dreaded Trusted Third Party TTP) using smart contracts. The clearinghouse/exchange does additionally provide the value of standardized expiry, contract size, collateral requirements, etc., which increases liquidity by driving all risk buyers/sellers into a limited product offering. I suppose with some clever rethinking and price discovery mechanisms a liquid market not dependent on standardized contracts is conceivable, but standards do simplify the price discovery process. Starting with a one-day-expiry CfD is one way to begin bootstrapping this. I suspect that in the trustless exchange of the future "credit" will be a bad word. I am dying to see someone demonstrate a working trustless reputation mechanism; I hear the core Ethereum team has one up their sleeve, but I'm not holding my breath.
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