Exotic Options as Smart Contracts

“Get out of the sun or you’ll die!”, cried the Lizard, “there are only two possible options, here!”

 “Not for me”, replied the Mammal, “evolution has written me a new possibility –I can regulate my internal body temperature.”

 “How is this possible?” asked the Lizard, marveling at the notion that what was once impossible for all animals was now possible for the Mammal.

 “Well, I’m not exactly sure”, answered the Mammal, truthfully.

 “I know how”, offered the biologist.

 The two animals turned towards her…

 lizard6_ir

 

There are persons, including us here at Specmat, who find themselves compelled to think-on and tinker-with second generation blockchain capacities. They share in common the ‘sense’ that combining the algorithmic art of cryptography with digitally-distributed public networks now enables us to write new protocols, which secure new kinds of relationships, whose endogenous capacities greatly exceed the limits of what was previously possible. It’s not so much that smart contracts written on a blockchain to create distributed applications (Dapps) now awaken us to new possibilities, as it is the case that these technologies have actualized a new set of possibilities which were previously nonexistent, and it is therefore up to us to awaken to, examine, and understand this fact, in order to think-on and tinker-with, and deploy their powers.

Nick Szabo, so far as I can tell, coined the term ‘smart contracts’. In his classic essay on the topic, he defines them: ‘Smart contracts utilize protocols and user interfaces to facilitate all steps of the contracting process…The basic idea behind smart contracts is [thus] that many kinds of contractual clauses (such as collateral, bonding, delineation of property rights, etc.) can be embedded in hardware and software we deal with…’[1] This seductively simple notion has profound capacities when deployed on a digitally-distributed public ledger, called a blockchain. In fact, whether Nick Szabo is or is not Satoshi Nakamoto is probably beside the point at this time. We’re currently witnessing the progressive differentiation of an era of second generation blockchain technology, wherein Ethereum and Eris Industries, among others, are developing and enjoining us to develop with them the unbounded number of new protocols which smart contract-enabled Dapps on a blockchain make possible. And here at SpecMat, as we’ve said before, we believe nothing is more suitably commensurate with the wagers of second generation blockchain technology than the second generation options technology called exotic options.

Let us evaluate this claim.

 

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Channing starts a goodserv

Channing believes she has a good idea for a start-up goodserv.

The first thing Channing must do is publicize her goodserv’s existence. She does this by registering her goodserv’s name and product with some Dapp, whose protocol is a distributed name registration database (a kind of Namecoin-equivalent), to which any first-to-file registrant who wishes to start-up a goodserv can go to register her goodserv’s name and product.

Channing registers her goodserv on this Dapp. Now Channing’s goodserv has been made public on blockchain.

The next thing Channing wants to do is fund her start-up. She needs to raise some funds to get things going. The most common method of raising funds is to take out a loan, or some other form of debt (e.g. a bond, a note, some commercial paper). But she’s reluctant to ‘go into’ debt to do so, since she knows this indefinitely indebts her goodserv’s unknown future market value to its present notional value, which is currently at zero. The other common method of getting seed money is to issue equity, so this is what she wants to do; but given the fact that Channing can’t issue ‘stock’ in a goodserv that doesn’t yet exist, and even if she could, she doesn’t want a set of sedentary ‘shareholders’ extracting the future surplus from her goodserv’s net profits, but rather would prefer to enfranchise ‘stakeholders’ working with her towards the mutual, shared success of their common venture –which is, namely, Channing’s goodserv. This means that Channing, in other words, is both aesthetically- and philosophically-disinclined to issue stock, so she will not be selling stock in her goodserv at this time.

What else can she do? How can she fund her start-up costs?

The answer is, Channing will write and sell exotic options. And she will use the cash from their sale to fund the start-up of her goodserv.

 

Writing Optionality

Exotic options are a second generation class of options. Options comprise a class of financial derivatives. Financial derivatives comprise a class of financial assets. Financial assets are commodities that can be bought and sold like anything else. The difference, however, is that anyone can write an option ex nihilo into existence, without having to first own anything whatsoever. To write and sell an option is simply to create and sell for a fee optionality to someone else; and to buy and hold an option gives its holder optionality.

There are two kinds of options. There are ‘call options’, the holding of which gives one the right to acquire something for a certain pre-agreed to price (called the ‘strike price’ K), on or by a future date (called ‘maturity’ or ‘expiration’). And there are ‘put options’, the holding of which gives one the right to part with something for a strike price K on or by expiration. Common financial markets practice is such that this ‘something’ which the call/put holder has bought the right to acquire/part-with is a stock, or some other standardized financial asset. Let us include this notion, but also broaden its scope of possible objects so as to include anything produced by a goodserv.

We have said Channing is going to fund her start-up by writing and selling exotic options. She is therefore someone who ‘operators’ optionality. She is writing optionality. She is creating optionality ex nihilo, and potentially ad infinitum (though this latter phrase, of course, is just a manner of speaking).

Operators are persons who write and sell, and buy and read options. Operators trade optionality. An operator will therefore need to keep a ‘book’, which houses her total portfolio of assets and liabilities: it will contain options which are written and sold (liabilities) and options which are held and may be read (assets), as well as any synthetic assets, cash-currencies, and any referent assets. These contents of an operator’s book are stored at a digital address, which is secured and managed by a smart contract on blockchain.

There are two types of operators, ‘writers’ and ‘readers’; and two types of operations, writing and reading. To write optionality is to compose and issue an option for a premium price to a reader, who now holds the right to choose to acquire some pre-agreed to asset A, whether an object, amount, or service, at a predetermined price K, if mutually pre-agreed-to conditions are met at maturity and/or during the life of the option. To read optionality is to acquire an option for a premium price from a writer, who now accepts liability to deliver some pre-agreed to asset A, whether an object, amount, or service, at a predetermined price to the reader, if mutually pre-agreed-to conditions are met at maturity and/or during the life of the option. For this reason we can see that writers issue optionality for a premium fee, and accept liability if conditions written into the option contract are met; and readers accept optionality, and pay a premium fee for the right to read optionality, thus exercising their optionality if conditions written into the option contract are met. We label the premium price of a call option C, and the premium price of a put option P.

In life, everyone wants options. The state of having options is called optionality. Options are a financial technology for creating and selling optionality. And operators on a blockchain can now write and read options, and will be constantly reading and writing optionality anew.

What we have just said equally applies to exotic options or vanilla options; these are the two classes of options. Vanillas are standardized, and conventionally-structured, and it is true that today ‘anyone’ can trade them, even without a blockchain, smart contracts, or Dapps. For example, today if you were to register (for a fee) in order to apply (for a fee) for an options account (on which you pay a fee) to begin trading options (for a fee) on one the many options brokerage houses, you will most likely only be buying and selling vanilla options (for a fee), and will not have the opportunity to write or read exotics (or if you are able to, there’s a big fee you’re charged). Exotics are bespoke, customizable, and have unconventional structures. And if managed by a Dapp as a series of smart contracts on a blockchain, there would be little-to-no cost for anyone to begin writing and reading options. You’d also immediately have a distributed space, with a self-authenticating, secure public ledger, which would be nothing less than (but also more than!) an autonomous space for transactions that is presently known and defined as a ‘market’.

 

Exotics as Smart Contracts on Blockchain

So let us first understand these two terms, ‘smart contracts’ and ‘blockchain’, and then we’ll consider their use-value for Channing’s attempt to fund her start-up with without indebting herself, but rather by writing and selling for a fee some optionality on her start-up’s future value.

 The most general acceptable definition of a smart contract is a user-agreed-to customizable rule or set of rules which governs case-specific interactions of the users of a blockchain. These interactions, like all interactions in life, produce and are comprised of arbitrary data.

The most general acceptable definition of a blockchain is a digitally-distributed space for the time-stamped storage of arbitrary data.

Like many profound technologies, both of these things sound remarkably simple, and in truth they are: the ‘arbitrary data’ stored on a blockchain could be the content and terms of an economic transaction between two or more parties, the amount of money in an account, the results of casting and tallying votes, or any other arbitrary data that one can imagine, or that two or more people might produce, or require to govern their interactions.

However, when the distributed technology of a blockchain is combined with the hyperflexible, fully-customizable technology of smart contracts, all of the blockchain’s opt-in users are immediately equipped with an interminable, modifiable, secure mechanism to convene, deliberate, vote, and implement agreed-to rules and permissions to create and modify data, through a set of self-administering and self-executing scripts. And these scripts can literally be anything, their potential is unbounded: any user-agreed-to consensus or security rules can be used to manage the blockchain. Once they’re written and agreed to, the scripts are then time-stamped, executed, and publicly registered on the blockchain. They are smart contracts.

Ok, fine. So let’s consider how Channing and her prospective equity partners could use a smart contract on a blockchain. There are a few exotic options that immediately come to mind (though by no means exhaustive), which Channing wants to write and sell. The first exotic she notifies prospective investors she’s willing to write is the following:

Example 1. Compound Options

Compound options are options on options. They are ‘compoundings’ of risky and therefore relatively inexpensive options within which are embedded one or more comparatively more expensive and ideally less risky options.

For instance, if investor R buys a call option on a call option on Channing’s goodserv, R has bought for the premium price of C1 the right to pay the first strike price K1 by the first exercise date T1, in order to receive a second call option C2, which then gives R the right to buy some referent asset A which Channing and R have agreed to ahead of time (and which is written into the terms of the contract) for the second strike price K2, by the exercise date T2. What is this reference asset? Maybe it’s the product or service Channing generates with R’s start-up funding. Maybe it’s a share of her goodserv’s value. Maybe it’s another call option. Maybe it’s a put option. Maybe its cash, which Channing’s goodserv will eventually generate. –But that’s the point: it can be literally whatever Channing and R agree to as the referent.

Why would Channing want to write and sell a compound option?

First off, Channing just needs some fast seed money to give her a chance to pay for her initial start-up costs. By writing and selling a call on a call to R (and other R’s), Channing acquires some immediate start-up funding, earned from the premium price of the option C1. If, after T0, Channing changes her business model, can’t get her act together, or suffers some set-back between T0 and T1, it’s likely R will not exercise the option for the premium price K1. On the one hand, Channing might be sorry to see R not exercise the C1 option by its expiration at T1, since this means she’ll now be lacking the subsequent second-stage funding she would have otherwise acquired, had R been willing to exercise this call option at the price of K1. But on the other hand, Channing owes nothing to R in return. She can walk away debt-free. She owes nothing to no one. She can try something else sometime in the future. However, if Channing makes good use of the funding she acquires by selling C1 to R; and if R sees this; it’s likely that R will either exercise C1 for the additional price of K1, which now gives R the C2 right to buy some reference asset A for some additional price they agreed to ahead; or R could also sell C1 before T1 to some other R, who will exercise C1 for the price of K1. Channing is probably ambivalent as to which of these occurs, since either way Channing is provided with additional start-up funding.

Why would R want to buy a compound option from Channing?

R has familiarized herself with Channing’s goodserv proof of concept, and either really likes its proposal, or at least believes it deserves a chance to succeed or fail on its own merits. But R doesn’t know what the future holds for Channing’s gooderv: it could be the next ‘big thing’, or it could prove unviable and fail. R does not want to lose too much money when taking a risk on Channing’s start-up, but R does want the option to invest in Channing’s start-up now, and possibly even invest more in the future. And after all, if Channing’s goodserv turns out to be successful, shouldn’t R be reasonably remunerated for believing-in and investing-in Channing’s start-up, when no one else would? By buying from Channing a relatively inexpensive call on a call for the premium price of C1 on her goodserv, on the one hand, R will not lose more than the initial premium price of C1, since if by T1 R is dissatisfied with the progress of Channing’s start-up, R simply lets the option expire unexercised, or possibly even tries to sell the option to someone else before T1 to try to recover as much of the C­1 money has possible. But on the other hand, when at T0, R pays the initial premium price C1, R is also acquiring the option to either exercise the option by T1 for K1, in order to now pay a new (and inevitably more expensive) premium price C2 to acquire the new (and more valuable) right to exercise the new call option C2 at T2 for K2; or once again, R could also sell her C1 option to someone else now for a profit, and simply walk away. If Channing’s goodserv begins to experience some success, or if R is otherwise satisfied with its progress, R is financially and/or psychologically remunerated for the early risk she’s taken. But if Channing’s start-up does not succeed, R has not lost very much money. R is not broke. R is not disillusioned. R can invest in something else sometime in the future.

In essence, then, a compound option allows both Channing and R to tailor their contract so as to mutually and equitably benefit from the success of this venture. It gives both of them some optionality. R is invested in Channing’s success. But R need not go broke wagering on Channing’s goodserv. Likewise, Channing is grateful for R’s early support, and is happy to try to reasonably remunerate R for wagering on the future success of her goodserv, when no one else would; but in no way is Channing’s prospective future interminably indebted to R.

However, compound options are only one method by which Channing writes and sells optionality to fund her start-up. She could also write forward start options, chooser options, or barrier options, and there are so many other exotic options as well. Let us briefly consider a few in closing.

Example 2. Forward Start Options

Forward start options are options that will start at some time in the future. The nature of Channing’s goodserv may be such that it will take some time to begin monetarily demonstrating its progress. By writing a forward start option, Channing can write and issue an option to fund the initial stages of her venture, without being compelled to immediately produce any nominal value. And R can hold this option without its value experiencing ‘time-decay’ (theta) as the date of its expiration nears.

Example 3. Chooser Options

Channing could also write a chooser options. After a specific period of time, the holder of a chooser option can ‘choose’ whether their option is a put or a call.

Example 4. Barrier Options

Channing may need to hire employees, in order for her goodserv to succeed. Channing could pay her prospective employees with barrier options. The payoff on barrier options depends on whether the referent reaches some pre-defined price point during a set period of time. This is a method of equitably-enfranchising those who may want to work with Channing towards the common success of her goodserv startup: if they do good work, they will be remunerated by the rise in value of their option; if they do not do good work, the value of their option will decline.

Channing can do all of this by easily downloading an application on her smartphone or computer, which allows her to advertise and customize the writing and selling of any of these four types of exotic options. A liquid market in exotics options will ultimately reduce transaction costs for both parties, and improve its market stability. But already from the beginning, if these exotics are executed by Dapps, written as smart contracts, and transacted on a blockchain, there is no reason for there to be anything but the most marginal of costs even from the outset.

But this is only one possibility. In a future post, SpecMat will examine how to englobe these Dapps within a DAO, by constructing a universal synthetic CDO.

 For the Mammals we are….    

neural_network_by_thenhan-d3cil2o

[1]“Formalizing and Securing Relationships on Public Networks”, Nick Szabo, First Monday, No. 9 Sept. 1997

 

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