by Jamie Holmes
Decentralization is continuing to infiltrate everything from how we find a new home to how we find work. Now, it is moving into derivatives. To provide solutions to the increasing difficulty of using centralized risk management, Velocity aims to provide a method for autonomous derivatives using Ethereum smart contracts. By working with the Ethereum blockchain, this will allow greater risk transparency and reduces counterparty risk. Margin trading, that is trading only using a fraction of collateral for a position, has long been centralized due to the complexity of managing risk in positions, requiring brokers and other third-parties. However, Velocity removes the need for these third-parties where smart contracts function as an escrow between buyers and sellers as an autonomous clearing house.
“Velocity will enable speculators to hedge risk on the prices of digital assets,” Daniel Cawrey, communications officer at Velocity, told BTCMANAGER. “We know this is something the space needs. Derivatives are essential to the modern financial markets. This is why we are bringing them to cryptographic assets like bitcoin, Ethereum, etc.”
Velocity will allow individuals to hedge or gain exposure to movements on an underlying asset and hold a leveraged position on any given price feed in the distributed finance world.
“To start with, we’ll be offering a smart contract called the American-style collar option as proof of concept,” Cawrey said. An option contract is a bet on the market price of an asset going up (call option) or down (put option) over a fixed period of time. Collar options are the same except that they have a cap on the maximum payout; this feature allows the Velocity system to remain solvent and fully capitalized at all times as well as not exposing the holder of the option to catastrophic losses. Further details about collar options can be found in the Velocity whitepaper.
Capping payouts means that any significant movement in underlying asset prices does not negatively impact the system. Systemic risks are removed and makes the Velocity system immune to ‘Black Swan’ events. Therefore, Velocity’s contracts may not be attractive to investors who want uncapped payouts but this is done deliberately to create a safer market for both hedgers and speculators.
The beta phase of the project will begin in the third quarter of this year with a token pre-sale and beta launch followed by a formal release in the second quarter of 2017. While there are no plans at the moment for Velocity to submit a proposal to The DAO, says Cawrey, the company hasn’t ruled out the possibility in the future. Trade execution, margin maintenance and trade settlement will all be performed by smart contracts on the Ethereum blockchain, whereas traditionally these are the functions of clearing houses, brokers and exchanges.
Velocity is not a single market. Instead it is a platform the amalgamates several markets. Any user of the Velocity platform can create a market by defining the initial parameters which in turn determine the payoff functions of the buyers and the sellers and the underlying asset the platform should track. For example, the initial parameters would be the chosen price feed which identifies which asset you want to hedge or speculate on, the time of expiry of the option contract and the maximum payoff.
For financial markets to function, four mechanisms are necessary; an issuer of a financial contract, a clearing house, an auctioneer and a market maker. Velocity automates the first two of these mechanisms and aims to execute these four functions on-blockchain to provide transparency. This will allow the organisation to realize their goal of transparent marketplaces for any digital asset while simultaneously sustaining system stability.