Applying Options Methodology To Crypto Trading
“When I think about blockchain and cryptocurrencies, the first thing that comes to mind is the potential for self executing derivatives-- smart contracts with no counterparty risk and no third parties,” said Kevin Darby, Managing Partner at Blue Trading Systems. “Code that is written into the blockchain can be called upon to send currency to a specific address conditionally. For instance, a vanilla call option payoff could be easily replicated in a smart contract on the Ethereum network; the holder of the option could even send exercise instructions directly to the contract without aid of an intermediary – this is something that couldn’t be done before.”
Kevin Darby is a self-proclaimed math and finance nerd. He spent a big part of his career as a quant and engineer for an options trading firm. After discovering the potential of blockchain and cryptocurrencies, Kevin began researching how his knowledge of professional grade derivatives technology could be applied to the crypto markets. We sat down with him to talk more about this and to learn a little about what he is doing to help solve some of the most pressing matters in the digital assets space today.
Kevin’s career in options started after a year and a half of undergraduate studies at the University of Illinois
“I dropped out of college and got a job as an engineer at Blue Capital Group. I stayed there for 12 years before a group of us spun out in 2011 and created Blue Trading Systems (BTS), which provides an advanced derivatives platform for professional traders,” he said.
While mainly focused on professional trading software, BTS usually embraces one or two research projects per year. Given blockchain’s emerging role in professional finance, Kevin started trying to solve some of the largest problems facing the digital asset industry. He believes that the largest of these issues is related to transactions per second.
Transactions Per Second
“If you look at all the major crypto transaction rates, they vary significantly, but are not fast enough,” said Kevin. “For example, Ethereum’s rate is 10-15 transactions per second while Bitcoin is between 3-7 transactions per second. Some currencies take as long as an hour to transfer. If these currencies are ever going to be used as a normal form of payment, this needs to be solved.”
Darby believes the solution lies in the structure of blockchain itself.
"We have a prototype solution that involves changing the structure of the blockchain to allow better average throughput, but there is a lot of nuance that has to be correct in order for determinism and security conditions to obtain. Proving this out is going to be fun."
An Inherent Security Risk
Kevin also considers security to be a major issue that needs to be addressed. He brought up the recent attack on Ethereum Classic (ETC), which cost more than $1 million.
“51% of hashing power was controlled by one entity and they used that control to rewrite the blockchain and spend money twice,” he explained. “An alternative consensus mechanism or hybrid proof-of-work/proof-of-stake approach could be effective in reducing the probability of a successful attack. Plus, some algorithms could help make crypto green and not spend so much energy reaching consensus.”
Kevin believes he has found a way that could to reduce the probability of an attack in his research.
“Using statistical methods drawn from our experience in options we can greatly reduce the probability of (and increase the penalty for) potential collusion,” he said. “Also, much has been said about better wallet and key security. Those are important points, but in this instance none of that would have helped. Hackers rewrote the history to move currency out of people’s wallets. In order to create insurance products like FDIC or SIPC for crypto, hacks like this need to be low probability events, and that’s the crux of this portion of the research. Fiat banks are still robbed on occasion, but it doesn’t happen often enough to make them uninsurable”
An Influential New Technology
While there are still challenges to be addressed, Kevin believes blockchain is here to stay.
“This is different and new and something that members of the finance community have to wrap their heads around,” he said. “We are essentially trading and spending large 'special’ numbers created out of a software network. This has deep ramifications as to how we define money.”
Though he believes that smart contracts can provide the same exposure and benefits as derivatives contracts, he thinks the true innovation lies even deeper, “the money can do stuff now, and that's a big deal. This is a fundamental change”
While Darby has been able to apply his options background to digital assets and understand the industry problems enough to come up with some potential solutions, he is still concerned about price volatility.
“Price volatility is too high for real means of economic exchange right now,” he said, but he believes that problem to be solvable too. “To really test that, well, we’d have to actually launch an alternative crypto currency implementation. I hope we are able to do that soon ”
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