The era of structured products is coming to an end. These are financial instruments that have different payouts, like derivatives, based on different outcomes. They are different from derivatives in that they are built like bonds. One of the biggest short coming of these is their lack of a large secondary trading market before maturity. That is, if you try to sell one before its maturity date, you might get what the financial industry calls a “haircut”. In finance this is commonly referred to as liquidity risk.
The good news is, liquidity risk doesn’t have to exist. With blockchain, the new ledger for tracking financial transactions based on hash mining and communal validation, you can structure any number of payment scenarios and not be concerned about the ability to carry these out before a certain date.
Why is that? It sounds too good to be true. Well, for one, you don’t need to structure a customized derivative product like a bond. It can truly be a weighted sum of the underlying positions and it can be valued, or marked to market, as often as those positions are. You might wonder if this is not the same as an exchange traded fund (ETF). It’s not because even these funds cannot possibly track the underlying investments perfectly, for many reasons including their need to constantly rebalance their holdings to match the target weightings.
So if blockchain is so great, why can’t all securities trade as blockchain entries – a sort of ecosystem of crypto currencies each representing a company or an expected financial outcome? They can! In fact, blockchain based exchanges for securities already exist and in contrast to the dark trading pools you might have read about, they are transparent and subject to communal validation.
So why does this mean structured products are going away? Because blockchain provides a method for creating guaranteed payouts linked to predicted outcomes without the cost of bundling the transactions into a bond. This lowers transaction costs dramatically and also expands the possibilities for complex derivatives.
Many structured products will pay a multiple of the change in the underlying security IF and only IF, that security is above or below a certain threshold. Even setting this simple chain of events up into a bond is not simple. Usually there are various banks involved – the issuer, the reseller, and the buyers and sellers of the underlying securities. That is, a lot has to go right for this instrument to work the way you want it to. With blockchain, you could create derivatives of infinite complexity – for example based on the logarithm of the change in the underlying security or something even fancier like a polynomial function of four variables, each corresponding to a measurable financial ratio.
Of course the end of structured products will not be overnight, and like other financial instruments that had their heyday pass they will not go gently into the night. But wait and see and you just might own a blockchain based product in the next five years.