Blockchain Hedging

Hedge Structure. How other blockchain hedging or option platforms work.

Let's explore how other platforms can use ERC20 tokens as hedging collateral within a smart contract.

Options - example

An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) on or before a specific expiration date. As detailed in the previous chapter.

Using ERC20 tokens as collateral in options requires the development of a decentralized options platform. This platform would enable users to deposit ERC20 tokens as collateral and then write/mint put options against those tokens.

Ways to achieve this:

1. Collateral Locking Mechanism: When a user wants to write an option, they first need to lock a certain amount of ERC20 tokens as collateral in the smart contract. The locked tokens will act as a security deposit.

2. Option Premium: Users who want to buy options will need to pay a premium, just like in traditional options trading. The premium will be used to compensate option writers and to cover potential losses in case the option is exercised.

3. Risk Pooling: Smart contract can pool the premiums and collateral from multiple users. This pool will be used to cover potential losses for option holders if the price of the underlying asset declines.

4. Automated Settlement: The smart contract should be designed to settle options upon expiration. If the price of the underlying asset is below the strike price at expiration, the option holders can exercise their options and receive the agreed-upon payout from the risk pool. If the price is above the strike price, the options will expire worthless, and the collateral will be released back to the option writers.

5. Liquidity Provision: To ensure liquidity for users, the platform can incentivize liquidity providers to deposit ERC20 tokens into the smart contract, which can be used as collateral or to cover potential losses.

6. Market Making and Pricing Mechanism: A robust and efficient market-making and pricing mechanism should be implemented to ensure fair and accurate pricing of options based on the underlying ERC20 token's market price.

This is how other decentralized hedging platforms are built to mimic as close as possible what traditional hedges offer to their clients.

This is the basis on which we will build our protocol, and derived smart contracts that deliver the same financial outcome for both parties whilst mitigating risks.