S&P 500 options on the blockchain? Not as silly as you think

As a journalist, skepticism can be your best friend. 

But in some cases, it can also be your worst enemy, shielding you from what might actually be interesting because you are too busy looking for "the catch." At The Block, we strive to be especially vigilant because of the history of hyperbole in this space. 

Most recently, headlines around a test of the S&P 500 on the bitcoin blockchain drew my skeptical eye. London-based skew, a cryptocurrency startup working on analytical tools, has teamed up with Tokyo-based Digital Garage to test whether a simple S&P 500 options trade could settle on blockchain. 

That rose immediate red flags. Cboe could send the firms a cease and desist letter (if it hasn't already) — as the exchange venue is the "exclusive home" of the widely traded contract. Also, did they pay S&P the proper royalty fee? I thought it was another instance of the decentralized finance world thinking it could bastardize traditional finance without following the proper rules. Similar to when Abra thought it could offer synthetic exposure to U.S. equities through a platform that enables bitcoin to track the pricing of a given stock — in what many in the finance world likened to an equity derivative. In the case of skew, no, they didn't get in touch with Cboe or S&P 500. 

But it probably doesn't matter because it was a one-off proof-of-concept. Yes, crypto folks have been prone to cut regulatory and financial procedures in their attempts to usurp finance. But in this instance, I think we see an example of an attempt to display the potential of blockchain. Settlement. 

In options land, where billions of dollars trade hands in a year, settlement is often time-consuming and expensive. Wall Street firms can execute a trade rather quickly — in under 50 microseconds on Cboe, thanks to a recent tech migration. But the settlement — the process by which funds and securities move between traders — takes multiple days. The point of the experiment was to bring that process onto the bitcoin blockchain, through smart contracts, to make it quicker.

CoinDesk did a pretty good job of explaining how it worked:

So on Sept. 6, [Emmanuel] Goh (CEO of skew) says, he took some British pounds from an in-house research-and-development fund at skew, converted those into bitcoin, and then used the proceeds to buy 10 S&P 500 call spreads – a popular type of option – from Crypto Garage, all under a new smart contract, with terms agreed to by both counterparties in minutes. The expiration date for the options was set for the third Friday of the month, similar to the standard practice on many exchanges.

According to Goh, the settlement took 45 minutes. Pretty remarkable, and points to what big dealers could end up doing amongst themselves, says Thom Thompson, a derivatives specialist.

"If a bunch of big dealers start doing big transactions off exchange and use blockchain for the trade and for uncleared margin collection then you take that systemic risk out of the clearinghouse," he said, referring to firms like Chicago-based OCC, which sit between large options bets. 

"Clearinghouses work perfectly for lots and lots of customers with lots and lots of positions. It is when you get a handful of interconnected big fish in the clearinghouse that the risks get big."

Goh agreed there was a disruptive angle to this story, but was forthcoming about it being early days. Specifically, it is clear that Bitcoin (on-chain) could not handle the scale of trading which occurs in options on a given day. 

"The P2P disintermediation angle through the Bitcoin blockchain is probably the most disruptive," he said in an email. "However there are still very complex challenges to solve before this starts being a more imminent threat - for instance on scaling the Bitcoin blockchain or the fact that the trades have to be fully collateralized."