The Financial Derivative Ecosystem is Old - Decentralized Ledger Technology is its Fountain of Youth

Abstract

Financial derivatives are a crucial part of our global financial infrastructure. They serve as effective hedging tools and improve economic development, but conversely are complicated and subject to heavy regulation. Decentralized Ledger Technology (DLT) enables a distributed, trustworthy ledger that stores encrypted information. It could enable frictionless, transparent, financial derivative processing by creating an inherently trustworthy ecosystem that eliminates the need for transaction verification. This paper discusses how different DLT protocols could facilitate financial derivatives. We then present a protocol for facilitating financial derivatives using Stellar's DLT protocol. Assessing our protocol shows that it processes derivatives efficiently with complete transparency. Comparing our DLT based derivatives to traditional derivatives affirms our belief that DLT enables an increase in transparency and reduction of market friction. However, we also found that DLT based derivatives have increased security and counterparty risk. Overall, if the developer mitigates the risks associated with DLT, our protocol could enable a level 3 blockchain application to improve the financial derivatives ecosystem significantly.