Investors trade options and forwards to make money. However, businesses use these financial instruments as a means to reduce and mitigate exposure to risks. The most common methods of hedging are through derivative instruments such as swaps, futures and options.
As we have written previously, Discreet Log Contracts (DLCs) can offer some novel opportunities for hedging risk unique to the crypto economy. Specifically, for mining operations and block fees.
A Discreet Log Contract is a “simple” oracle contract scheme proposed by Tadge Dryja of MIT. DLCs can be executed using almost any blockchain, including Bitcoin. An oracle contract starts with users locking up the funds involved. Then those funds are spent based on some external outcome broadcasted by an oracle.
Here is a quick review of some possible hedges using Discreet Log Contracts:
- Total Transaction Fee Levels – This is a hedge by exchanges- or anyone – looking to move large amounts of bitcoin. We know fees increase as the volume of bitcoin increases and if you are moving your funds on-chain, it can make sense to hedge against high fee periods.
- Hash Rate Derivative – As it becomes increasingly difficult and expensive to mine bitcoin, mining operations could hedge to protect against potential downside and risk of their infrastructure investments becoming obsolete. Additionally, the ability to hedge this risk could have upstream benefits in the amount of risk capital necessary to begin mining operations.
- Energy Pricing Hedge – Mining bitcoin consumes a lot of energy. A contract could be constructed that enables miners to hedge – using bitcoin – against rising energy costs.
Creating these types of crypto industry specific financial products would have benefits beyond mitigating risks.
It would incentivize additional capital into the bitcoin market as more investors and speculators trade for profit. And as with any market, the smarter and more savvy the investor, the more profit they stand to gain. The person or group that understands energy markets and bitcoin production best, will have an advantageous position in that market.
Moreover, the greater crypto market as a whole benefits by the creation of additional liquidity and greater price discovery.
Consider blockchain fees. We are currently in a low-fee environment. But we have seen when congestion hits that fees can spike rapidly – as high as $37.00 in December of 2017. Also consider more and more funds being moved on-chain. This will result in greater competition for transaction confirmation in the next block. Thus, higher fees. We also know that fees must go higher in order for the bitcoin blockchain to sustain its security model.
It isn’t far fetched to believe fees could reach into the hundreds of dollars – or more – as they compete for confirmation in an increasingly more expensive mining process.
With DLC hedges, individual investors, miners and speculators can protect against the volatility of both of these factors i.e. transaction fee movements as well as mining costs. This can bring critical stability to a growing network of global, decentralized yet interconnected actors in the crypto economy.
While the launch of Bitcoin Options and Futures on Bakkt and CME offer more hedging options available through traditional exchanges, Discreet Log Contracts offer some unique advantages.
With Discreet Log Contracts, crypto investors can speculate while taking advantage of the privacy and security offered by bitcoin. DLCs are designed to minimize the trust required to execute a transaction between parties. Likewise, it extends privacy by essentially obscuring from external parties that two parties are contracting at all. We wrote an extensive review of the DLC security and trust model you can read here.
Further, DLCs offer almost unlimited flexibility and extensibility. All that is required from a technology perspective are multi-signature contracts and timeouts. This means any blockchain and layer 2 solution can create a contract from a single Oracle. The result is a larger pool of market participants and greater opportunity for profit-making, risk mitigation and price discovery.
If you are interested in learning ore about Discreet Log Contracts, check out our full Discreet Log Contracts series here for additional background information and in-depth technical analysis.
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