By Edward. H, Gate.io Researcher
[Abstract] Dual Currency Product is a non-principal protected financial product, a combination of two financial instruments, namely options and deposits. It is not vulnerable to market volatility, giving you access to all-the-time benefits from transactions. This article will show you the origins, principles and returns of Dual Currency Product. It will highlight its suitability in a market that features both small fluctuations and uncertain trends. Overall, it’s a product for cryptocurrency holders and users who think highly of the crypto industry and have a certain demand for liquidity.
[Key Words] Dual Currency Product, Option, Financial Derivatives, Straddle
Earlier this month, the Poly Network heist caused tens of thousands of users to lose nearly $610 million. Although the hacker announced the return of all the stolen funds, his shocking behavior has ignited wide doubts over DeFi security.
With the hype of Yield Farming last summer, DeFi became a hot craze which was followed by yields of more than 100% or even 1,000% which attracted a large amount of investment. However, this high yield comes with great risk due to the small market size. Many Decentralized financial products have weak technology support and are vulnerable to attack. In centralized finance (CeFi), new financial products for the crypto market which are based on the traditional ones have been developed by major exchanges. Among these projects, Dual Currency Product (dual currency investment) enjoys high returns along with certain risks. If used properly, you can truly gain access to all-the-time benefits regardless of the market fluctuations.
Options: Flexible and Efficient Financial Derivatives
There are introductions to common derivatives such as futures and options, from the perspective of their history, nature and usage in the previous article (The Necessary Terminology for Investing in Cryptocurrency: Financial Derivatives).
As sophisticated financial instruments, options are "rights to accept the future price". When the contract buyer pays a certain premium for purchasing an option, he/she has the right to choose whether to follow the agreed price (known as the strike price) within a specific time period.
There are two types of options: call options and put options. A call buyer has the right to choose whether to "buy" the underlying asset from the option seller, and this right is dubbed a call option. In contrast to the call buyer, a put buyer has the right to “sell” the underlying asset to the option seller, and this right is called a put option. Options can be divided into four categories according to two operations in buying and selling.
The benefits and risks to the option buyer and seller are inconsistent. Take a call option as an example (as shown in the graph below): the horizontal axis (S) represents the price of the underlying asset in the option, the vertical axis (π) stands for the resulting gain or loss, C is the premium for a call option, and K denotes the strike price.
For the call option buyer, the premium needs to be paid at the beginning, so the initial return is -C. When the underlying asset price is below the strike price (S<K), the buyer usually won’t buy the underlying asset directly from the option seller because there will be an underlying asset that can be purchased at a lower price in the spot market. And when the price of the underlying asset is higher than the strike price (S>K), the option buyer will buy the underlying asset from the seller because he can benefit from purchasing it at the strike price which is lower than the prevailing market price and selling it immediately in the spot market at the price of the underlying asset. If there is slight growth in market price(K<S<K+C), the option buyer's profit in the spot market is not enough to cover the premium; but when there is a large rise(S>K+C), the profit will exceed the premium.(as shown in the left graph)
Regardless of price fluctuations, the call option seller can definitely receive the premium (C) which may be the maximum return that the seller can achieve. When the price rises too much (S>K+C), there will be a loss incurred in the seller, which corresponds to what is known in the market as Tail Risk. （as shown in the right graph）
For a put buyer, he/she has the right to “sell” the underlying asset to the option seller. This kind of right is called a put option. When the price of the underlying asset is above the strike price, the buyer usually won’t exercise that right, because the underlying asset in the spot market can be sold at a higher price (at the same time, the option seller will also gain the most). Only when the asset price is lower than the strike price does the buyer exercise their option (at this point, the lower the price of the underlying asset, the less the option seller gains).
In general, option buyers have a lower winning rate. There is a ceiling on losses, but no theoretical limit on gains; Although option sellers enjoy a higher winning rate, they get limited returns and theoretically have unlimited losses.
Options can be traded long or short and have characteristics in hedging. Their leverage property is similar to that of futures. There are many derivatives and financial categories constructed based on options in the financial market, and Dual Currency Product is one of them.
Dual Currency Product: Options-based Financial Innovation
Dual currency instruments have a long history in traditional finance, especially in the foreign exchange sector, where they have been used extensively. HSBC, for example, defines its dual currency investment product as“A Dual Currency Investment is a non-principal protected investment product with floating return. By linking to the performance of foreign exchange rates, you will have a chance to earn potential return, as well as meet your foreign currency investment needs.”
Due to the high operational difficulty of options, major cryptocurrency exchanges have also launched a simplified financial instrument based on options, namely Dual Currency Product. In terms of financial essence, buying the Dual Currency Product can be interpreted as a sale of an option to the platform.
In the BTC section of Gate.io’s Dual Currency Product, you can invest in USDT and BTC. The USDT investment corresponds to the put option and the BTC investment corresponds to the call option. We will take the investment in BTC, whose transaction process is logically simple, as an example:
In this dual currency product named BTC-3SEP21-52000-C, “C” stands for the call option; “52000” refers to the pegged reference price which is equivalent to the strike price in an option; “3SEP21” shows that the expiration date is September 3rd, 2021 when the settlement needs to be completed at 8:00(UTC).
Annualized Return Rate=Yield/Position Duration*365*100%
Image: Graph for Sell Call
The yield for Dual Currency Product is updated in real-time according to the market environment. However, the yield will be locked in when the product is purchased successfully. The return that occurred in the locked period is equivalent to the margin (C) that a user receives for selling the option.
Subsequently, the bitcoin to USDT price will fluctuate. At settlement, if the bitcoin price (settlement price, i.e. S) is higher than the pegged price (K), it will be settled in USDT. This is equivalent to the situation when a call option buyer chooses to exercise the option and the seller (i.e. the user) sells their BTC for USDT (just like getting cash in an option).
When the settlement price is lower than the pegged price (K), it will be settled in BTC. This is equivalent to a call option where the buyer doesn’t exercise their right, and the seller (i.e. the user) still has his/her BTC in hands without selling it (similar to an option in which the seller's underlying asset is not sold).
Generally, as the expiration date gets closer, the yield to maturity(YTM) in Dual Currency Product will be lower. This is consistent with the time value of an option.
Straddle: Strategy in Dual Currency Product
Dual Currency Product is different from regular options. There is no need to pledge cash or an underlying asset for selling the ordinary options, but it’s necessary for users to "deposit" BTC or USDT when purchasing this product. The model "deposit + option" is actually similar to the Short Straddle in traditional finance.
Continuing with the example of the product BTC-3SEP21-52000-C, the settled currency will not be BTC. It will be USDT when the settlement price is higher than the pegged price(K). This means that user’s purchase of the product is equivalent to the sale of a call option(to the platform) that expires on September 3rd when selling a put option to the platform with the same amount and expiration date.
Therefore, purchasing Dual Currency Product can be considered as selling both a call and a put option to the platform. The top right is a graph involving the most common option portfolio strategy—Straddle, with the combination of the graphs of Sell Call and Sell Put. Investors will profit from a straddle when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid.
The actual return for a user purchasing this product is similar to that of a straddle. When the delivery price is exactly equal to the pegged price, users can obtain the maximum return. When the market trend is not clear, the product can allow you to have access to all-the-time benefits regardless of the market volatility, within a certain price fluctuation range. The greater the market fluctuation, the higher the return rate will be.
But the purchase is also likely to cause losses when the market price deviates significantly from the pegged price. That's why we believe that Dual Currency Product is a non-principal protected financial instrument with a fixed return rate.
Who is the Dual Currency Product designed for?
1. For users who value returns rather than currency conversion
From the USDT-based perspective, BTC/ETH is a profit-making instrument similar to stocks, and the return of Dual Currency Product is similar to that of a straddle portfolio in traditional finance. The gains depend on short-term volatility, and the lower the volatility, the higher the user's return.
For users who are less concerned about currency conversion, both of the following are suited to the product.
Type 1: Users who lack judgment about the market direction and only want to hold coins for a fixed return should buy the product with a large difference between the strike price and the current price. Then there is a good return for both the upside and the downside.
Type 2: Investors who want to pursue high returns with this instrument often have an in-depth understanding of market conditions and have their own judgment of the future price. When the settlement price is close to the pegged price, they can earn extremely high yields.
2. For users who are used to holding crypto
From the cryptocurrency-based perspective, the risk of the Dual Currency Product is mainly from crypto conversion. When the settlement price is higher than the pegged price, the user's assets will be converted to USDT. At this point, obviously the lower the pegged price is, the higher the conversion risk is, but at the same time, the higher the yield is. Therefore, users can purchase the bullish product with less conversion risk, and obtain more stable and larger gains through compound growth.
Those who hold a large amount of BTC/ETH and also have a certain need to liquidate (such as miners) can choose the product with higher yield and conversion risk, so as to earn steadily when the price is low and cash out when the price is high.
3. For users who want to sell at the top and buy at the bottom with the product
Since crypto assets will be converted when the pegged price is reached, users can buy at the bottom and sell at the top by means of this dual currency tool, and get extra fixed profits. But it requires users to have a clear prediction of the price trend so that the topping and bottoming price is close to the pegged price.
Users can buy bullish products with BTC/ETH assets and sell them when the pegged price is reached as well as earn more USDT. Meanwhile, users can purchase the bearish product with USDT and buy BTC/ETH when the pegged price gets reached, as well as earn additional assets.
Please note that the investment product is not principal-protected and its performance is determined by many parameters such as yield, pegged price and so on. An instrument with a high yield may not be an optimal one. Even for a product with high nominal yield, there is a possibility of loss in USDT if the settlement price is significantly different from the pegged price. Please exercise caution when investing.
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Author: Gate.io Researcher: Edward. H
*This article represents only the views of the researcher and does not constitute any investment suggestions.
*Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.