Physically Settled Options

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What to Expect From Ledgerx’s ‘Physically-Settled’ Bitcoin Options

Institutional trading and clearing platform Ledgerx is preparing to offer ‘physically-settled’ bitcoin options. The company is currently waiting for full regulatory approval from the U.S. Commodity Futures Trading Commission (CFTC) to trade and clear bitcoin options. Bitcoin.com caught up with CEO Paul Chou to find out more about their upcoming bitcoin derivatives products.

Ledgerx has two registration applications pending with the CFTC. The first is as a swap execution facility (SEF), for which it received a temporary registration approval from the Commission in September 2020. The other is as a derivatives clearing organization (DCO), which any clearinghouse must register as before providing clearing services with respect to futures contracts, options on futures contracts and swaps.

“If approved, Ledgerx would be the first federally regulated bitcoin options exchange and clearinghouse to list and clear fully-collateralized, physically-settled bitcoin options for the institutional market”, the company’s website claims.

In December, Miami International Holdings (MIH) announced the completion of an investment in Ledgerx’s parent company, Ledger Holdings. Early investors of the company include Google Ventures and Lightspeed Venture Partners, a venture capital firm out of Menlo Park, California. The latest investment provides Ledgerx with “the capital that is critical to help us meet the minimum financial requirements necessary to be approved as a DCO and SEF by the CFTC”, Chou remarked at the time.

While pending CFTC’s approval, the company is “restricted from any live trading or clearing activities”, Chou told Bitcoin.com.

What Products Will Be Offered?

Bitcoin.com (BC): What and how many products will Ledgerx offer?

Paul Chou (PC): Ledgerx will initially list vanilla puts and calls on bitcoin with standardized strikes and expirations. Strikes will be in a range around the current spot price and expirations will be from one-to-six months in tenor.

BC: Where will these products be listed?

PC: The products will be listed on the Ledgerx SEF (Swap Exchange Facility) and cleared by the LedgerX DCO (Derivatives Clearing Organization). We’re an integrated exchange and clearing operation so all parts of the transaction lifecycle from contract listing, trade matching, to final settlement are handled by us.

‘Physically-Settled’ Instead of ‘Cash-Settled’

BC: Can you explain what “fully-collateralized, physically-settled bitcoin options” mean?

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PC: Ledgerx’s focus is on physically-settled options. This means that the long holder of the option has the right to purchase, in the case of a call, or sell, in the case of a put, actual bitcoin. This is in contrast to derivatives that are cash-settled, where the holder receives fiat.

Many of our customers transact in bitcoin in the course of their business, so physically-settled options that deliver bitcoin are more useful to them.

BC: What is the benefit?

PC: Accepting bitcoin as collateral at the clearinghouse enables us to fully-collateralize physically-settled positions such as short call options, ensuring that the clearinghouse holds the full deliverable for all trades.

This model reduces risk for participants and enables comfort around clearing a new, volatile asset class. A long option holder will never have to worry about taking a forced haircut on his expected bitcoin deliverable.

Potential Customers

BC: Who can buy/trade Ledgerx products?

PC: Any participant who is an Eligible Contract Participant (as defined by the Commodities Exchange Act) may participate in trading on the Ledgerx SEF. Under this definition, retail would not qualify, but a range of hedgers and professional investors would be eligible.

BC: How much interest do you expect these products to garner?

PC:

We have significant demand from companies within the Bitcoin ecosystem, such as natural hedgers, as well as trading firms that are interested in the opportunity presented by a new options market.

BC: What is Ledgerx spending its time on while waiting for the CFTC’s approval?

PC: In addition to continuing various tests of the platform, we’ve been working on product development for other derivatives we can list down the line. We expect to have a range of interesting digital currency-related products that will suit both hedgers and investors / speculators; these products will look nothing like traditional financial derivatives and we aim to introduce them later this year.

What do you think of Ledgerx’s physically-settled derivatives products? Let us know in the comments section below.

Images courtesy of Shutterstock, Ledgerx, and CFTC

CMS options, cash-settled/physically-settled swaptions

CMS options are traditionaly replicated using a theoritical “continuous” strip of swaptions (see for instance Hagan’s paper “Convexity Conundrums : Pricing CMS Swaps, Caps and Floors“):

  1. In the paper, Hagan implicitely chooses physically-settled swaptions by using the delivery annuity $L(t) = \sum_^ \delta_ P(t, T_)$
  2. At a point, he makes a modeling hypothesis in order to rewrite the zero coupon bond and the (delivery) annuity only in terms of the swap rate $R$ and ends up having “street-standard” formula which reminds me of the cash-annuity:

$$ \frac = \frac<(1+\frac)^<\delta>>\frac<1><1-\frac<1><(1+\frac)^>>$$ where q is the (swap) number of periods per year and $\delta$ some corresponding fraction period: see section 2.1. CMS Caplets in the paper for more details.

my question is the following:

Since we now know that there is a need to correctly model cash-settled and swap-settled swaptions (ICAP quotes for the cash-settled/physically-settled straddles forward premiums are actually non-negligeable, especially for long tenors), what is the market practice for the CMS options replication ? is it done by using cash-settled or physically-settled ?

Physical Delivery Defined

Physical delivery is a term in an options or futures contract which requires the actual underlying asset to be delivered upon the specified delivery date, rather than being traded out with offsetting contracts.

Breaking Down a Physical Delivery

Derivatives contracts are either cash-settled or physically delivered on the expiry date of the contract. When a contract is cash-settled, the net cash position of the contract on the expiry date is transferred between the buyer and the seller. For example, assume two parties enter into an E-mini S&P 500 futures contract to be settled in six months for $2,770 (the futures price). If the value of the index on the day the contract expires is higher than the futures price, the buyer gains; otherwise, the seller profits. The difference between the spot price of the contract as of the settlement date and the futures price agreed on will be credited or debited from the accounts of both parties. Say, the closing value of the index six months from now is $2,900, the long futures holder’s account will be credited ($2,900 – $2,770) x $50 = 130 x 50 = $6,500. This amount will be debited from the account of the party shorting the position. [Note that $50 x S&P 500 index represents 1 contract unit for E-mini S&P 500 futures contract].

With a physical delivery, the underlying asset of the option or derivatives contract is physically delivered on a predetermined delivery date. Let’s look at an example of physical delivery. Assume two parties enter into a one-year (March 2020) Crude Oil futures contract at a futures price of $58.40. Regardless of the commodity’s spot price on the settlement date, the buyer is obligated to purchase 1,000 barrels of crude oil (unit for 1 crude oil futures contract) from the seller. If the spot price on the agreed settlement day sometime in March is below $58.40, the long contract holder loses and the short position gains. If the spot price is above the futures price of $58.40, the long position profits, and the seller records a loss.

Exchanges specify the conditions of delivery for the contracts they cover. The exchange designates warehouse and delivery locations for many commodities. When delivery takes place, a warrant or bearer receipt that represents a certain quantity and quality of a commodity in a specific location changes hands from the seller to the buyer who then makes full payment. The buyer has the right to remove the commodity from the warehouse or has the option of leaving the commodity at the storage facility for a periodic fee. The buyer could also arrange with the warehouse to transport the commodity to another location of his or her choice, including his or her home, and pays any transportation fees. In addition to delivery specifications stipulated by the exchanges, the quality, grade, or nature of the underlying asset to be delivered are also regulated by the exchanges.

Most derivatives are not exercised but are traded out before their delivery date. However, physical delivery still occurs with some trades—it is most common with commodities and bonds but can also occur with other financial instruments. Settlement by physical delivery is carried out by clearing brokers or their agents. Promptly after the last day of trading, the regulated exchange’s clearing organization will report a purchase and sale of the underlying asset at the previous day’s settlement price. Traders who hold a short position in a physically settled security futures contract to expiration are required to make delivery of the underlying asset. Those who already own the assets may tender them to the appropriate clearing organization. Traders who do not own assets are obligated to purchase them at the current price.

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