Rehan Tariq, head of trading and structuring at Murex Americas, presented a case study during the SRP Americas conference in Chicago based on a research and development (R&D) project to provide investors with exposure to crypto beyond the cash and listed markets.
The research and development (R&D) project was developed for clients interested in issuing crypto-linked structured notes and looked at different payoffs including yield enhancement, reverse convertibles and autocalls, as well as dual currency deposits, power reversal dual currency notes and principal-protected notes.
“The research has not gone through compliance but provides a case study for crypto structured notes,” said Tariq (pictured). “For us, it was a way of confirming Murex’s MX.3 integrated platform readiness in terms of pricing, risk management, hedging and workflows, etc.”
People want to get exposure, but they also want to be protected against volatility - Rehan Tariq, Murex
Of course, the research made some assumptions - using relative volatilities from option exchanges and created a generic index instead of using a published benchmark.
“We used our advanced equity local volatility model to price autocalls and black model for capital-protected notes where we looked at different levels of yield and protection levels, notes pricing and hedging. The yield curve was modelled based on the exchange trade futures to calculate the forwards and implied rates,” said Tariq.
Findings
The conclusion of the Murex research confirms the system readiness, said Tariq.
“As a proof of concept everything worked as expected, as with any other structured note - hedging, back-to-back trades, risk management, as well as pricing and issuance,” he said.
There is appetite from issuers of structured products to enter the crypto market as investors increase their demand to get exposure to this asset class, but from Tariq’s perspective a lot of things need to happen before it gets to active trading in the North American market.
“There is a lot of talk about the applications of blockchain technology to deliver these new crypto structured products - settling trades – and how other areas of the value chain beyond issuance such as custody could be impacted,” he said, adding that the Murex research was purposely based on the classical trading and settling set up as “this would help to remove the dependency on blockchain technology”.
According to Tariq, an increasing number of market players are seeking exposure to cryptos and ways to participate and bring products to market, but they want to do it within their existing framework.
“There is a lower barrier for entry if the notes are issued in a classical way where the payoff is linked to crypto index instead of going full on DeFi and settling it on a block chain,” Tariq said. “Regardless, even if the note is issued utilising DeFi and settlement is on some blockchain, the pricing, hedging, trade repository and issuance process still follows the classical methods and the proof of concept is still relevant. Only the settlement system would change.”
Adoption
The main challenge to increase adoption is regulation, according to Tariq.
“The US does not have the spot ETF fully approved yet and you can only access these products via ETNs, Exchange traded Futures or directly buying crypto from the crypto exchanges,” he said. “The recent downturn in the crypto market has also turned off a lot of investors for now.”
However, Tariq sees the offering of digital currencies by the central banks as one of the turning points and catalysts that may help push the market forward in the coming months and years.
“Investors would want to buy or get exposure to digital currencies issued by central banks, and if the system turns out to be stable you could see currency notes being replaced for at least some payments as we saw in few jurisdictions recently,” said Tariq.
Structured products are well positioned to promote adoption and take advantage of the demand for crypto exposure as they can capitalise on their flexibility to cater for different risk profiles.
“Capital protection is a very powerful selling point,” said Tariq. “Many bitcoin investors that got burned with the recent crash would have been very happy if they had invested in crypto-linked capital-protected notes.
“People want to get exposure, but they also want to be protected against volatility.”
For investors with a strong conviction that crypto is here to stay, autocall and reverse convertible structures can take advantage of the volatility to deliver high yields of up to 15% “because when you sell the put, you will get all that premium and you can stack it up to your bond, and offer a higher yield”.
Target market
According to Tariq, structured notes can also cater for more sophisticated investors and offer more complex payoffs and innovative underlyings (baskets) to extract value of this asset class.
Currently, if a Japanese investor, for example, wants to get exposure to USD rates via a power reverse dual-currency note (PRDC), they buy bonds and Japanese yen, but they get rates in USD, and there are all sorts of FX options embedded in them.
“We expect dual currency crypto deposits to gain increasing traction especially among foreign investors,” said Tariq. “Doing these products with cryptos would be a completely different experience if cryptos are yielding some kind of interest rate from a repo market or from staking, and investors want to get exposure to that.”
This is what some crypto hedge funds were doing - staking strategies and getting yields up to 40- 50% because of supply demand. One side of the market wanted to short it but there was no easy way to short it so they had to borrow and then assume the price would go down, but then borrowing costs started to go up and made these strategies too expensive.
“If somebody wants to get exposure to those interest rates, instead of going for that kind of strategy they can just buy a structured note linked to crypto/interest rate and get the exposure they want,” said Tariq. “Then it becomes a similar concept as dual currency deposits, which you can link to staking rates or repo rates.”
Outlook
According to Tariq, crypto-linked structured notes will take a while to become mainstream in North America but as the market evolves more investors will contemplate entering the market either via cash, trading futures in CME and ICE or investing in exchange-traded products (ETPs) which have become a growing business especially in Canada.
“The exotic (derivatives) part of the crypto market is moving slowly as most of the demand is concentrated in cash or vanilla trades,” said Tariq. “Enquiries have gone down in the last couple of months as the market has been not performing very well, but we expect requests to resume once the market stabilises. The current market level is also offering an interesting entry point for investors to take advantage when the market bounces back.”