In the investment world, the two critical factors that investors consider are risk and return. While everyone wants to fetch the highest return with the lowest risk for their investments, that is never the case. Risk and returns are positively correlated- the higher the risk, the higher the return, and vice versa.
Markowitz theorizes this framework in his Modern Portfolio Theory.
Financial Engineers and Wall Street Stalwarts have tried multiple ways to develop products that provide the best of both worlds (see concept explainer in Newsletter #14). Still, it’s not a one solution fits all situation, and now we have a variety of structured products, optimizing for risk and return but at the expense of transparency.
Structured products are essentially a basket of assets that returns an optimized risk-return profile. A typical structured product is a capital protected note built with two components:
The lower risk component provides capital protection through its yield, while the riskier derivative sets the participation rate.
The participation rate is the rate at which a note holder gains when the underlying increases in price.
Fund diversification benefits are delivered when the underlying assets also have a diversified payoff. That means you need to combine different asset classes.
Bitcoin and crypto have been correctly lumped together as an asset class because Bitcoin had an enormous pricing power over the remaining crypto market. A reality that is changing over time as financial payoffs of different nature is tokenized.
The above tweet is no longer accurate. However, Tradfi may still have the extreme view that crypto is a $ 2.3T market in bubble.
And when these structured product dynamics are applied to crypto, things become more attractive. Investing in crypto may seem appropriate only for degens (abbr for degenerates, read this poetic definition of it here), however volatility is what attracts traders with their capital to grow this space. Everything needs bootstrapping, and to start a new industry, financial volatility provides the best risk-reward environment to get achieve growth for everyone involved.
Volatility however is not great when it comes to the actual consumption of the services that crypto project may provide. In fact it is inversely correlated to its utility. That’s why liquidity providers exist to reduce slippage to trade in and out of assets. Insurance against smart contract bugs and hacks are helping to reduce the risk as we speak. Options markets to provide indeed more avenues of exposure to crypto assets.
The equivalent of structured products in DeFi are structured tokens.
The first ever structured token was developed by DEXTF Protocol, that launched the Structured Floor Token (SFT) on ETH. The SFT on ETH returned your original capital if the price was below the strike price at expiration and profit as if you were holding 1:1 ETH if above the strike price.
Today we have a better understanding of what a floor price as evangelized through NFTs on Opensea. SFTs are therefore capped on the downside and unlimited on the upside.
While these may sound like fantastic products, these tokens would be intended only for those investors who want to have:
So if we look at it at a glance-