While the premise of our Summit was that there is a gap between the demand for structured products on digital assets and the supply, that does not mean that such products do not exist at all. Quite the contrary.
In our fifth session we talked with two of our partners from STS Digital, a principal dealing and liquidity provision firm for crypto derivatives and a close partner of GenTwo. In the first half we looked at demand as a market maker sees it. The second half we went under the hood, taking apart two Bitcoin products to show in detail how a tailored payoff is actually assembled and what an investor gives up to get it.
Maxime Seiler is Co-Founder and Chief Executive of STS Digital. Jeremy Dominh is Chief Investment Officer at STS Digital, where he runs structured solutions and quantitative investment strategies.
The Other Side of the Trade
STS Digital is a principal dealing and liquidity provision firm for crypto derivatives. We began with what that means in practice, and in particular with what separates a principal dealer from a broker.
“There’s a big difference between a principal dealing firm and a broker, and it comes down to who takes the risk and the other side of the transactions a client wants to engage in,” Seiler said. “When you trade derivatives, everything a client trades has another side to it. A broker facilitates finding that other side. The broker doesn’t take any risk. It connects a buyer and a seller and helps the initiating client find the best trade and the best price.”
A principal dealer works the other way, and takes the risk onto its own book.
“A principal dealer and price maker like STS is the venue, and we’re the bilateral counterparty to all the transactions our clients engage in,” Seiler said. “When a client wants to trade an option, STS Digital is the counterparty. It becomes a lot easier for clients to transact, because they don’t need to go through a broker who then has to source and find liquidity. We are the liquidity provider. We price it directly in-house and make tradable prices our clients can transact on, and the trade gets done directly between our clients and STS. Then we have the principal risk that we need to warehouse and hold.”
That model is what lets the firm offer breadth. Seiler described a single account from which a client can price and trade options across a very wide token universe.
It’s essentially a vertically integrated, one-stop shop, where you can have an account and from there trade options in over 400 different digital assets today. You’re not constrained by the strikes you want to trade, the maturity, or even how many legs.Maxime Seiler
“It’s essentially a vertically integrated, one-stop shop, where you can have an account and from there trade options in over 400 different digital assets today,” he said. “You’re not constrained by the strikes you want to trade, the maturity, or even how many legs. If you want a fairly complex structure with three, four, five or more legs, you can just structure it, send a request for a price, either via API, portal, voice, or chat to the trading desk, and get a price.” Depending on the route, he said, a price comes back in a second or less over the API and within a couple of minutes by voice.
The effect is that a client can assemble an exposure rather than take one off a shelf. When we put it to Seiler that this amounted to building your own, he agreed.
“You can go on the portal, add lots of different legs, and trade options,” he said. “This is the core of the platform we’ve built over the last four and a half years, and it’s the base required to create structured products, because packaging up options makes it easier for an investor who doesn’t want that complexity. They just want a simple payoff and a simple return at maturity. A structured product packages up a lot of different options into one payoff an investor can subscribe to.”
Two Kinds of Buyer
Next we asked Seiler about what STS is seeing in terms of client demand. This has been one of the main topics throughout the week. In the Supply Gap session we looked at demand from the vantage of the asset manager and the end client. In the Tokenization session we heard about the growing demand from issuers looking to tokenize. Here we were looking at demand more from the point of view of a market maker dealing with institutions and sophisticated investors.
Seiler said there were two main groups. The first group comes out of traditional finance.
“There’s an institutional segment coming from TradFi looking at plain-vanilla payoffs, on Bitcoin, on ETH, and more and more on other majors, but staying within the top five or top ten tokens by market cap,” Seiler said. “There it often comes down to yield, selling options to generate yield, either in Bitcoin or in dollars, and making a Bitcoin exposure generate yield on top.”
The most common version of that trade is call overwriting, where a holder of an asset sells call options against it and collects the premium as income. Seiler described it setting off a loop that feeds on itself.
“We see a lot of demand there, and it’s been a driving force in the options market: selling options for yield, which creates a self-reinforcing feedback loop,” he said. “The more options you sell, the more volatility compresses, and the more volatility compresses, the better the risk-reward gets to sell options. That drives spot into tighter bands where Bitcoin trades in a less volatile, more range-bound fashion, and in doing so the risk-reward of those strategies improves again.”
He dated the pattern and traced its mark on pricing. “That started around the Bitcoin ETF approval and has grown steadily since,” Seiler said. “As a consequence, implied volatility has traded down to all-time lows, the term structure has flattened, and the wings have become incredibly cheap on an absolute basis.”
The second group behaves differently.
“If we move away from institutions to the more crypto-native segment, we see something similar,” Seiler said. “Crypto-native participants tend to be reactive to the cycle. On the way up they get overexcited and don’t want to sell, and on the way down they regret not taking profits. So there’s a structural pattern where foundations, token projects and crypto-native businesses lack proactivity in trading the cycle and managing their cash-flow risk. We often see late hedging.”
He set that against the current market. Over the past year, on the way up, the crypto-native side held too much exposure and did not want to sell, take profit or hedge its dollar operating costs. After Bitcoin passed its peak, in what he called the post-October-10th era, the same participants waited for better prices to hedge and take exposure off. In the second half of this year that changed. Sellers accepted lower altcoin prices and, in Seiler’s words, began “re-engaging in selling options to earn yield, hedging downside, and managing cash-flow risk more proactively.”
Seiler was careful to say the two groups do not account for everyone. Some participants use options simply to take directional views and chase alpha. And there is a growing institutional interest in buying structured upside to Bitcoin, on the argument that the asset had roughly halved from the previous year’s highs and that cheap options made re-entry attractive. “Spot low, vol low, gives really interesting setups to get exposure to the upside while managing downside,” he said, describing investors who had been underexposed trying to catch up through options.
Two Products, Taken Apart
For the next segment we took a deep dive into two actual digital asset structured products: a barrier reverse convertible (BRC) and a capital protected note (CPN), both on Bitcoin. These were two products that GenTwo and STS had worked on together and just brought to market, and both were illustrative of the kinds of things Seiler had been talking about. It was Dominh, STS’s CIO, who took us through the mechanics.
He took the barrier reverse convertible first. A convertible bond is a bond the holder can turn into shares if the issuer’s stock does well. A reverse convertible runs that logic the other way. The investor earns an enhanced fixed coupon, and if the underlying falls through a set level, the barrier, they are repaid in the fallen underlying rather than in full cash.
“The purpose is for investors looking for short-term yield, more like fixed-income investors used to dividends or income every month or quarter, who want to diversify into digital assets to generate that yield,” Dominh said. “The yield comes from risk, from volatility, which is the primary driver of price for derivatives. The investor is effectively selling downside insurance and getting paid for it. You can see yourself as an insurance company.”
The payoff splits into scenarios according to where Bitcoin sits at the end of the term, which can run three, six, nine or twelve months.
“If Bitcoin stays at the current level or goes higher, the product returns a fixed coupon plus your initial notional,” Dominh said. “If it’s below the barrier, the coupon is still paid in any case, but because the investor is selling that insurance, they also pay out some insurance amount. That’s a loss. The investor takes some loss on Bitcoin, but still has a buffer from the premium received.”
The coupon cushions a fall rather than cancels it. Against a shallow move it can absorb the loss. Against a deep one it offsets only part. That is the trade the buyer is making, income now in return for accepting the downside below the barrier.
Dominh was direct about who the product is wrong for.
“Seeing the shape of this payoff, you can understand this product isn’t meant for investors speculating on a very bullish market,” he said. “If you think Bitcoin is going to 200K by year-end, you’d be better off buying Bitcoin, or ETFs, or a leveraged product. This is for investors who want a defined income and some soft capital protection on the downside, and who aren’t necessarily very bullish on Bitcoin.”
For its part, the capital protected note is built for the investor on the other side of that question, the one who is positive on Bitcoin but not willing to weather a severe fall.
“This is for another type of investor, more of an allocator who’s actually more positive on the price of Bitcoin, but still not extremely aggressive and wants some capital protection on the downside,” Dominh said. “You ensure a minimum return on the downside, say 90%. If at the end of the product’s life Bitcoin falls below the strike, which is today’s level, you still get your capital protection, your floor. Even if Bitcoin goes to zero, in this example you still get 90% of your capital back. What you pay for that is giving up some of the upside in a rally. If Bitcoin goes really high, you wouldn’t participate as much as a spot holder, but that’s what ensures the floor. In between, you have participation in the Bitcoin price.”
The two products are mirror images in how they treat protection. The reverse convertible sells protection and is paid a coupon for it. The protected note buys protection and funds it by handing back part of the upside.
“You can think of the capital protected one as for an equity holder, and the barrier reverse convertible as for a fixed-income holder,” Dominh said. He added that neither is aimed at speculators. “These aren’t originally made for speculators. They’re for institutions that want consistency in their returns. The most important thing for an asset manager, portfolio manager, or family office isn’t a one-time glory trade. It’s capital preservation, and that comes with disciplined risk management.”
You can think of the capital protected one as for an equity holder, and the barrier reverse convertible as for a fixed-income holder. These aren’t originally made for speculators. They’re for institutions that want consistency in their returns.Jeremy Dominh
Using the Cycle
Later in the session Seiler drew the two products back together and set them against the thing that makes Bitcoin hard to hold in the first place, its cyclicality.
“The inherent volatility of Bitcoin makes it difficult for investors to understand when and how to get exposure,” he said. “What has persisted throughout the entire adoption of the last decade, going from zero institutional coverage to fairly wide coverage now, is the cyclicality of the asset. Using a structured product gives you the ability to use each part of a cycle to implement views and get exposure in a more risk-managed way.”
Then he mapped each product onto a moment in that cycle.
“When prices are quiet and the market’s sideways, in a slow crypto-winter type of market, using barrier reverse convertibles is a great way to earn yield, selling the expensive part of options, which is the downside,” Seiler said. “And if Bitcoin has rallied a lot, using a CPN to have more upside exposure while limiting downside is a great way to get exposure without chasing the market and taking the full downside. The interesting part for investors now is being able to implement views on where we are in the cycle, and to get better risk-adjusted exposure to the asset class.”