Blockchain-based Options for Physical Settlement of Commodity Futures

Abstract

On April 20, the negative price in the last trading session of the Chicago Mercantile Exchange (CME) West Texas Intermediate (WTI) oil futures shocked many traders and investors globally. It caused much potential risk exposure for commodity futures trading and impacted pricing and valuation models in many derivatives. One of the essential hidden risks of commodity futures exposed by this event is high storage and delivery cost of their physical settlement, which reduces the hedging functionality of commodity futures during high volatile market periods, such as the coronavirus (COVID-19) pandemic. This chapter proposes options to hedge the risk by the fluctuation of physical settlement cost. Since both listed and over-the-counter (OTC) options may take a long time to be issued in the market, we propose to use blockchain technology to issue physical settlement rights by tokens. The transportation and storage provider can make profits by this covered-call like options strategies. At the same time, commodity futures traders can get proper insurance for this kind of recent unexpected risk for sky-rocketing high physical delivery cost. Blockchain technologies such as smart contract and decentralized settlement system can be more flexible to offer these options rather than traditional derivatives exchanges. And the premium can be paid by the commodity itself to the transportation and storage provider to link token value closely to physical goods and reduce inflation caused by currency over-issue. The simulation and scenario analysis are done to demonstrate the risk hedge functionality of these options for the April 20 event. And we show that based on economic theory, the combined price of commodity futures and its physical settlement options should be larger than zero if the economics is to keep moving forward. © 2021 World Scientific Publishing Company.