How Does a Lack of Liquidity in the Underlying Asset Complicate Physical Settlement?
A lack of liquidity in the underlying asset means that if the option writer does not already possess the asset, they may struggle to acquire it quickly and at a fair price to fulfill the physical settlement obligation. This can lead to a "delivery default" or force the writer to buy the asset at a premium, increasing their loss.
In a tokenized system, the smart contract may require the writer to pre-lock the underlying asset as collateral to ensure settlement, mitigating this liquidity risk.
Glossar
Physical Settlement
Delivery ⎊ The concept of physical settlement, particularly within cryptocurrency derivatives and options, signifies the actual transfer of the underlying asset ⎊ be it a digital token or a commodity ⎊ rather than a cash-based offset.
Underlying Asset
Foundation ⎊ The concept of an Underlying Asset, within cryptocurrency derivatives and financial markets, establishes the core reference point for valuation and risk transfer.
Lack of Liquidity
Depth ⎊ The presence of insufficient depth in a market signifies a lack of liquidity, characterized by a substantial bid-ask spread relative to the asset's price and trading volume.