Blockchain: Streamline Oversight, Build Trust

The excitement behind blockchain and distributed systems technology is, at its core, about making systems more efficient, self-reliant, and less expensive to run. Blockchain replaces outdated trust systems with technology that facilitates transparent and trustless commerce. This framework opens an entirely new spectrum of business opportunities that were previously impossible.

What this means for auditing and human systems in the current financial world

Every participant in a debt instrument or derivative can synchronously verify the contract’s state, rather than relying on phone calls and emails. Better yet, the entire terms of the agreement are programmatically executed by the smart contract logic agreed upon at asset creation — even cumbersome variables like margin and coupon payments.

No more hearsay around deal terms, or a fat-finger mistake putting €28bn into the wrong account. Just all sides of a trade being held to a contract, and a massive injection of efficiency that will unlock capital and dramatically accelerate its deployment.

This transparency and condition of certainty (who owes and owns what) become even more critical in markets driven by complex terms historically negotiated bilaterally. Worse yet, these instruments demand fast and efficient execution to avoid broader, systemic market shocks.

Credit Default Swaps: A Market in Desperate Need of Innovation

There is general agreement that CDSs are useful market tools that help hedge and trade risk, creating more liquidity for locked up capital, and create a good indicator for credit conditions. However, in the 2007–2008 global financial crisis, we found that the information about CDSs was opaque at best, and deliberately obfuscated at worst. There was no clear way to determine whether the debt wrapped in a given CDS was backed by sufficient holding, whether final settlements could be called for CDS defaults, or even how to value CDSs on open markets since they were traded OTC.

A smaller bank may have wanted to hedge against a loan to another institution and buy exposure to a CDS from that institution. Without a clear view of the CDS institution’s risk profile, however, the smaller bank had no real understanding of how a CDS would hedge their lending risk. Finally, this obfuscation was significantly compounded as traders played a dangerous game of musical chairs to shift risk again and again across the market to avoid being left in the wind.

Private sector advances in CDS self-regulation have finally begun to come to fruition 12 years later. Significant strides have been made to establish standards and move CDS markets to an exchange structure with more transparency than OTC markets. We now have central counterparties to account for the actual debt obligations.

But that begs the question of how much the financial industry is spending on self-regulation. Is there is a better way to achieve the same goals? How much time and resource could be saved by embracing technology that automates these functions, while mutualizing the cost and responsibility for maintaining the system?

A Trust-Based Technology

Could blockchain solve this messy system of tracking CDS obligations, balance sheets, trades, and counterparty involvement?

Remember, blockchains offload trust to the technology. To participate in a blockchain CDS marketplace, a full accounting of the balance sheet obligations would be present and accessible in the system. A trader could have a full view of the risk associated with any given CDS, empowering them to trade on the fundamentals of the assets and obligations.

Traders would be able to obtain accurate data to make decisions at unparalleled speeds. As efficient as well-funded, expert bodies can be, settling and verifying transactions or balances in one second or less would open up a tremendous amount of time and liquidity for all of these products — vital components to proper risk management.

The world of credit default swaps is just one example of a market that takes considerable time and energy to create a transparent system and minimize the impact of bad actors. Blockchain technology will have incredible impacts on other markets, and even across markets where contracts for CDSs could be swapped for real estate or alternatives — all of which would be validated beforehand by the network.

We’ll see fewer arrears, more visibility when debt is unlikely to be paid back, and more recourse for non-payment. Debt holders will have more options than just writing off millions, or billions, each year in nonpayment, and even more in sunk costs of regulatory hurdles.

And the best part? These vast improvements are no longer a pipedream.

We’re ready to build the future of markets like CDS — a future without the fragility and reckless speculation that became a powder keg for the 2008 global financial crisis. We now have the tools to build financial markets that are future-proof. All we have to do is start.

Let’s talk — get in-touch to see how we can partner and build the future of finance together by emailing me at john@avalabs.org.