Cryptocurrencies and smart contracts enable the transfer of value in a secure, irreversible, and transnational manner without the need for a centralized intermediary. They can improve and eventually supplant the world financial system with code.
I’m excited for the future of the blockchain and the promises of Web 3.0 and Open Finance. Despite my optimism, I feel that blockchain is increasingly seen as a panacea to the problems of the financial system. One such example is financial derivative products. Relying on blockchains to fix derivative markets can result in the creation of new risks that would result in re-centralization and overexposure to asymmetric downsides that didn’t exist previously.
The current settlement and clearance process for a derivative trade—whether OTC or centrally cleared— is an extraordinarily inefficient and error-prone given amount of intermediaries involved. OTC contracts can remain outstanding months or years before settlement, resulting in extended counter-party risk. Derivative contracts require collateral, which adjusts to changing circumstances like changes in the credit ratings for the parties involved.
OTC derivatives are opaque in nature. Since they are bilateral, no party has a clear picture of the trade. A default on one derivative transaction can cascade to other transactions resulting in market failure. In 2008, large financial institutions entered derivatives transactions such as MBS and CDOs that left them overexposed to fluctuating housing prices. After the crash, regulators could not discern the price, volume, or identity of parties involved, which resulted in a bailout.
Derivatives are thus an obvious use case for blockchains as they rely on intermediaries and analog systems to enforce the contract. Smart contracts can memorialize certain aspects of derivatives contracts using code—automating the process, reducing costs and errors. These contracts can incorporate oracles to adjust terms (like collateral). They are also transparent and tamper-resistance, which allows enforcement agencies to assess the value and risk of pricing. In the future, derivatives contracts can embed market rules. A smart future can have its termed programmed and margin requirements encoded, which would prevent excessive orders and check for parties taking large positions.
While the transparency and automation properties of derivative markets on the blockchain are appealing, they are offset by systemic risks. Blockchains excel at automating a derivative trade in a trustless manner, but they are not clearinghouses. Clearinghouses prevent the risk of default of market participants. They also improve liquidity in certain high-volume and standardized tractions. Through novation and collateral, intermediaries provide insurance to participants.
But the issue with derivative markets on the blockchain is more profound. The notion that the blockchain will fix the problems of derivative markets is a form of naive intervention coated with market fundamentalism.
“Iatrogenics is compounded by the “agency problem” or “principal-agent problem,” which emerges when one party (the agent) has personal interests that are divorced from those of the one using his services (the principal). ”
–Antifragile: Things that Gain from Disorder by Nicholas Nassim Taleb.
I recently saw a white paper of the implementation of Credit Default Swaps on the Ethereum blockchain. The issue with Credit Default Swaps is not an issue of trust or transparency, but dangerous risk/reward distortions and reflexive developments that can result. As George Soros notes, CDS is “like buying life insurance on someone else’s life and owning a license to kill him.”
Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
– “One Way to Stop Bear Raids” by George Soros.
So, the problem of derivatives on the blockchain is more profound. It’s derivatives themselves. With derivatives, if the underlying assets have mild fat tails, then the derivative will produce fatter tails. Mispricing of derivatives has often not been discovered until it is a disaster.
Many believe bank management have the derivative risks under control using mathematical models that capture the complex interaction of factors embedded in derivatives trades. This is empirically disproven by Long-Term Capital Management, the Quant Quake, and 2008.
Many of these “experts” have constructed elaborate management tools based on empirically false assumptions about the frequency and severity of bad events and the correlations among them. Risk managers sometimes acknowledge these limitations but then say their tools are “better than nothing.”
This is why blockchains are so appealing to apply to derivative markets. Neomania is deeply ingrained in American culture: what’s new is seemingly better. Most seem to forget the origins of new and sexy risk management tools: Long-Term Capital Management, the Quant Quake, and 2008. They always are products of these new technologies.
Stocks, bonds, commodities, currencies, interest rates, and market indexes are also regulated and traded differently. I’m unsure what a commodity derivative transaction will look like on the blockchain. The decentralization qualities of crypto are historically dangerous in financial markets too. Only after the Great Recession did regulators centrally clear and manage derivatives trades; markets started off decentralized.
I’m definitely not against derivatives and I myself was a user of vanilla products to hedge. They remain important for banks to guard gainst credit risk, liquidity risk, and market risk. My position is against a sinister form of iatrogenesis where exotic, dangerous derivatives practices can hide behind the banners of financial innovation and technological progress.