October 15, 2016

Stratification Problem of Legacy Assets When Bundled to Blockchains

A transition period from legacy to blockchain assets is imminent. The greatest organizational challenge will be dealing with the stratification of various types of underwriters.

Blockchains are winning in many financial sectors but not quite immediately. People will not switch en masse to “native” blockchain-based assets such as BTC, ETH any time soon. The trend towards blockchains is apparent, it has already whirlpooled currency a lot and equity sectors to some extent but many financial instruments can not be completely blockchain-ized and are slow to hybridize. That certainly includes physical values such as precious metals and many sorts of securities.

What is a “hybrid” asset?

Hybrids are combinations of two components. For our purposes: a token being transported from one party to another over a blockchain as well an underlying property — i.e. something of value that exists outside of the blockchain.

Within this document, we are discussing the case of fiat currencies if not specifically mentioned otherwise. Fiat-over-blockchain covers a lot of popular applications from modernization of FX trading to remittances.

  • Digital tokens travel over a blockchain and do not depend on the value of the “native” blockchain’s crypto-currency
  • Tokens are authentic, and — for mere simplification — their security level is generally considered matching the transport blockchain’s one (we suppose that if a particular blockchain can’t store enough data by its internal mechanisms, external storage is also fully decentralized)
  • A typical cryptocurrency wallet setup is that only the owner possesses the private key; in the hybrid mode, however, a third party such as a bank can also be involved into a multi-sig pool so most traditional banking business models can apply

Building Competitive Advantage for Issuers

Each type of token is backed up by an unconditional legal promise of the issuer, just like any fiat currency. An issuer performs many functions such as gathering KYC data and managing back-end accounts. In this architecture, however, an issuer not only distributes mobile wallets but also issues and redeems the “money” itself. This sort of functionality allows the new breed of issuers to develop a competitive advantage over traditional issuers. Examples of legitimate companies that can become issuers are banks, retails chains, mobile operators, payroll companies, money exchange operators.

  1. Issuer provides consumers with mobile wallets; deposits money in relation to debt or deposits; maintains account data. Customers enjoy a similar experience analogous to present-day “online banking”.
  2. Amazingly, an issuer can serve as an acquirer by simply buying back its digital tokens. Another option is to list those tokens on third-party cryptocurrency exchanges.
  3. An issuing institution can expand its reach by buying back its digital tokens from other banks at a reasonable discount.
  4. Wallets can pay to one another directly as well as to merchant consoles. Additionally, merchants may be enabled to top-up accounts directly.
  5. Consumers can transact (i.e. buy and sell digital tokens) with third parties including banks where they do not have accounts.
  6. Similarly, merchants are free to trade tokens anywhere they prefer. No party, including merchant’s bank, needs to control or certify merchant’s consoles since they do not store any user-data.

The technical (i.e. blockchain) side of the hybrid model is being tested by many startups. Examples of services where some forms of promissory notes (mostly junk) get attached through some meta-data storage to a blockchain are numerous. None, to date, are easy-to-use and include a legitimacy model, though. Gladly, very few technical questions remain concerning the viability of the model so it is the time for crypto enthusiasts and experts to allocate some resources, focus efforts on the legitimacy issue, and finally solve it.

A token is a “bearer instrument”, i.e. whomever holds the object is assumed to be the owner or have the title to the underlying property. Being completely traceable, it may show some properties of the “registered instrument”, but in general cases, no record is kept of who owns the underlying property or records of the personificated transactions involving transfer of ownership. Whoever physically holds the tokens is assumed to be the owner. In general, the legal status of the token depends on whose wallet contains said token.

It is important to emphasize that a digital token, being also a negotiable instrument, can be legally enforced to be redeemed by the party in possession. Each token holds the name of the institution which guarantees to buy it back, however nothing can prevent tokens from circulating on the free market.

Dealing with the Initial Chaos

When considered together, the above creates a stratification problem when various underwriters will create and use tokens representing same nominal property and value but different redemption reality. Of course, the market price will reflect that but the high speed and convenience of digital exchanges do not takes us any closer to the high standards of the legacy checks environment. The market should not be contaminated with tokens most places wouldn’t accept. Due to the basic chicken-or-egg problem, the market will develop in isolated local stratas, starting its growth from a popular remittance corridor or a place where an innovatively-minded retail bank would create a local community of blockchain money.

To avoid stratification (and also to avoid the future blockchain-ized assets space from devolving into a junkyard) a path to operator validation procedure is needed. There’s no central authority that would take responsibility and spend resources doing this. We actually do not want such an authority to take charge. We have to somehow get going there by ourselves, step-by-step. By the way, most of existing operators of assets-over-blockchain services have been doing quite the opposite over all these years. They have allowed the creation of uncountable coins on top of both Bitcoin and Ethereum blockchains, so the place is already quite messy and confusing.

The problem of initial chaos is compounded with the fact that “good” participants — such as banks guaranteeing the tokens with reserves — will be in short. Banks don’t want to give up their reserves. In the best scenario, the underlying assets should be guaranteed by either bank capital or actual cash reserves set aside. In most countries, banks are regulatorily persuaded towards reduced liabilities, not even mentioning the natural unwillingness of banks to give up on even a fraction of money-making turnover-included assets. Of course, at the end of the day the reduced costs of the hybrid fiat-blockchain model will compensate but that is not going to save us from a yet long shortage of good operators/underwriters. So, it’s going to be filtering war against creeping invasion of shit-operators in an environment of good operators being stubbornly conservative.

So the complexity of the task is so high that maybe the altruistic evolutionary mechanisms should be turned-on. This is probably the case where the format/standard war is not good for anyone. Should we see one team showing some traction, others should join their standard rather than compete.

Each market participant is free to make money on his end, via his end-users but we do need a new version of the Bills of Exchange Act, mutually “enforced” with no authorities stepping in.

This new tech and 136 years of financial experience should have taught us something, right?

The Growing List of Blockchain Benefits

For those who spent the last two years in a tank on Mars, we’re not the first to list the advantages but here is yet another summary of blockchain benefits:

  1. SAFER. The main advantage is the ultimate security features of blockchains capable of withstanding even human factors such as corruption. The benefits offered by blockchain technology are far beyond its use as a “safe and free” ledger, though:
  2. LOWER COSTS with BROADER REACH. Blockchain technology can reduce the costs associated with a variety of processes within monetary and financial systems in general and capital markets in particular. Blockchain streamlines the existing markets infrastructure, reduces dependency on third-party intermediaries, and reinvent elements of the transaction lifecycle. This cost reduction, along with substantial simplification of processes lowers various entry barriers so previously unbanked or otherwise underserved population can now be included.
  3. NEW P2P PATTERNS. A blockchain-based market allows transactions in a P2P manner without the intermediation services provided by various institutions.
  4. SIMPLE & ONE-LAYERED. On the blockchain, the entire lifecycle of a trade — including its execution, clearing, and settlement — can occur at trade level, lowering post-trade latency and reducing counterparty exposures.
  5. NEW SMART PROGRAMMATIC FEATURES. Through the utilization of smart contracts, financial instruments can be pre-programmed to carry out additional fees and actions, such as payment of bond coupons or dividends.
  6. BETTER KYC/AML. An individual’s or entity’s identity can be stored on the blockchain, ensuring secure and rapid authentication without the warehousing of sensitive data at third-party repositories.
  7. BETTER REGULATION ENVIRONMENT. The blockchain is fundamentally a record of transaction history, delivering a fully transparent, accessible transactional database for governing bodies and other privileged users.