Crypto Finance Meets Regular Finance

Yesterday I casually suggested that the ideal thing to turn into a smart contract on the blockchain is an interest-rate swap: It’s just a series of exchanges of money, with no need to do anything in the real world, so it is easy to encode in computer instructions. But one reader correctly objected that the real meat of an interest-rate swap as a contract is its credit terms. An interest-rate swap is an unfunded way to get interest-rate exposure. Instead of putting up $1,000 to buy a bond and getting back 2.5 percent interest every year, I sort of pretend that I did that: You give me 2.5 percent of $1,000 every year, and in exchange I give you whatever Libor is that year. But neither of us ever puts up the $1,000.

That means that if interest rates move sharply against me — if Libor goes to 10 percent — then I have to come up with $100 each year, and you have to trust that I’m good for it. And that trust usually comes in the form of credit support annexes and collateral posting and the possibility of suing me and so forth, a whole apparatus that lets market participants trust that their counterparties will pay them in the future. Turning that into a smart contract is harder: The smart contract could theoretically be required to pull any arbitrary amount of money from my computer and send it to your computer, and the only way to guarantee that it will be able to do that is to lock up a lot of my money for the whole length of the contract. Everything has to be fully collateralized in order to automate it with perfect reliability. And so unfunded exposures — bets where I may have to pay you later and you may have to pay me later but neither of us pays now — are harder to put into smart contracts on the blockchain.

This is in some sense not a bug but a feature; many cryptocurrency enthusiasts like Bitcoin precisely because it limits fractional-reserve banking and excessive leverage and other evils of the traditional financial system. But outside of crypto, much of the work of finance is about finding new ways to take on leverage. And so when you introduce finance people to cryptocurrencies, their first reaction is often “well this is neat, lots of volatility, computers, I can work with this,” but their second reaction is often “wait but we need to find a way to borrow this thing.”

Anyway here’s a story about a former Goldman Sachs and Merrill Lynch structurer who “plans to launch a platform for digital currencies later in 2018 that will allow private or institutional investors to strike so-called repurchase agreements or repos with one another”:

Holders of a cryptocurrency—institutions or private individuals—will earn money from lending it out via the Oxygen platform. In return they get another cryptocurrency, which they agree to take as collateral until their original currency is returned. Borrowers get access to a cryptocurrency they want to use or trade short-term. That could allow them to trade it or use it for transactions.

Of course some Bitcoin exchanges already allow for lending and shorting. The point is that this is a feature that people want; it is also a feature that is not built into the Bitcoin blockchain. The core feature of Bitcoin — the technological problem that Satoshi Nakamoto set out to solve — is that you can’t spend Bitcoins that you don’t have. The core feature of finance — the technological problem that bankers have set out to solve for millennia — is that you can spend money that you don’t have. That’s what finance is; it’s the business of moving money from the people with the money to the people with productive uses for other people’s money. There is an obvious tension.

Elsewhere in tensions between blockchains and finance, here’s a story about the Lightning Network, a bid to ease congestion on the Bitcoin blockchain by basically deferring settlement of Bitcoin transactions:

In this system, two parties open a channel and commit funds to it. The opening of a channel gets broadcast to the blockchain and incurs the normal bitcoin transaction fee. The channel can stay open for however long—say, a month—during which time the two users can exchange as many payments as they like for free. When the time expires, the channel closes and broadcasts the final state of the pair’s transactions to the blockchain, incurring another transaction fee.

A lot of what I read about the blockchain for finance involves speeding up settlement time. If you trade stocks or syndicated loans or whatever on the blockchain, people argue, you can have instantaneous settlement instead of waiting days or weeks for your transactions to clear. Meanwhile a lot of people who actually trade stocks or loans or whatever are skeptical of that goal: Gaps between trade and settlement are not just technological failures; you need that time to line up funding or stock borrow or permissions or whatever. It turns out that even trading Bitcoin on the Bitcoin blockchainmight work better with a one-month settlement delay. Again and again, the messy reality of the traditional financial system keeps intruding on the crystalline purity of the blockchain.

Elsewhere, here is a headline saying “Davos: Blockchain can no longer be ignored,” and imagine ignoring blockchain. I am imagining it right now and it is a lovely feeling. I should point out that the World Economic Forum was writing breathless love letters to the blockchain back in 2016; “let’s not ignore blockchain” is among the most Davos-y sentiments I can think of.

And last week Venezuela sort of released the white paper for its cryptocurrency? It is called the “petro,” and we have made fun of it before, but even by the standards of joke-cryptocurrency white papers Venezuela’s is a poor effort. Tonally it is is more of a “manifesto” than a “white paper,” though I suppose that is true of a lot of cryptocurrencies. Monica de Bolle and Martin Chorzempa of the Peterson Institute are unimpressed: “It combines serious misunderstandings with wishful thinking about the benefits of blockchain technology, along with evidence that the government is either trying to fool its populace or that it does not understand the basics of cryptocurrencies, or both.” The U.S. Treasury is also unimpressed: Its sanctions FAQ (item 551) notes that the petro “would appear to be an extension of credit to the Venezuelan government,” and that people who buy it “may be exposed to U.S. sanctions risk.”

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