Could the Blockchain, the distributed ledger that powers Bitcoin, prevent the next financial meltdown?

First Global Credit, Inc. Chief Executive Officer Gavin Smith believes that it could, and shared his thoughts on a soon-to-be published missive on the subject with SiliconANGLE.

He opens by comparing what happened last time around, as the nominee for Best Picture at the Academy Awards, The Big Short, demonstrated.

“[The Big Short] related the story of the subprime mortgage crisis in the United States, where a series of opaque and illiquid financial instruments were sliced and diced into a series of increasingly complex derivatives, the notional value of which ended up being many times greater than the size of the underlying mortgages,” Smith writes.

“When homeowners, who were the people responsible for paying the underlying mortgages, defaulted on those mortgages, investors in these derivatives (collateralized debt obligations (CDOs), CDOs-squared, synthetic CDOs, credit default swaps, etc.) lost a lot of money. Those who sold these derivatives short (Michael Burry et al) made a lot of money.

“So what could have prevented this? One theory is that had Blockchain-enabled smart contracts been used in the financial system, there would have been fewer opportunities for misbehavior by market participants. Now, this is a fairly bold claim, and a robust analysis of why this might be the case is beyond the scope of this brief article.”

Smith notes that Blockchain-enabled smart contracts offer:

• pieces of computer code, the logic of which replicates the reasoning of contractual clauses, which usually work along the lines of “If I sign a contract with you in which I agree to sell you 10 apples at $1 per apple, and you refuse to pay me, then I have to seek redress through the courts;” a smart contract, on the other hand, could contain code which, should the payment terms not be complied with, would automatically penalize you.
• Smith argues that this kind of self-enforcement reduces transaction costs, and in the example above, the transaction costs include the cost of litigating through civil courts to seek redress and compensation in the event of a contract breach.
• As smart contracts reside on a Blockchain, they would allow a real-time auditing of who owns what side of a given trade.
• Smart contracts would allow for real-time pricing of even illiquid securities, since all of the transactions (including those transactions that create derivatives from underlying assets) would be fully auditable; in this case you would know who owned what tranche of a CDO, who issued which mortgages that made up the AAA, AA, A, etc., tranches of the CDO, and, even, if the system were designed well, which homeowner signed which mortgage documents.

“Perhaps most importantly, since all of this would be software-based, you would have no middlemen (or women) looking to create ever more complex derivatives,” Smith notes.

Gavin Smith

Creating derivatives of derivatives (so-called CDOs-squared or –cubed, etc.) is not a great thing according to Smith, as it makes the financial system more complex and less transparent while only creating more income potential for those in the know.

“Since people aren’t good at policing themselves [and] in the absence of any system which prohibits people from making more money, complexity, opacity, and illiquidity are the result,” he claims.

The problem comes down to the entire layer of derivatives being propped up by the people at the bottom (in this case, mortgage holders) continuing to pay their dues, but originally (as shown in the film) its base failure was the presumption that housing prices would go up forever.

“Borrowers got overextended, lost their jobs, and defaulted on their mortgages. Because those mortgages were then packaged into CDOs, which themselves were packaged into other derivatives, no one knew what anything was worth and banks couldn’t unload their positions in these derivatives very easily,” Smith notes.

Blockchain as a solution

Smith argues that a Blockchain-based smart contract is a possible solution to the problem of misaligned incentives and opaque financial instruments.

“By removing much of the human element, and replacing people with code, we are presented with an opportunity to create a clear, objective framework for the pricing of financial assets and enforcement of contractual obligations,” Smith claims.

“And what if you could use similar technology to preprogram transactions such as the payout of a derivative or other security, all done through a public ledger system such as blockchain without the risk of intervention or the inefficiency created by the involvement of an intermediary counterparty agent?” he muses.

Smith compares such a system to computer programming (SQL in this case), where any contract is a series of IF-THEN-ELSE statements and gives an example of such a statement as “IF payment of 1000 USD in Bitcoin is made to BobbyRick by Term 1’s expiration date, THEN Term 1 is completed AND is recorded as completed in the Blockchain,” followed by “If those clauses are met, then the counterparty’s (walkerdavefun) escrow is released. OTHERWISE, Term 1 FAILED, AND is recorded as failed in the Blockchain. THEN the escrow is released to BobbyRick.”

While some basic knowledge of SQL and logic processing is required to understand that last paragraph, if you do know some it actually makes a lot of sense as it prevents abuse of the system, be it far better than the current system does.

“All of this is obviously much more efficient than standard contract breaches, which, as discussed earlier, need to be remediated through human-controlled and –operated civil or criminal courts,” Smith concludes. “Thus, software-based smart contracts provide a compelling and exciting opportunity for those interested in making a fairer and less opaque financial system.”

All quotes are published with the permission of the author.

Image credit: The Big Short/ Paramount Pictures; First Global Credit