This is part of a blog series Can Blockchain Save Our Financial System?
This blog examines how blockchain can make the financial systems simpler and better by replacing complex derivatives with automated smart contracts.
To read the previous blog post about how Blockchain Technology Can Reshape Economics, click here.
To learn about how Bloxable is building the most advanced debt platform using blockchain and smart contracts, visit us here.
One of the things that makes our traditional financial markets susceptible to crashing is the complexity of the financial system.
Consider the stock markets. A number of illiquid and obscure financial instruments are sliced and repackaged into a series of complex derivatives. The conceptual value of these derivatives ends up being much higher than the size of the mortgages included in the package. A number of banks bet on the value of these securities going higher while other banks make hedge bets on the value of these securities going down.
In case of homeowner defaults, these derivatives would lose value and become worthless. While many of the investors would lose a lot of money, a number of investors who would have made hedge bets on these derivatives would make huge profits.
The system is difficult to understand and cannot be used by ordinary investors which keeps them out. The market is largely controlled by bankers who possess expert knowledge about derivatives.
A Blockchain based financial system would be far better as it would allow greater control to ordinary investors.
Complexity of Derivatives
Some experts believe that if the markets are built on a Blockchain software, it would remove the need for bankers as middlemen. One of these experts is Gavin Smith, CEO of the First Global Credit.
Smith points out some of the practices followed by the traditional banks in the markets. One of these is to create derivatives of derivatives. These instruments are very complex which makes them less transparent than regular security contracts. The only people that actually benefit from these complex instruments are bankers. They are able to increase their income potential while providing no real benefit to their depositors.
People motivated by greed and higher income potential are not very good at policing themselves. When derivatives lead to greater complexity, opacity and illiquidity in the market, the result is always a collapse, somewhere down the road.
Similar problems were seen in 2008 when derivatives were thrown into the market by mortgage holders who stopped paying their dues of monthly payments. Smith argues that even if the borrowers had not defaulted, the market was headed towards a crash.
The derivatives were built on the presumption that house prices would continue to go up forever which was the underlying problem.
The loans were packaged into complex collateralized debt obligations (CDOs). These CDOs were later packaged into other derivatives. No one really knew what anything was actually worth and banks could not unload their positions in the easily.
Blockchain Based Securities
A Blockchainbased financial security would remove much of the human element from the markets. When people are replaced with automatically executed code, we will be able to create an objective and clear platform for pricing of securities and enforcement of contract obligations.
This would offer two benefits. First, it would simplify the contracts and a larger number of people would be able to make sound investment decisions by reviewing contracts.
Second it would allow the contracting parties to preprogram transactions such as the payout of a derivative or other security when a pre-set condition is met. This is achieved through a series of IF-THEN-ELSE statements that execute automatically.
When all of this is done through a publicly accessible ledger it would remove the risk of intervention from an intermediary. This would further increase investor trust on the financial system with the knowledge that they can monitor the transactions at any time.
A Blockchain based financial system offers speed, accessibility, automation, security and simplicity. It would put power of investment back into the hands of individuals and remove the need for third party intermediaries.
It would take time to develop the perfect platform however and we do not expect that people would switch to it overnight. We believe that once this system reaches a certain threshold, we would see much wider adoption by major banks and institutions.
To learn about how Bloxable is building the most advanced debt platform using blockchain and smart contracts, visit us here.
