FinTech@Kellogg
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FinTech@Kellogg

Non-fungible tokens and smart contracts: A new way to settle illiquid securities?

As Bitcoin continues its relentless climb, there has been a renewed focus on cryptocurrencies and the possibilities of blockchain. One of the most hyped technologies of the past ten years, blockchain has failed to live up to its initial promises and many have dismissed it as having no immediate potential especially considering many proposed use-cases seem like solutions in search of problems. In spite of this, there are a few areas of development that are especially promising. One example is recent developments is the use of “non-fungible tokens” and “smart contracts”. I will be exploring in this article how combining these two new developments could potentially make securities settlement quicker and faster.

The “official” NFT logo

Non-fungible refers to the characteristics of the token, with each token being unique and not necessarily interchangeable with other NFTs — this is in contrast to other crypto products like Bitcoin or Ethereum that are fungible in nature and can be exchanged for one another easily. This is important because these NFTs can keep track of a wide variety of features and characteristics that would otherwise be hard to keep track of on a blockchain-based system. So far, the most common use for NFTs is in video games, with the most famous being Cryptokitties, where users can breed and sell digital cats (each cat being represented by its own NFT). Other common uses so far have been for video game skins and collectible meme images and other types of digital art. However, viewing NFTs as only the equivalent of digital baseball cards severely underestimates their potential (imagine if Gutenberg had only used his printing press to print playing cards)! NFTs, because of their ability to encode lots of unique details about themselves on the blockchain, could just as easily represent bond covenants, bank loans, or other types of complex unique securities like structured notes or futures contracts. NFTs can be created through a variety of software programs (e.g. 0xcert or Opensea.io) that allow you to input the details of the NFT and then “mint” it to the blockchain.

Cryptokitties! Cuddly and collectible

However, an NFT by itself is functionally no different from the PDF of a bond covenant — it is only when you combine NFTs with smart contracts that their value becomes apparent.

Smart contracts are self-executing code on a blockchain that automatically implement the terms of an agreement between parties. They are not traditional legal contracts, which require courts or some third party to arbitrate, but rather computer programs that complete tasks on the blockchain using agreed-upon sources of information to confirm the conditions have been met (these sources of information are generally referred to as “oracles”).

One area where these types of smart contracts could be useful is securities settlement. Securities settlement refers to the transfer of ownership of securities in accordance with the terms of an underlying agreement between two parties. Typically, the agreement is either to trade securities, to use securities as collateral for other obligations or to lend securities. Sometimes securities are only needed temporarily and if so, it is often cheaper, quicker and/or less risky to borrow securities from others than to buy them outright. In return, the borrower transfers other securities or cash to the lender as collateral and/or pays a borrowing fee.

Currently, securities settlement, especially for illiquid securities can be a manually intensive process and often requires user intervention. While the settlement of commonly trade securities are generally straightforward and for the most part computerized, for illiquid securities with unique characteristics pricing and transferring them can be difficult and require counter-parties to settle manually — even sometimes by fax! Smart contracts could potentially increase speed and accuracy by requiring less manual intervention approving flows between counterparties and calculating trade settlement amounts using “oracles”, then transferring the securities or funds automatically on predetermined dates or price points.

Turning illiquid securities into tokens could make things easier for beleaguered back-office staff but it is not without its risks. Translating illiquid or complex securities into tokens may remove the risk of manual error but it does introduce new risks into the settlement cycle.

There are two main risks that could arise with the increased use of smart contracts and NFTs and one drawback that may limit their use.

The first is the risk of smart contract contagion. This is the idea that interlocking smart contracts could fail in unforeseen ways, thus triggering a chain reaction in related smart contracts that could cause a financial crisis. (In theory this is similar theoretically to the risks of “flash crashes” that can sometimes occur in financial markets today)

The other main risk is known as “oracle failure”. As discussed, smart contracts only execute when conditions that have been coded into the contract are met, and the way the software determines this is through information sources such as oracles. If oracles were to give inaccurate or incomplete information, then the smart contract could potentially execute even if the conditions of the contract weren’t met in reality. One recent example of this occurred with the decentralized finance protocol Compound, where users lost over $100 million dollars following the failure of an oracle that supplied data to Compound’s smart contracts. One obvious method to mitigate this type of failure would be to rely on a network of oracles for information and reduce the effect that any one single oracle could have — this is the goal of oracle protocols such as Chainlink and Band.

There are also network effect issues that will have to be taken into account — e.g. smart contracts (at least at the moment) only work if counter-parties are willing to invest in such a system. There is also the necessity of deciding on one standard of smart contracts i.e. Ethereum based smart contracts (which so far have been most popular) versus smart contracts running on other standards such as Tezos or Qtum.

This is not what you want… (Flash crash of 2015)

By having an easy way for counter-parties to represent illiquid securities on the blockchain and to allow them to interface with smart contracts, non-fungible tokens represent one way financial companies take blockchain technology from viral hype to real products companies rely on for their day to day business. Securities settlement is currently undergoing a revolution as it becomes increasingly automated — from manual faxes to distributed ledgers and quicker settlement times, the past five years have seen more change than the previous fifteen. While there is no guarantee that smart contracts and NFTs will become a part of the securities settlement infrastructure in the future, there are strong incentives for companies to experiment with this novel technology. “Cryptokitties” may soon find themselves no longer the bigs dogs of the NFT space, instead replaced by less cuddly credit-linked swaps or exotic structured notes.

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