The Decentralized Investment Bank

Disclaimer: I am one of the founders of CoinAlpha, a company that creates blockchain-based financial protocols and products. This is a discussion about a new way to apply blockchain technology, not a solicitation for investment nor investment advice.

Twenty years ago, a tiny startup named Amazon decided to sell books on the Internet. At the time, retail was dominated by companies like Sears, K-mart, and Walmart, each of whom operated an extensive network of brick-and-mortar big-box stores across the US, stocked with millions of items. Confident that their brand, item selection, and physical infrastructure proved an unassailable competitive advantage, the large retailers paid Amazon no heed.

Today, Amazon has a market capitalization of $468 billion, Sears and K-mart are dead, and Walmart had to pay $3.3 billion for an unproven, massively unprofitable startup just to compete with Amazon.

The difference was the internet. With a web-based platform that decreased costs, increased selection and improved convenience, Amazon created a better experience for manufacturers and consumers alike. For large retailers, their physical store infrastructure turned out to be less of a competitive moat and more of an albatross that hampered them from migrating to the internet age.

Similarly, we believe the blockchain will enable a similar revolution in financial services. Just as Amazon shattered the dominance of large retailers with a platform that connected merchants and consumers directly, the blockchain makes possible a network where investors, companies and asset managers can transact directly and bypass the investment banking oligopoly.

At CoinAlpha, we aim to build this network. Below, we explain why it’s necessary and how we prove that it’s possible.

What investment banking really is

First, let’s define investment banking. While firms like Goldman Sachs and JPMorgan have many different lines of business, they essentially fulfill a simple, core function. Investment banks intermediate the flow of capital between capital suppliers and capital utilizers.

Those who supply capital have different criteria for giving up their hard-earned capital. We can classify these criteria along dimensions, such as purpose (hedging vs speculation), duration (long vs short), and risk tolerance (conservative vs aggressive). To accommodate these different criteria, investment banks create securities: legal agreements that govern the use of capital. Securities restrict how capital can and cannot be utilized, as well as how investors will be compensated for the use of their capital.

For example, here are some securities classified by purpose and duration:

• Long-term capital appreciation: stocks, bonds, funds
• Short-term yield with liquidity: Treasury bills, repo agreements
• Hedging: futures, swaps and other derivatives

Generally, investment banks earn fees from creating securities, facilitating their sale to investors, and operating a secondary marketplace afterwards. Since securities underpin the global financial system, these fees are extremely high. Goldman Sachs (with only 7% market share) earned $38 billion in revenues last year, more than Facebook.

Why investment banking is broken

If you asked investment bankers if their industry was facing imminent wholesale disruption, most would probably say no. But large retailers in the late nineties would have said the same thing.

That’s because from the inside, it’s hard to see the two big problems with investment banking, and how the blockchain might solve them:

1. Securities still depend on humans
2. Market participants are forced to trust one another

Securities still depend on humans

Recall that a security is just a legal agreement that governs the use of capital. Agreements such as prospectuses and partnership agreements spell out in painstaking detail all the rules and logic associated with the security, like how the capital can be used, when investors owe or are owed money, and how each payment should be calculated.

But since the financial world no longer runs on paper contracts, the rules and logic contained in these legal agreements must be transcribed into code. Since these agreements may be hundreds of pages long, getting this right is a painful, laborious process. Each major market participant maintains large teams of people called back office whose primary function is to ensure that the capital flows comply with the logic and rules contained in each security’s legal agreements.

Despite the resources poured into getting this right, mistakes abound, from billion-dollar fat finger errors to willful manipulation that goes unnoticed because rules are not properly enforced. Even today, one of the most lucrative strategies for hedge funds and trading desks is identifying mis-priced securities due to calculation errors or payment delays.

Market participants are forced to trust one another

For simple, standardized securities such as stocks and government bonds, trusted intermediaries such as exchanges and clearing houses ensure transaction accuracy and idempotency. Yet for more complex securities such as funds, asset-backed securities, and derivatives, no such trusted infrastructure exists.

Instead, each market participant needs to either build their own back office to verify and process security transactions, or trust the work of others. The large investment banks have invested billions into building the back office teams and systems for many different types of securities, just like how the large retailers built chains of big-box stores that stock many different items. In both finance pre-blockchain and retail pre-Internet, it’s far easier to transact with large players instead of with smaller firms who don’t have their breadth.

Yet despite their massive back offices, even the largest investment bank still needs to trust the work of others. When I worked for Citigroup and JPMorgan in the mid-aughts, I created derivatives backed by hundreds of mortgage-backed securities. Each mortgage-backed security was itself backed by thousands of mortgage loans. It would have been impossible to verify that all of these underlying securities were being accurately represented and processed, so we had to rely on the statements provided by intermediaries such as accountants and auditors.

This reliance on third-party information can have massive negative consequences:

KPMG, along with the other auditors of the Madoff feeder funds, did very little to ensure investors weren’t being ripped off. Observers say it’s likely that all the accounting firms did was check the statements that Madoff himself produced. In the 64-page document [a feeder fund] sent to all its potential investors is the statement “Valuation provided by the counter party affiliate [Madoff] will not be subject to independent review.” — TIME, The Madoff Fraud

Investment banking is broken because there is no single source of truth for securities.

Securities as blockchain-based smart contracts

Due to two recent innovations from the cryptocurrency world, we already have the technology to create a single source of truth for securities. I’ve tried to define them below in layman terms:

• Blockchain: a public database where many different nodes have a copy of it, which allows accuracy to be verified through consensus of all the nodes.
• Smart contract: a computer program stored on a blockchain that holds the rules and logic associated with a transaction.

Recall that securities are simply just legal agreements. For the foreseeable future, this legal backbone remains necessary in order to comply with jurisdiction-specific regulations and to handle scenarios that require qualitative judgment.

But a blockchain-based smart contract is a superior way of encoding the rules and logic for securities. Rather than maintaining redundant back offices that transcribe the words contained in a security’s legal agreements into code or trusting someone else’s numbers, market participants can simply check and verify a single, immutable smart contract.

What the next generation of securities will look like

In the future, we believe that securities will continue to serve their core function: governing the flows of capital between suppliers and utilizers. Yet by using a blockchain-based smart contract as the single source of truth upon which all participants can depend, a security will no longer require intermediaries like an administrator, auditor, and the investment bank’s back office to function properly.

• Transparency: Since the blockchain’s public ledger contains a history of all transactions that can’t be changed, it serves as a replayable audit trail that all market participants agree to and accept. This makes existing third-party verification systems such as accountants and auditors redundant.
• Efficiency: Rather than traditional transfer systems such as ACH and wire transfer that may require confirmation and verification by many different intermediaries, blockchain-based payments are instantaneous, publicly confirmed, and virtually free.
• Accuracy: Calculations codified into a smart contract can be automated and enforce pre-existing requirements. This prevents human errors like overpayments, missed payments, and fat finger mistakes.

I know what you’re thinking. As a blockchain nerd who reads whitepapers and aspirational blog posts in my spare time, I always have the same thought when I read them: “This sounds great in theory, but where’s the substance?”

Proving that it can work

When Martin, Carlo and I started working together to build a decentralized investment bank, we spent a lot of time thinking about where to start. Investment banking is an industry with high barriers to entry and switching costs. Incumbents are averse to change and move slowly, as I found out the hard way when Citigroup was a customer for my last startup.

We wanted to ship a product that offered immediate value, rather than write a whitepaper or launch a mock prototype on testnet. As Mike Tyson famously said, “everyone has a plan until they get punched in the mouth.”

Since all three of us are former startup founders, we know what getting punched feels like. We also know how necessary that feeling is. Until you experience the cold, uncaring gaze of real users upon what you thought was the next iPhone but instead turned out to be the next Zune, you won’t learn how to make your product better.

As a showcase, we decided to build a hedge fund that implements a machine learning-based trend-following strategy on a portfolio of liquid cryptocurrencies. In addition, the fund would use a blockchain-based smart contract to replace the traditional back office and other third-party intermediaries. We chose this direction in order to:

• Solve an immediate need for crypto investors: maintaining long-term upside while minimizing downside volatility
• Demonstrate how the blockchain can eliminate middlemen and provide greater transparency, efficiency and liquidity for investors

In addition, we have open sourced our fund’s smart contracts (see description at our wiki).

What’s Next?

To enable our protocol to assist other fund managers, we have built extensible core components, such as a trade execution layer to intelligently size trades and a web-based portal that facilitates investor onboarding and investment.

Later, we will extend our platform and create other types of blockchain-based securities, like derivatives and asset-backed securities.

Given the structural advantages that blockchain-based securities have over legacy securities, we are confident that the market will eventually adopt them.

When that happens, the legacy infrastructure maintained by today’s leading investment banks will no longer be a competitive advantage, but instead a hindrance to change. Rather than being forced to go through large investment banks, suppliers and utilizers of capital can transact directly by entering into blockchain-based smart contracts.

A platform will still be necessary to match market participants, provide standardized protocols for different types of securities, and facilitate trade execution. However, it will look much more like a technology company than a legacy investment bank.

We call this platform a decentralized investment bank.