Here’s how blockchain and its smart contracts can reduce currency risk
A major purpose of the financial industry is the reduction of investor risk. In order to reduce a financial institution’s risk of losing some or all of their shareholder’s or depositor’s money in an investment, they need to both verify the existing risk and lower it within the means available to their institution.
Very relevant to the international solar market is the risk of negative carry due to inflation or deflation. What the investor most likely cares about in the end is how much money they will receive in a currency which they can use to pay for their living costs and whatever else they want to buy. If someone funds a project in Germany but they live in the US, they’re not interested in how much schnitzel they can buy with the money the borrower is paying back, they may be more interested in how much BBQ they will be able to pay for back in the US. An example of a negative carry would be if an American investor funds a solar install in Bremen and if the EU central bank decides to print 50% more currency than is in circulation and this causes 50% in inflation (a lot of assumptions, I know), then the American investor’s euros will be worth 50% less when they’re paid back and will be 50% less dollars when they’re sent to them after initial repayment if the dollar remained the same.
Traditionally, this risk is managed through contractual methods. Financial institutions will agree with other institutions or within their own organization that another party will take on the risk. Specific methods of handling that risk include forward contracts which are agreements between parties on a certain price for a certain product at a certain time. In the case of the American invested in German solar, his financial institution would have the option of agreeing with another institution to have their newly paid back Euros bought from them in exchange for a certain amount of USD, essentially agreeing to a future exchange rate. The third party is incentivized to take this agreement if they believe the fluctuation in foreign exchange rate Euro/USD will be at least neutral or favorable to them and if the fee they can charge for the contract is at least as valuable as the risk they are taking on.
This is where blockchain technology can come in handy. Instead of the financing contract being ‘uncovered’, as is the term in the traditional financial industry, the contract can have mechanisms coded-in that protect the primary investor from fluctuation in exchange rates. This is especially relevant to blockchain due to the significant fluctuations in cryptocurrency.
Our project may initially require the need to have an agreed upon exchange rate that both parties would be content with during repayment. Smart contracts could also offer a feature where one party, both parties, or both parties and a third party may come to a consensus at a later time in the loan period on an updated exchange. This allows for good faith to be implemented if wanted and immutability of the original agreement to be kept if preferred.
In addition, third parties can also be leveraged in a parallel manner. The assumption is that the implementation and availability of these risk management features will be a competitive trait of this technology. Firms in this field should be looking forward to how they can improve in this area to gain market share away from their competitors.
